What Are FHA Loans?

By Markets Fool.com

FHA stands for the Federal Housing Administration, a government agency within the Department of Housing and Urban Development. One of the most common mortgage programs available is the FHA loan. For many, an FHA loan is a fantastic option to buy a home. For others, the benefits don't quite outweigh the costs.

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To decide if an FHA loan is right for you, here are the facts you need to know.

How FHAs Work
Even though the FHA is a government agency, getting an "FHA loan" does not mean the government will be lending you money. Instead, the FHA loan is a program designed to encourage non-government lenders to make home loans they might not otherwise make.

When a lender makes an FHA loan, the lender receives a guarantee from the government to help cover any losses if the loan ever goes bad. That guarantee lowers the risk for the lender, allowing it to offer terms and credit standards they wouldn't typically accept.

For borrowers without a large down payment, lower income, or bad credit, that can be the difference between getting a loan and not.

The Benefits of FHA Loans
There are two major benefits of an FHA loan:

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  • Those with bad credit can still qualify: For traditional mortgages, a borrower will generally need a minimum credit score between 660 and 680 to qualify. FHA loans are much more tolerant of lower credit scores, requiring a minimum score of just 580.
  • Low down payment requirements:In fact, they can be as low as 3.5% of the purchase price. For individuals and families without big savings accounts, the typical 20% down payment requirement can be a deal breaker. To qualify for a traditional, 20% down mortgage, a family would have to put down $20,000 to buy a $100,000 home. That's a huge sum of money for most families. An FHA loan would only require $3,500, a much more manageable savings.

For lower-income, younger, or first-time home buyers, these benefits can be extremely attractive.

The Drawbacks of FHA Loans
FHA loans are certainly not for everyone.

  • The costs: FHA loans are required to include a "mortgage insurance premium," known commonly as MIP. MIP is calculated on a case by case basis based on the size of the down payment, the length of the loan, and loan size. MIP payments can increase your monthly payment by several hundred dollars a month. That's a significant and unnecessary cost if you qualify for a traditional mortgage.
  • The limitations: Further, applying for an FHA loan requires more paperwork than a traditional mortgage, and it limits the maximum amount you can borrow. Those max limits are determined on a state-to-state and even city-to-city basis. FHA loans can only be obtained from FHA-approved lenders who use certain FHA-approved service providers, most notably appraisers.

Is an FHA Loan Right for Me?
At the end of the day, an FHA loan is a fantastic option for individuals and families without the savings or credit history to qualify for a traditional mortgage. Young, lower income, and first-time home buyers particularly can benefit.

For those individuals and families with the savings and credit score to qualify for a traditional mortgage, an FHA loan is not worth the extra time and monthly MIP expense. In these cases, going the traditional route is the better option.

The article What Are FHA Loans? originally appeared on Fool.com.

Jay Jenkins has no position in any stocks mentioned. The Motley Fool recommends American Express. The Motley Fool owns shares of Capital One Financial. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.