FHA loans: What are they and how do they work?

An FHA loan is a home loan insured by the Federal Housing Administration. Since it is insured by the government, FHA loans have lower down payments and credit requirements compared to conventional loans. When you get an FHA loan, the money won’t come directly from the government, but from a government-approved lender.

As of 2019, borrowers only need a minimum FICO score of 580 to qualify for an FHA loan with a down payment as low as 3.5% of the home’s purchase price. However, despite generous terms, loans originated after 2013 with smaller down payments require that you pay an insurance premium for the entirety of the loan. The upper loan limits for FHA loans are $726,525 for high-cost areas.

As such, FHA loans are typically the choice of low-to moderate-income borrowers with little cash on hand, or first-time buyers with less-than-perfect credit when it comes to financing options for home.

FHA loans vs conventional loans

Loans insured by the Federal Housing Administration are similar to the conventional loans in many ways. Both offer options regarding interest rates, loan terms, and loan amounts.

The mortgage limits are set by the Federal Housing Financing Administration (FHFA). Conforming loans (as opposed to jumbo or non-conforming loans) fall within those limits and meet the guidelines set by Freddie Mac and Fannie Mae.

You can use an FHA loan for single-family houses, homes in one- to four-unit buildings, and some manufactured and mobile homes.

If you’re fixing up a home or buying an energy-efficient home, you may want to apply for different type of FHA loan. We’ll discuss other types of government-backed loans later.

At a glance, here are some features of FHA loans vs conventional loans.

How an FHA loan works

Most people will not be able to buy a house in cash and will instead apply for a mortgage, which is a loan specifically intended for the purchase of a home and is paid over time.

Your mortgage amount is typically the price of your house minus the down payment, a lump sum that you pay up front. With a conventional loan, the down payment requirements for a home are typically 20% of the home purchase price. That means if you’re purchasing a $250,000 home, you need to pay down $50,000 at the time of closing.

If 20% of the purchase price seems like more than you can afford, a FHA-insured loan can be of help. It’s backed by the government, which has two important consequences:

• The credit requirements are more lenient and you’ll have a smaller minimum down payment.
• If you default or can’t make payments, the government will be held responsible and pay claims to your lender. To make up for this, an FHA loan requires you to pay two different types of mortgage insurance premium (MIP).

Mortgage Insurance premium

Mortgage insurance premiums (MIP) are functionally the same as private mortgage insurance (PMI). Both of these are payments required by lenders if your down payment is less than a certain percentage. In case the of conventional mortgages, the insurance premium protect the lender in case you stop making payments or default on your loan. For FHA loans, the payments are more like a fee to the government for backing your loan as they don’t exactly need protection.

With an FHA loan, you’ll pay an Upfront Mortgage Insurance Premium (UFMIP) and an Annual Mortgage Insurance Premium (MIP). As of 2019, the UFMIP is 1.75% of your loan amount. The Annual MIP is anywhere from 0.45% to 1.05% of your loan amount, depending on your loan amount and term. Annual MIP is typically factored into your monthly payment.

While this insurance premium might be more than the PMI for conventional loans, remember that you can deduct your monthly mortgage interest payments from your taxes. Learn more about claiming the mortgage interest tax deduction.

Cancelling MIP

You can cancel your MIP under certain circumstances depending on your loan-to-value ratio.

If you bought a $250,000 home with a $240,000 FHA-insured loan, your LTV would be 96%.

If your LTV is over 90%, you will make MIP payments for the life of your loan. If the LTV under 90%, you can cancel MIP after 11 years.

For loan terms 15 years or less:

For loan terms longer than 15 years:

Qualifying for an FHA loan

While there are no minimum or maximum income restrictions for those seeking FHA loans, there are other eligibility requirements, including:

• Steady income stream that will likely continue the first three years of the mortgage
• Social Security number
• At least two years must have passed after bankruptcy and three years after foreclosure. (Learn more about getting a mortgage after bankruptcy.)
• Credit score of 580 and above for a down payment as low as 3.5%
• Credit score between 500 and 579 for a down payment as low as 10%
• Your debt-to-income ratio must fall below 43%
• Or fall below a maximum debt-to-income ratio of 50% if your credit score is above 580

There are also requirements for the property, which include the following:

• Your home must be the primary residence, or a secondary residence, but not an investment property
• Your home must meet HUD property guidelines
• Your home must undergo an FHA-approved appraisal

How to apply for an FHA loan

To get an FHA loan you’ll need to first find an FHA-approved lender from the HUD website and apply as you would for a conventional loan or mortgage. Here’s a rundown on the mortgage process.

The FHA loan limits vary by county and are updated annually by HUD. Government-backed loans usually have a fixed rate, though adjustable-rate mortgages are available as well.

When it comes time for the down payment, it can come from your savings or a grant. You can also pay for the down payment with a gift from a family member, for which you'll need a gift letter.

Other types of FHA loans

• VA loans: Veterans can apply for these home loans that are serviced by the US Department of Veteran Affairs and have no downpayments.
• FHA energy-efficient mortgage: Also known as green loan. An energy-efficient mortgage helps finance the purchase of an environmentally sustainable home or make energy-efficient upgrades to your home.
• Home Equity Conversion Mortgage (HECM): If you're a senior aged 62 or older, you may qualify for a reverse mortgage insured by the government.
• Section 203(k) rehabilitation loan: Apply for this FHA construction loan if you plan to fix up property in need of repairs.