Understanding FHA Loans: Complete Guide & Sources
An FHA loan is a type of mortgage insured by the Federal Housing Administration (FHA) that often comes with benefits that make the home buying process easier for first-time homeowners.
An FHA loan is a mortgage insured by the Federal Housing Administration (FHA). These mortgages originate from private lenders but are insured by FHA and adhere to the agency’s guidelines and policies.
This insurance allows banks to offer loans with fewer restrictions than conventional loans, including a minimum down payment of 3.5% or a minimum credit score of 500.
Find out how FHA loans work, what FHA loan requirements are and how to apply for an FHA loan.
An FHA loan is a government-insured mortgage offered by private lenders who work with the Federal Housing Administration.
To qualify for an FHA loan, you must meet requirements like having a minimum FICO score of 500, a maximum debt-to-income ratio of 56.9% and a minimum down payment of 3.5%.
Meeting FHA’s minimum guidelines won’t guarantee approval, but the lower thresholds make FHA loans easier to get for the average homebuyer.
What Are FHA Loans?
An FHA loan is a mortgage offered by private lenders but regulated and insured by the Federal Housing Administration (FHA). Requirements for FHA loans are more relaxed, like down payments as low as 3.5%, credit score requirements lower than conventional loans and a higher loan amount, depending on your location.
Compared to traditional loans, FHA loans have more relaxed requirements, making them a popular option for first-time homebuyers. FHA loan borrowers have a choice between a 15- and 30-year term with fixed interest rates and a maximum loan amount that varies based on their state and county.
While FHA loans have many benefits that make them more accessible, FHA’s guidelines require you to carry mortgage insurance. Mortgage insurance protects the lender’s financial interest in case you default.
How Does an FHA Loan Work?
The U.S. Department of Housing and Urban Development (HUD) Federal Housing Authority administers FHA mortgages. FHA does not lend money to homebuyers. Instead, it insures loans made by private, FHA-approved lenders.
Borrowers apply for FHA home loans with lenders like banks, credit unions and mortgage companies. The lenders underwrite the loans based on FHA guidelines and their own policies. If approved, the loans are funded by the lender and insured by FHA.
The homebuyer pays for FHA mortgage insurance. With the mortgage insured against default, the lender‘s risk of losses is reduced significantly. Therefore, the lender can approve mortgages for homebuyers with smaller down payments.
Trying to decide between an FHA and a conventional (non-government) home loan? Run the numbers with MoneyGeek’s FHA vs. Conventional Loan Calculator.
What Are the Types of FHA Loans?
Aside from FHA loans, which are mortgages, the FHA offers different types of home loans.
FHA 203(k) Loans
A 203(k) home loan factors in the cost to purchase the home and the cost of any repairs or renovations it needs. The loan eliminates the need for a loan in addition to the mortgage to pay for renovations and provides a single, long-term option that covers both needs. A 203(k) loan will cover various rehabilitation costs, including structural alterations or reconstruction, major landscape work, accessibility improvements and energy conservation improvements. However, luxury additions like swimming pools and tennis courts would not be covered.
The eligibility requirements for a 203(k) loan are similar to those for an FHA loan, making it great for first-time homebuyers who want to buy an affordable property that needs a bit of work.
Home Equity Conversion Mortgage (HECM)
A Home Equity Conversion Mortgage (HECM) is for seniors who already have a home with a significant amount of equity. The HECM is a reverse mortgage that lets you convert your home’s equity to cash. To be eligible for a HECM, you must be at least 62 years old and live in the property you are borrowing against. You must also demonstrate the financial capability to repay the loan while still making timely payments on any property charges.
Not all homes can be borrowed against. To qualify for a HECM, your home must be a single-family or two- to four-unit home with one unit occupied by the borrower, a HUD- or FHA-approved condo or a manufactured home that meets FHA’s eligibility requirements.
Section 245(a) Loan
A Section 245(a) is a home loan known as a graduated-payment mortgage (GPM). It is a type of loan for borrowers who expect an increase in income over the years. With an FHA 245(a) loan, monthly payments start low and gradually increase over time.
This allows low-income individuals to buy homes earlier and pay off their mortgages sooner than conventional loans by anticipating income increases. To qualify for a Section 245(a) loan, you must first meet the standard FHA loan eligibility requirements.
