What is an FHA loan and how does it work?

FHA loans are incredibly popular among first-time homebuyers. The acronym stands for Federal Housing Administration, which is the organization that offers FHA loans through partnerships with banks and mortgage lenders. First-time buyers often opt for these loans because they tend to have fewer requirements, leaner credit score requirements, and you only have to put 3.5% down when buying a home.

How does an FHA loan work?

FHA loans work much the same as conventional mortgages, but the credit score and down payment requirements differ. Let’s use a hypothetical example to illustrate what an FHA loan looks like in action.

Cindy is buying her first home and trying to decide which loan works best for her needs. Since Cindy has a FICO credit score of around 580, her mortgage broker tells her that an FHA loan may be a good option because that’s the minimum requirement by the FHA.

Additionally, Cindy has been saving for a down payment but isn’t a millionaire, so she’s managed to save about 4% of her total budget. Again, her broker lets her know that since FHA loans only require a 3.5% down payment, this might be the way to go. Cindy’s budget is $400,000, so her down payment if she buys a house at this price would be $14,000.

The best part for Cindy is that FHA loans tend to come with lower interest rates due to their being backed by the federal government, making them less risky loans for lenders. So, Cindy qualifies for a 5% interest rate.

Pros and cons of FHA loans

What is the mortgage insurance premium on an FHA loan?

The mortgage insurance premium requirement is one of the biggest negatives of FHA loans. Since the federal government backs these loans, they want an extra layer of financial protection that’s offered through an MIP. This covers the financial burden if you stop making payments.

There are two types of MIPs associated with FHA loans:

• Upfront mortgage insurance premium: This is a one-time fee you pay at the time of closing. It’s typically 1.75% of the loan amount. This premium gets added to the loan balance or paid upfront as a closing cost.
• Annual mortgage insurance premium: This is an ongoing, annual premium that you pay as part of your monthly mortgage payments.

FHA loan vs. conventional loan: Which is better?

When deciding on a mortgage type, you’ll run into many different options. FHA and conventional loans are two of the more common options, but that is pretty much where the similarities end; their qualifying requirements are very different.

How do I qualify for an FHA loan?

There are many qualifications you must meet for an FHA loan, but they’re not exactly difficult requirements. In fact, FHA loans make it easier for different types of borrowers to qualify. To secure an FHA loan, you need:

• A credit score of 580, or at least 500: Those with scores of 500 can still qualify if they’re willing to put at least 10% down. For those looking to make a lower down payment, a credit score of 580 or more is a must.
• A record of consistent employment: Lenders get wary if you can’t demonstrate consistent employment. When I applied for my FHA loan, my mortgage officer told me that they tend to look for a two-year stint at a particular job or at least in the same industry.
• A debt-to-income ratio (DTI) below 43%: If you already have a mountain of other debt, many lenders won’t approve you for a mortgage, which is arguably the biggest debt you’ll take on. You need to keep your DTI (how much debt you have vs. how much you make) below 43% or lenders won’t see you as qualified.
• A 3.5% down payment: The best part about FHA loans is the low down payment. A 20% down payment is difficult to come up with, but 3.5% is much more manageable.
• A property that meets a certain standard: FHA loans have strict safety standards that conventional loans don’t always have. “So if you're considering a home that needs a new roof, you'll unlikely be able to use this type of financing,” explained Bill Gassett, a Realtor with over 35 years of experience. The same goes for porches, utilities, and other necessary features in the home, all of which have to meet inspection requirements for you to qualify.
• A property that is your primary residence: You can’t use an FHA loan for investment properties or part-time properties. You must make the home you buy your primary residence.

How do I find an FHA-approved lender?

Finding an FHA-approved lender isn’t difficult, you just need to know where to look. The U.S. Department of Housing and Urban Development (HUD) has a lender search option that allows you to search for FHA loan lenders in your area. You can search by location and lender name, and select different boxes to narrow your search down even more. If you’re looking for online-specific lenders, their websites should have all the information you need.

FHA loan FAQ

What are the borrowing limits on an FHA loan?

The maximum amount you can borrow with an FHA loan is $1,089,300 for a single-family home in a high-cost area. For low-cost areas, the borrowing limits max out at $472,030.

How long does it take to get approved for an FHA loan?

A lender is required to act on your application within 30 days and inform you of its decision. That said, the full-length application and funding process for FHA loans varies based on the lender you’re working with. You should expect the whole process to take a month or so.

What types of FHA loans are there?

There’s not one universal type of FHA loan, since the Federal Housing Administration offers multiple programs, including:

• Basic home mortgage 203(b): This is the more common FHA loan that you run into if you’re an average first-time buyer looking to secure a mortgage on an already built, structurally sound property.
• 203(h) disaster victims program: This loan program helps anyone affected by natural disasters get a new mortgage and reestablish themselves as homeowners.
• 203(k) rehab mortgage: This program allows you to buy a home in need of some TLC and fix it up with a rehab loan, which turns into a more traditional loan.
• FHA Section 248 program: This program is specifically for Native American buyers looking to buy homes on Native land.

This isn’t an exhaustive list of FHA-based home loans, but you can look on the HUD website to see all of your options.

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