FHA Loans: What They Are and How They Work

Written by Samantha CatheyUpdated: 28th Dec 2021
Share this article

Disclaimer: This post contains references to products from one or more of our advertisers. We may receive compensation (at no cost to you) when you click on links to those products. Read our Disclaimer Policy for more information.

Part of the proverbial American dream, homeownership is a goal of lots of individuals and families.

Unfortunately, housing just isn’t accessible to many Americans due to credit challenges and steep monetary requirements.

Enter the Federal Housing Administration (FHA) and the various government-backed loans it provides to those dreaming of owning a home.

What Is an FHA Loan?

Insured by the FHA but provided by mortgage lenders with the administration’s approval, FHA loans offer more favorable terms for potential borrowers like lower minimum credit scores and smaller down payments than conventional home loans.

The government isn’t actually loaning out money, but its sponsorship enables more lenient requirements while still protecting lenders like banks and credit unions against loss.

The FHA, which is part of the Department of Housing and Urban Development, or HUD, supports homeownership for first-time, minority, and low- to moderate-income borrowers.

Each year about a third of FHA’s insurance endorsements are for minority homebuyers, and since its inception in 1934, it has insured more than 40 million home loans.

How FHA Loans Work

What’s so appealing about FHA loans is that borrowers can have a credit score as low as 500 and still qualify.

If their score is between 500 and 579, they are required to put at least 10 percent of the home’s purchase price down, but if it’s 580 or above, they need only provide 3.5 percent.

Borrowers are required to purchase mortgage insuranceregardless of their down payment amount, unlike with conventional mortgages that only require private mortgage insurance (PMI) if less than 20 percent is applied.

Despite what it sounds like, these mortgage insurance premiums protect the lender, not the borrower.

There are two types of premiums that are required to accompany FHA loans, but we’ll cover those specifics a little later.

FHA loan applicants are required to have a debt-to-income ratio of no more than 43 percent, though a very select few lenders may allow all the way up to 57 percent.

Someone’s debt-to-income ratio is their monthly debt payments divided by their gross monthly income.

The percentage helps lenders determine how much money applicants can borrow without overextending their finances.

FHA Loan Requirements

FHA loans come with fixed interest rates in either 15- or 30-year terms. The term refers to the length of the mortgage, and a fixed interest rate means exactly what it says—it doesn’t change. To qualify, borrowers must meet this long list of requirements:

  • Have two years of verifiable employment history
  • Have proof of income through tax returns, pay stubs, and bank statements
  • Be financing a primary residence (sorry, no second homes on the beach or investment properties)
  • Make certain the property is appraised by someone FHA-approved who meets HUD guidelines
  • Have a front-end debt ratio (monthly mortgage payments and fees) of no more than 31 percent of gross monthly income
  • Have a back-end debt ratio (mortgage payments plus all other monthly debts) of no more than 43 percent of gross monthly income

Additionally, individuals cannot apply for an FHA loan for one to two years after bankruptcy, or three years after foreclosure, though some exceptions can be made.

FHA Loan Down Payments

A down paymentis the initial up-front payment for the purchase of a house or other expensive item. The dollar figure of it is linked directly to a borrower’s credit score.

The lower the credit score, the higher the down payment required. Remember, individuals with a FICO score of at least 580 can put as little as 3.5 percent down. Those with scores between 500 and 579 are required to apply 10 percent.

NOTE: Some first-time home buyers are fortunate enough to receive monetary help from parents or grandparents for a down payment. Any such gifts must be well-documented to be accepted with FHA loans to make sure it’s not a loan in disguise.

FHA Mortgage Insurance

Insurance safeguards the FHA lender against loss if a borrower defaults on their mortgage. With FHA mortgages, insurance premiums are paid for the life of the loan unless the down payment is 10 percent or more, in which case premiums fall off after 11 years.

There are two types of insurance premiums built into all FHA loans:

  • Upfront mortgage insurance premiums are 1.75 percent of the loan amount but can be incorporated into the full financed mortgage. This is paid when the borrower gets their loan proceeds.
  • Annual mortgage insurance premiums are anywhere from .45 percent to 1.05 percent, depending on the loan term, loan amount, and initial loan-to-value ratio, or LTV. This ratio is used by lenders to determine how much risk they are assuming. This annual premium is paid monthly.

FHA Interest Rates

The interest rate a borrower is offered is based on their income, credit score, and down payment amount.