Energy Efficient Mortgage (EEM)
FHA’s Energy Efficient Mortgage allows aspiring homeowners to make energy conservation improvements. It’s similar to a 203(k) but only focuses on renovations or improvements that can help reduce energy bills. For instance, homeowners will be allowed to add solar or wind energy systems to their homes. The requirements for an EEM are similar to a 203(k) loan.
Pros & Cons of FHA Loans
FHA loans have a lot of benefits, but they may not be the best option for every borrower. Explore the different pros and cons of FHA loans below.
Benefits of FHA Loans
- Low Minimum Down Payment. A down payment is the largest obstacle to homeownership for many would-be buyers. FHA's minimum down payment is 3.5%. The money can come from the borrower's funds, a gift or a loan from an acceptable source.
- Low Minimum Credit Score. FHA minimum credit scores are low: 580 for a loan with a 3.5% down payment and 500 with 10% down. This allows underwriters to approve mortgages to applicants whose credit has been damaged by circumstances beyond their control, applicants with low scores who have successfully re-established credit or prospective homebuyers with low scores but good credit histories.
- Underwriting Flexibility. FHA guidelines are more forgiving of credit mishaps than most other programs. Underwriters are instructed to distinguish between applicants who habitually misuse credit and those with valid reasons for their lapses. Consumers with past bad credit who have established good payment patterns are normally treated more leniently. In addition, FHA guidelines allow higher debt-to-income ratios (expenses divided by gross income) than most conventional programs.
- Streamline Refinance. FHA's streamlined refinance program allows homeowners to easily refinance their mortgage to a home loan with better terms. Lenders are not required to verify the borrower's income or employment, no appraisal is necessary, and there is no minimum credit score to qualify. This allows homeowners whose property values, incomes or credit scores have dropped to improve their financial positions by refinancing.
- Chapter 13 Bankruptcy. Most mortgage programs require borrowers to wait several years after a bankruptcy discharge before they are eligible for financing. That makes sense for those who wipe out their debts with a Chapter 7 filing. However, those in Chapter 13 bankruptcy spend up to five years in their plans repaying their creditors before they receive a discharge. The FHA recognizes the difference and allows applicants in Chapter 13 to be eligible for financing after making 12 on-time monthly payments to the plan, as long as their bankruptcy trustee approves it.
- Chapter 7 Bankruptcy. With many mortgage programs, applicants must wait four years (two if there are extenuating circumstances) after discharging a Chapter 7 or 11 bankruptcy before they are eligible for home financing. With FHA mortgages, the waiting period is cut in half for most applicants and to just one year if there are documented extenuating circumstances (for example, the death of a wage earner or an employer going out of business) and applicants have re-established good credit history.
- Assumable. A homeowner who sells a property they bought with an FHA loan can allow the buyer to take over the mortgage. This move can eliminate thousands in closing costs for the buyer. This can be a powerful advantage for the seller when the interest rate on the FHA loan is lower than the seller would pay on a new mortgage. For the buyer, an assumable loan can translate into a higher selling price or swifter sale.
FHA loan limits vary by county. To find out your limits, visit the Department of Housing and Urban Development (HUD)’s website and use their FHA Mortgage Limits tool. This allows you to check what the limits are in each county. Simply input your state, county and county code, select “FHA Forward,” and leave all other forms blank. Once you hit “Send,” the details under “One-Family” show the limits in your county.
Drawbacks of FHA Loans
- Mortgage Insurance Costs. FHA mortgage insurance premiums (MIP) are on the high side. FHA borrowers pay an upfront fee of 1.75% of the loan amount, which can be paid in cash or added to the mortgage. They also pay an annual premium, which is added to their monthly payments. For most, that is 0.85% of the outstanding mortgage balance. Unlike mortgage insurance for conventional loans, FHA MIP lasts for the life of the loan.
- Loan Limits. FHA loans were created to make homeownership accessible to people of modest means, not to help the rich buy mansions. For this reason, HUD limits the size of the loans it insures. FHA mortgage limits for specific counties can be found on this FHA Loan Limits page.
- More Paperwork. Compared to conventional loans, FHA borrowers must sign a few extra forms, many of which protect the borrower. This adds several minutes to the application process, but the protections associated with some disclosures are probably worth it. For example, the FHA Amendatory Clause changes the purchase contract to allow the buyer to cancel a home purchase if the property does not appraise for at least the sales price.
- FHA Appraisal. FHA's appraisal includes common items a home inspector might look for. FHA-financed homes must meet minimum safety and livability standards to qualify for financing. This means that not all home appraisers are qualified to perform FHA appraisals, and FHA appraisals usually cost a little more. FHA carefully discloses that its appraisal does not replace a home inspection.
