FHA Loan Basics
Pros and Cons of Borrowing With FHA Financing
FHA loans bring home ownership into reach for buyers who might have a hard time getting approved with conventional lenders. These loans are not right for everybody, but they have several appealing features:
- Make a down payment as small as 3.5 percent.
- Get approved to borrow with thin credit or problems in your credit history.
- Buy single-family homes, condos, multi-unit properties, and manufactured homes with FHA backing.
- Get extra funding (above and beyond your purchase loan) for renovations and repairs with the FHA 203k program.
- Fund your down payment with gift money or help from the seller.
We’ll cover all of the details below. To get an FHA loan, speak with a local or online lender and ask about FHA programs.
What Is an FHA Loan?
An FHA loan is a home loan that the U.S. Federal Housing Administration (FHA) guarantees. Private lenders like banks and credit unions issue the loans, and the FHA provides backing: If you don’t repay your loan, the FHA will pay the lender instead.
Because of that guarantee, lenders are willing to make substantial mortgage loans in cases when they’d otherwise be unwilling to approve loan applications.
Created in 1934 during the Great Depression, the FHA is a government agency that provides mortgage insurance to lenders. Before the FHA came into being, housing markets were struggling. Only four in ten households owned homes, and loans were a burden for buyers. For example, borrowers could only finance roughly half of a home’s purchase price (as opposed to putting 3.5 percent down), and loans typically required a balloon payment after three to five years.
The FHA has insured over 47.5 million loans over its lifetime, and it is the largest insurer of mortgages globally.
Currently, the agency insures 7.95 million single-family homes and over 14,000 multifamily properties. In part, this program helped move homeownership rates in the U.S. to a high of 69.2 percent just before the 2008 mortgage crisis, although that rate has dropped slightly as housing markets recover.
Benefits of FHA Loans
FHA loans aren’t perfect for everybody, but they are an excellent fit in some situations. The main appeal is that they make it easy to buy property. But remember that these benefits always come with tradeoffs. The most attractive features include:
Small down payment: FHA loans allow you to buy a home with a down payment as low as 3.5 percent. Other (conventional) loan programs may require a larger down payment, or they require high credit scores and high incomes to get approved with a small down payment.
If you have more than 3.5 percent available, you might be better off making a more substantial down payment. Doing so gives you more borrowing options, and you’ll save money on interest costs over the life of your loan.
Other peoples’ money: It’s easier to use gifts for your down payment and closing costs with FHA financing.
Also, sellers can pay up to 6 percent of the loan amount toward a buyer’s closing costs. You’re most likely to benefit from that in a buyer’s market, but even in strong markets, you can potentially adjust your offer price enough to entice sellers.
Assumable loans: A buyer can “take over” your FHA loan if it’s assumable. They pick up where you left off, benefiting from lower interest costs (because you’ve already gone through the highest-interest years, which you can see with an amortization table). Depending on whether or not rates change by the time you sell, the buyer might also enjoy a low interest rate that’s unavailable in the current environment.
A chance to reset: With a recent bankruptcy or foreclosure in your history, FHA loans make it easier to get approved. Two or three years after financial hardship is typically enough to qualify for financing.
Home improvement and repairs: Certain FHA loans can be used to pay for home improvement (through FHA 203k programs). If you’re buying property that needs upgrades, those programs make it easier to fund your purchase and improvements with just one loan.
How Do You Qualify for an FHA Loan?
When compared to conventional loans, FHA loans are typically easier to qualify for.
The FHA makes homeownership accessible to people of all income levels. With the government guaranteeing the loan, lenders are more willing to approve applications.
Check with several lenders: Lenders can (and do) set standards that are stricter than minimum FHA requirements. If you’re having trouble with one FHA-approved lender, you might have better luck with a different one. It’s always wise to shop around.
Income limits: No minimum income is required. You just need enough income to demonstrate that you can repay the loan (see below), but FHA loans are geared toward lower-income borrowers. If you have a high income, you aren’t disqualified, as you might be with certain first-time home buyer programs.
Debt to income ratios: To qualify for an FHA loan, you need reasonable debt-to-income ratios. The amount you spend on monthly loan payments should be relatively low, compared to your monthly income. Typically, it’s best to be lower than 31/43. But in some cases, it’s possible to get approved with D/I ratios closer to 50 percent.
Example: Assume you earn $3,500 per month.