The lower the credit score and down payment, the higher the interest rate. It is also tied to prevailing interest rates, or the average interest rate in the economy, which originates from the federal funds rate.

The annual percentage rate, or more affectionately well-known as APR, illustrates a loan’s actual yearly cost by including fees such as mortgage insurance, closing costs, and loan origination charges.

So, while the interest rates for FHA loans are typically below-market, the APR is higher than that on a conventional loan because FHA rates include fees, whereas conventional loans assume 20 percent down and therefore no private mortgage insurance.

FHA Income Requirements

The FHA and its approved lenders do not require applicants to make a certain income. There is no minimum nor a maximum cap on someone’s salary, but individuals must provide documents to prove their income is stable.

They are asked to hand over pay stubs, W-2s, federal tax returns, and bank statements, in addition to other documents the lender may request.

FHA Loans and Credit Score

Loan applicants can have a credit score as low as 500, but HUD prohibits applicants from being denied based solely on a lack of credit history. So, even with zero credit, people are encouraged to apply.

Keep in mind these are guidelines from the FHA, and individual lenders can require a higher score. Applicants can boost their chances of approval by finding someone who specializes in FHA loans and offers manual underwriting.

FHA Loan Limits

Updated each year based on the country’s home price movements, loan limits have a “ceiling” and a “floor” that the FHA will insure.

This year, the floor limit for single-family home loans in the majority of the country is $356,362, up from $331,760 in 2020.

For high-cost regions, like large metropolitan areas, the ceiling is $822,375, an increase of nearly $60,000 from last year.

High construction costs in “special exception” regions like Hawaii and Alaska further push up the allowed limit. Limits are based on county property values.

Curious what they are in your location? Check out the FHA Mortgage Limits page.

What Are the Types of FHA Loans?

The most basic FHA mortgage is the 203(b) loan, used for most homes as long as they do not require more than $5,000 in immediate repairs.

In addition to these 15- and 30-year loans, the FHA insures other types, some of which have very specific tailored use. Here are a few:

  • 203(k) Rehab Mortgage: A fixer-upper loan, the 203(k) rehab is designed for acquisition and rehabilitation. No more than $35,000 is allowed to be rolled into the purchase or refinance price. Repairs must conclude within six months by a qualified professional. Eligible home renovations may include: replacing dangerous flooring, roofing, or plumbing, adding accessibility improvements for disabled people living in the home, or making structural repairs. In some cases, borrowers may also “modernize” the home by adding central air, for example. There are standard and limited loans, each with higher and lower loan limits, respectively.
  • Construction Loan: These loans finance the land purchase and subsequent construction of the home. Applicants need a higher down payment, and it’s usually more difficult to qualify.
  • Title 1 Property Improvement Loan: This is a fixed-rate loan used for home improvements from appliance upgrades to accessibility renovations to energy-efficient enhancements. To boost a home’s functionality with this loan, there are no minimum credit score or income requirements, but loan limits and terms vary depending on the type of structure.
  • Energy Efficient Mortgage: These loans finance energy-efficient upgrades like wind or solar energy systems or new insulation to ultimately curb the cost of utility bills. Projects must be professionally assessed to qualify.
  • 245(a) Loan: Also known as the “graduated payment mortgage,” this FHA loan caters to borrowers whose incomes will increase over time. Payments start small then gradually increase.

How to Apply for an FHA Loan

National banks, credit unions, community banks, and independent mortgage lenders all can facilitate FHA loans. Yet, the same loan can have different costs and underwriting standards between lenders.

It may seem obvious, but the applicant’s first step is to know their budget inside and out. There are a ton of mortgage calculators online to help buyers estimate monthly payments based on different down payments and home prices.

Families need to consider income, expenses, and savings. After that, it’s time to gather all the necessary documents.

People need two recent paystubs, two years of tax returns, and bank and investment statements for an FHA loan.

This will get them ready for preapproval or prequalification, which jump-starts the mortgage underwriting process and lets sellers know buyers are serious about purchasing.

Regardless of the home loan he or she is trying to acquire, applying for a preapproval from multiple lenders is the first step. Applicants can expect this process to take 30 to 45 days.

NOTE: During the coronavirus pandemic, some FHA mortgage lenders have been substantially raising their FICO credit score requirements, even though official minimums have remained unchanged.

What Are the Pros and Cons of FHA Loans?