- Harder for Condos. Not all condominiums can be financed with FHA home loans. In fact, most condominium projects are not FHA-approved. The homeowners' association (HOA) or board must submit an extensive application package to HUD to secure approval. However, FHA will approve a single, qualifying unit in a non-approved development if no more than 10% of the project is financed with FHA home loans.
- CAIVRS. The Credit Alert Interactive Voice Response System, or CAIVRS, is a federal database all lenders must check before approving government-backed loans. It tracks people who owe the government money, have incurred federal liens or judgments or have defaulted on government-backed loans. CAIVRS is not an issue for most borrowers. However, if you turn up on CAIVRS, you’re ineligible for FHA financing. You must enter into a repayment plan or have the reporting agency delete the listing before you can borrow a government-backed loan.
Regardless of whether you intend to get an FHA loan, it’s wise to improve your credit score. A high credit score will allow you to get more competitive rates from private lenders, some of which may be better than what an FHA loan offers.
How to Qualify for an FHA Loan
Many would-be borrowers are tripped up by the difference between FHA’s official guidelines and the real-world requirements of mortgage lenders. Here are the most liberal FHA guidelines:
- Minimum FICO score of 500.
- Maximum debt-to-income ratio of 56.9%.
- Minimum down payment of 3.5%.
Can you get FHA loan approval with these qualifications? Not really. It’s very difficult to obtain an FHA home loan with a low FICO score, small down payment and a high DTI.
First, FHA guidelines require that if a borrower's FICO score is between 500 and 579, the minimum down payment increases to 10%. Moreover, when the Urban Institute tracked mortgage approval rates in 2017 for so-called low-credit-profile applications — those with FICO scores of around 580, a down payment of 3.5%–5% and a DTI ratio of over 50% — it found that over 30% of these applications were denied.
It’s good to understand that while borrowers with low credit scores may be approved under FHA guidelines, bad credit presents a barrier to getting a loan approved. FHA requires borrowers to have a good payment history for at least 12 months and directs underwriters as follows:
"The Mortgagee must analyze the Borrower’s delinquent accounts to determine whether late payments were based on a disregard for financial obligations; an inability to manage debt; or extenuating circumstances."
If it appears that you are not managing your debt correctly and making your payments as agreed, you won’t be approved for an FHA loan. It won’t matter if your credit score exceeds the minimum.
To find the best FHA mortgage lender for your needs, follow the tips below:
- Compare lenders: It’s smart when looking for a lender to shop around. Each lender has its own FHA loan rates and fees, so comparing them can help you save.
- Check the lender’s reputation: The terms for a mortgage often last a long time, starting at 15 years. Make sure you choose a lender with a good reputation and great customer service, as you’ll want to ensure that your experience while paying for the mortgage is as smooth as possible.
- Understand all the details: To find the best FHA lender, get a clear estimate of your APR and ask your loan officer questions about how many loans they have closed and their lending process.
Alternatives to FHA Mortgages
While FHA loans are great options for first-time homebuyers, they aren’t the only ones. Explore other options to finance your home below.
Conventional Loans With 3% Down
Both Fannie Mae and Freddie Mac offer 97% mortgages to eligible first-time homebuyers. Like FHA mortgages, these loans offer flexible underwriting guidelines. However, they have a few advantages over FHA loans: The down payment is just 3%. There is no upfront mortgage insurance, and the annual premiums are lower. Borrowers can request mortgage insurance cancellation when the loan balance drops to 80% of the original home value.
Some home sellers are willing to finance their properties. Through this option, the buyer may avoid FHA loan fees and other home-buying costs like title insurance. Sellers may be more willing than mortgage lenders to overlook credit or income issues.
However, buyers of owner-financed homes should consider having an appraisal done to avoid overpaying for the property. Inspections and title insurance are still good for the buyer's protection, and it's wise to hire a real estate lawyer to review the loan terms. Individual sellers don't have to play by the same rules as licensed mortgage lenders, meaning borrowers have fewer protections.
USDA and VA Home Loans
FHA is not the only government mortgage program. VA and U.S. Dept. of Agriculture (USDA) home loans offer many advantages over FHA loans for eligible individuals. The U.S. Department of Veterans Affairs insures mortgages for eligible service members, veterans and some family members.