- To meet standard requirements, it is best to keep your monthly housing payments below $1,225 (because $1,225 is 31 percent of $3,500).
- If you have other debts (such as credit card debt), all of your monthly payments combined should be less than $1,505.
Credit scores: Borrowers with low credit scores are more likely to get approved for FHA loans. If you want to make a 3.5 percent down payment, your score can be as low as 580. If you’re willing to make a bigger down payment, your score can potentially be lower still (a 10 percent down payment is typical for FICO scores between 500 and 580).
Again, lenders can set limits that are more restrictive than FHA requirements. If you have low scores (or no credit history at all), you may need to find a lender that does manual underwriting. That process lets lenders evaluate your creditworthiness by looking at “alternative” credit information, including on-time rent and utility payments.
Loan amount: The FHA limits how much you can borrow. In general, you’re limited to modest loan amounts relative to home prices in your area. Visit HUD’s Website to find local maximums. If you need more money, consider jumbo loans, but be aware that you need strong credit and income to qualify.
Worth a try: Even if you think you won’t get approved, talk with an FHA-approved lender to find out for sure. When you don’t meet standard approval criteria, compensating factors—like a large down payment that offsets your credit history—can help you qualify.
How Do FHA Loans Work?
Private lenders issue FHA loans and the FHA provides the lender with a guarantee to reduce the lender’s risk. To get a loan, start with a local loan originator, online mortgage broker, or loan officer at your financial institution. Discuss your options, including FHA loans and alternatives, and decide on the right program for your needs.
Mortgage insurance: The FHA promises to repay lenders if a borrower defaults on an FHA loan. To fund that obligation, the FHA charges borrowers (that’s you) a fee.
- Home buyers who use FHA loans pay an upfront mortgage insurance premium (MIP) of 1.75 percent.
- Borrowers also pay a modest ongoing fee with each monthly payment, which depends on the risk the FHA takes with your loan. Shorter-term loans, smaller balances, and larger down payments result in lower monthly insurance costs. Those charges range from 0.45 percent to 1.05 percent annually. Most borrowers with a small down payment and 30-year loan pay 0.85 percent (or 85 basis points).
FHA loans are available for multiple types of properties. In addition to standard single-family homes, you can buy duplexes, manufactured homes, and other types of properties.
To avoid paying the highest premiums, choose a loan that lasts 15 years or less, and put down at least 5 percent.
Trump era insurance costs: Insurance costs change over time, and they were set to move lower than they are today. The Obama administration paved the way for a 0.25 percent reduction in annual insurance premiums effective January 27, 2017. Homeowners using the popular 30-year loans with a low down payment would have paid as little as 0.60 percent annually, saving them roughly $500 per year. However, the Trump administration announced a reversal of those rate cuts on President Trump’s first day in office.
In addition to higher costs for borrowers with limited resources, that executive order disrupted closings scheduled to take place shortly after the planned rate cut.
How FHA Loans Compare: Rates and Terms
While FHA loans come with appealing features, it’s still worth comparing them to conventional loans
Mortgage insurance: With FHA loans, the upfront mortgage insurance premium may increase your loan balance, and monthly FHA premiums can cost more than private mortgage insurance would cost. What’s more, in many cases, it’s impossible to cancel mortgage insurance on FHA loans. But it’s much easier to cancel PMI on conventional loans as you build equity.
Interest rates: In theory, FHA loans should have lower interest rates because the lender takes less risk. But the difference is typically minimal (0.17 percent, in recent years), and FHA rates might even come in higher. In early 2018, Ellie Mae reported that conventional loan interest rates were only four basis points (or 0.04 percent) higher than the average FHA rate.
Low down payment: FHA loans make it easy for most people to buy with very little down. But you might also be able to buy a house with a conventional loan and a small down payment. Especially if you have good credit, you can find competitive offers that beat FHA loans, including loans that would require even less than 3.5 percent of your own money down. With those programs, you could be able to eliminate any mortgage insurance eventually by building equity in your home.
Loan limits: In some cases, FHA doesn’t provide enough funding when you need a large loan. If you buy particularly expensive property or you’re looking in a hot market, FHA might not work for you.
It’s always wise to shop around. Compare offers from several different sources—including FHA loans and conventional loans—before you decide to take action. Speak with a mortgage professional to get guidance on which programs are right for your situation.
For more details on the pros and cons of government loans, see FHA Loan Pitfalls.