Pros:

  • Great for first-time homebuyers, including those who have not owned for at least three years.
  • Lower credit score and down payment requirements than conventional loans.
  • Bankruptcy or foreclosure are not necessarily roadblocks to homeownership. Many people still qualify for FHA loans after experiencing financial hardship. It all depends on the lender.
  • Down payments can be 100 percent gift funds. Very few loans allow the entire down payment to come in the form of a gift. Relatives, charitable groups, government homebuyer or state housing assistance programs, or even employers are all eligible to give.
  • Sellers are allowed to pay up to 6 percent of the loan’s closing costs. Most conventional loans cap seller’s contributions to 3 percent of closing costs.

Cons:

  • Mortgage insurance cannot be avoided. Borrowers with less than 10 percent must pay the annual premiums for the full life of the loan, whereas with conventional loans once he or she has built up 20 percent of equity they no longer have to pay private mortgage insurance. In an FHA loan, there is a risk people will pay more later for providing a small down payment now.
  • There are loan limits and property requirements. Borrowers’ loans cannot exceed certain amounts, which vary based on location, and only certain types of homes qualify.
  • Homeowners could inadvertently actually pay more! Interest rates on FHA loans are low, but the APR can sometimes be higher than conventional loans. Remember, the APR illustrates the total cost of borrowing, not just interest and principal.

FHA and Conventional Loan Differences

Conventional loanshave higher requirements than FHA loans. Borrowers need a minimum credit score of 620.

When scores surpass 720, individuals should opt into a conventional loan over an FHA to pay less monthly.

Aspiring homeowners who can afford a large down payment are likely better off choosing a conventional loan. In addition, FHA appraisals are more stringent.

Differences Between FHA and Conventional Loans

>> More: FHA vs. Conventional Loans

What Are Some FHA Loan Alternatives?

Buying a home is arguably the largest purchase most Americans will ever make. In addition to FHA loans, here are the top three other options.

Each has its own qualifications plus advantages and disadvantages. Qualifying for a conventional loan will be a little more difficult, but it will present fewer barriers than securing an FHA or VA mortgage.

  • VA Loans: Active duty and retired military veterans and their families are eligible for these coveted loans. As long a primary residence is being financed, no minimum down payment is required, though the full loan amount is not guaranteed. Insured by the Department of Veteran Affairs, these loans also don’t require a minimum credit score. Review our list of the Best VA Mortgage Lenders.
  • Conventional Loans: These interest rates are usually higher than FHA rates, but the overall borrowing costs tend to be lower. A higher credit score and larger down payment is required, and lenders likely won’t accept debt-to-income ratios nearing 50. Private mortgage insurance on conventional loans is required when the borrower has less than 20 percent down.
  • USDA Loans: The primary USDA loan eligibility requirement is purchasing a home in a qualified non-urban area since these mortgages were created to stimulate the economies of rural America. There is no loan limit like with FHAs, but there are strict rules concerning income levels. If an applicant’s income exceeds 115 percent of the median income for the area, they are ineligible. Credit scores must be at least 640, but lower scores may still qualify with a lengthy manual underwriting process.
FHA Loan Requirements

Is It Hard to Get an FHA Loan?

Plenty of online mortgage lenders, banks, and credit unions of all sizes are FHA-approved. So as long as an individual qualifies, he or she can apply again and again until their loan is approved.

Since the eligibility requirements of FHA loans are more relaxed, they are easier to secure, but the underwriting process does take more time.

What Types of Homes Meet FHA Requirements?

Eligible homes include single-family homes, some condominiums, and certain mobile and manufactured homes.

Two- to four-unit multifamily homes are accepted if one of the units is the primary residence. All dwellings are subject to FHA appraisal.

What Disqualifies a House from FHA?

High-end homes often don’t qualify for approval since they are likely priced over FHA loan limits.

Additionally, a home in very poor condition may not be approved unless certain deficiencies are improved upon. A condo doesn’t qualify unless it is in a HUD-approved complex.

Bottom Line: What Is an FHA Loan?

FHA loans give more Americans the opportunity for homeownership, like buyers with smaller down payments and refinancers with little equity.

Attaining the magic 620 credit score for a conventional home loan takes time and diligence. Borrowers shouldn’t let a low credit score ruin their dreams of homeownership.

Samantha Cathey
Samantha Cathey

Samantha Cathey is a Senior Personal Finance Writer & Product Analyst with years of financial training and industry knowledge. She is a former banker, loan officer and investment advisor before dedicating her energy to helping individuals more creatively, through her writing. Samantha studied at the University of Idaho where she majored in Journalism and Writing. Her areas of expertise are mortgages, credit cards, loans, and investing.