These loans don't have down payment requirements, and borrowers don't have to pay monthly mortgage insurance. USDA loans allow qualified borrowers to get a mortgage without a down payment when buying a home in an eligible area and are often provided in rural areas. About half of all U.S. citizens live in neighborhoods eligible for USDA loans. USDA mortgages have funding fees (2%), which can be financed, and require annual mortgage insurance, but the premiums are lower than FHA insurance.
FHA Information and Sources: Helpful Links
FHA mortgages include more than just one product. You can find loans to buy and rehabilitate fixer-upper properties, loans to increase the energy efficiency of your home and loans to refinance a home, with or without an appraisal. Follow the links below for more information:
- FHA Loan Requirements. FHA purchase loan requirements include satisfactory credit (minimum credit score of 580 for 96.5% loans), stable, sufficient income and a down payment of at least 3.5% of the home's purchase price. These are the FHA's requirements. Some lenders also add their own guidelines to the FHA loans they issue and may have higher minimum credit score requirements.
- FHA Approved Lenders. Not all mortgage lenders are approved to underwrite or fund FHA home loans. Borrowers who want an FHA mortgage need to work with an FHA-approved lender. These lenders may display an FHA seal on their premises and on advertising. This seal indicates the FHA will approve their compliant loans.
- FHA Mortgage Insurance. FHA mortgage insurance comes in two parts: an upfront premium, which can be paid out of pocket or financed, and an annual premium divided by 12 and added to each mortgage payment.
- FHA Refinance. Homeowners with conventional, VA, USDA or FHA home loans can refinance with FHA mortgages. The FHA-to-FHA refinance is called an FHA Streamline refinance. Homeowners who qualify to refinance with conventional financing should compare the costs before choosing an FHA loan.
- FHA 203(k) Rehab Loans. FHA renovation loans (203(k) rehabilitation loans) can be used to build or rehabilitate homes. These loans can be used for purchasing or refinancing a home or property. Property owners with little or no home equity may be able to secure approval based on what the property is expected to be worth after renovation or construction.
- CAIVRS. CAIVRS is a federal database that tracks consumers who have defaulted on government debt. FHA loan applicants who are listed on CAIVRS are not eligible for FHA (or any other government-backed) home loans.
- How to Apply for an FHA Loan. FHA loan applicants need their bank, retirement and investment account statements, two pay stubs and W-2s for the last two years (if wage earners) or tax returns (if self-employed or commissioned employees). Their lender will help them complete a loan application and will pull their credit reports.
- FHA Loan Limits. FHA loan limits range in 2022 from $420,680 to $970,800 for single-family homes (higher for two- to four-unit properties), depending on the property location. Areas with higher housing costs have higher FHA limits, while those with lower costs have lower limits.
- FHA-Approved Condos. Only units in condominium projects approved by FHA can be financed with FHA home loans.
- FHA Mortgage Rates. The government does not set FHA mortgage rates. Private lenders approve and fund the loans and set interest rates and terms. It's up to FHA borrowers to compare offers from competing FHA lenders to find the best deal.
- Energy Efficient Mortgage (EEM). The EEM allows homebuyers and homeowners to improve the energy efficiency of their homes. The EEM can also be added to other FHA loans like the 203(b) renovation loan. To qualify for financing, the proposed improvements must be cost-effective; the savings must eventually offset the costs.
Frequently Asked Questions About FHA Loans
To help you figure out which financing method is best for your future home, MoneyGeek answered a few commonly asked questions about FHA loans below.
About the Author
- U.S. Department of Housing and Urban Development. "203(k) Rehab Mortgage Insurance." Accessed June 24, 2020.
- U.S. Department of Housing and Urban Development. "Energy Efficient Mortgage Program." Accessed June 28, 2022.
- U.S. Department of Housing and Urban Development. "FHA Mortgage Limits." Accessed June 28, 2022.
- Benefits.gov. "Home Equity Conversion Mortgages (HECM)." Accessed June 28, 2022.
- U.S. Department of Housing and Urban Development. "FHA's Office of Single Family Housing Training Module." Accessed July 19, 2022.
- U.S. Department of Housing and Urban Development. "Maximum Mortgage Limits: 2022." Accessed July 19, 2022.
- U.S. Department of Housing and Urban Development. "Handbook 4000.1, FHA Single Family Housing Policy Handbook." Accessed July 20, 2022.
- The Urban Institute. "Real Denial Rates: A Better Way to Look at Who Is Receiving Mortgage Credit." Accessed July 20, 2022.