What is an FHA loan?
An FHA loan is a government-backed mortgage insured by the Federal Housing Administration. FHA home loans require lower minimum credit scores and down payments than many conventional loans, which makes them especially popular with first-time homebuyers. In fact, according to FHA’s 2020 Annual Report, more than 83 percent of all FHA loan originations were for borrowers purchasing their first homes.
While the government insures these loans, they are actually underwritten and administered by third-party mortgage lenders.
How FHA loans work
FHA loans come in 15-year and 30-year terms with fixed interest rates. The agency’s flexible underwriting standards are designed to help give borrowers who might not qualify for private mortgages a chance to become homeowners.
But there’s a catch: Borrowers must pay FHA mortgage insurance, which is designed to protect the lender from a loss if the borrower defaults. Mortgage insurance is required on most loans when borrowers put down less than 20 percent. All FHA loans require the borrower to pay two mortgage insurance premiums:
- Upfront mortgage insurance premium: 1.75 percent of the loan amount, paid when the borrower gets the loan. The premium can be rolled into the financed loan amount.
- Annual mortgage insurance premium: 0.45 percent to 1.05 percent, depending on the loan term (15 years vs. 30 years), the loan amount and the initial loan-to-value ratio, or LTV. This premium amount is divided by 12 and paid monthly.
So, if you borrow $150,000, your upfront mortgage insurance premium would be $2,625 and your annual premium would range from $675 ($56.25 per month) to $1,575 ($131.25 per month), depending on the term.
FHA mortgage insurance premiums will be canceled after 11 years for most borrowers if they financed 90 percent or less of the property’s value — in other words, for those who put at least 10 percent down and stay current with their monthly mortgage payments. Loans with an initial LTV ratio greater than 90 percent will carry insurance until the mortgage is fully repaid.
FHA lenders are limited to charging no more than 3 to 5 percent of the loan amount in closing costs, and the FHA allows up to 6 percent of the borrower’s closing costs, such as fees for an appraisal, credit report or title search, to be covered by sellers, builders or lenders.
How to qualify for an FHA loan
To be eligible for an FHA loan, borrowers must meet the following lending guidelines:
- Have a FICO score of 500 to 579 with 10 percent down, or a FICO score of 580 or higher with 3.5 percent down.
- Have verifiable employment history for the last two years.
- Have verifiable income through pay stubs, federal tax returns and bank statements.
- Use the loan to finance a primary residence.
- Ensure the property is appraised by an FHA-approved appraiser and meets HUD guidelines.
- Have a front-end debt ratio (monthly mortgage payments) of no more than 31 percent of gross monthly income.
- Have a back-end debt ratio (mortgage plus all monthly debt payments) of no more than 43 percent of gross monthly income (lenders could allow a ratio up to 50 percent, in some cases).
- Wait one to two years before applying for the loan after bankruptcy, or three years after foreclosure (lenders might make exceptions on these waiting periods for borrowers with extenuating circumstances).
How to find an FHA lender and apply for an FHA loan
FHA borrowers get their home loans from FHA-approved lenders, which can set their own rates, costs and underwriting standards so long as the FHA minimums are met. Approved lenders range from the biggest banks and credit unions to community banks and independent mortgage firms.
Applying for an FHA loan requires a few key steps:
- Know your budget: Before you submit an application for an FHA loan, you’ll want to know how much you can afford to spend on a home. Consider your current income, expenses and savings, and use Bankrate’s mortgage calculator to estimate your monthly payments based on different home prices and different sizes of down payment.
- Compile your documents: Applying to borrow a large chunk of money means handing over a complete look under the hood of your finances. Before you apply for an FHA loan, have all these documents ready to go: two years of tax returns; two recent pay stubs; your driver’s license; and full statements of your assets (checking account, savings account, 401(k) and any other places where you hold money).
- Compare your offers: Getting preapproved with multiple lenders is helpful so you can compare different refinance rates and terms to make sure you’re getting the best deal.
FHA vs. conventional loans
Unlike FHA loans, conventional loans are not insured by the government. Qualifying for a conventional mortgage requires a higher credit score, solid income and a down payment of at least 3 percent for certain loan programs. Here’s a side-by-side comparison of the two types of loans.
|Conventional loan||FHA loan|
|Credit score minimum||620||500|
|Down payment||3% to 20%||3.5% for credit scores of 580+; 10% for credit scores of 500-579|
|Loan terms||8- to 30-year terms||15- or 30-year terms|
|Mortgage insurance premiums||PMI (if less than 20% down): 0.58% to 1.86% of loan amount||Upfront premium: 1.75% of loan amount; annual premium: 0.45% to 1.05%|
|Interest type||Fixed-rate or adjustable-rate||Fixed-rate|
Pros and cons of FHA loans
- You can have a lower credit score: If you haven’t established much of a credit history or you’ve encountered some issues in the past with making on-time payments, a 620 credit score — the typical magic number for consideration of a conventional mortgage — might seem out of reach. If your credit score is 580, you’re in good standing with most FHA-approved lenders.
- You can make a lower down payment: FHA loans also give the option for a smaller down payment. With a credit score of at least 580, you can make a down payment of as little as 3.5 percent. If your credit score is between 500 and 579, you may still be able to qualify for an FHA-backed loan, but you will need to make a 10 percent down payment.
- You can stop renting earlier: Since FHA loans make buying a home easier, you can start building equity sooner. Instead of continuing to rent while trying to save more money or improve your credit score, FHA loans make the dream of being a homeowner possible sooner.
- You won’t be able to avoid mortgage insurance: Since your credit score is lower, you’re a bigger risk of default. To protect the lender, you have to pay mortgage insurance. You can roll the upfront insurance premium into your closing costs, but your annual premiums will be divided into 12 installments and show up on every mortgage bill. If you put down less than 10 percent, you have to pay those annual premiums for the entire life of the loan. There’s no escaping them. That’s a big difference from conventional loans: Once you build up 20 percent equity, you no longer have to pay for private mortgage insurance.
- You’ll have to meet property requirements: If you’re applying for an FHA loan, the property has to meet some eligibility requirements. The most important is the price: FHA-backed mortgages are not allowed to exceed certain amounts, which vary based on location. You have to live in the property, too. FHA loans for new purchases are not designed for second homes or investment properties.
- You could pay more: When you compare mortgage rates between FHA and conventional loans, you might notice the interest rates on FHA loans are lower. The APR, though, is the better comparison point because it represents the total cost of borrowing. On FHA loans, the APR can sometimes be higher than conventional loans.
- Some sellers might shy away: In the ultra-competitive pandemic housing market, sellers weighing multiple offers often viewed FHA borrowers less favorably.
FHA loan limits in 2022
Each year, the FHA updates its loan limits based on home price movement. For 2022, the floor limit for single-family FHA loans in most of the country is $420,680, up from $356,362 in 2021. For high-cost areas, the ceiling is $970,800, up from $822,375 a year ago.
FHA is required by law to adjust its amounts based on the loan limits set by the Federal Housing Finance Agency, or FHFA, for conventional mortgages guaranteed or owned by Fannie Mae and Freddie Mac. Ceiling and floor limits vary according to the cost of living in a certain area, and can be different from one county to the next. Areas with a higher cost of living will have higher limits, and vice versa. Special exceptions are made for housing in Alaska, Hawaii, Guam and the Virgin Islands, where home construction is generally more expensive.
Other types of FHA loans
In addition to the standard 15-year and 30-year FHA loans for home purchases and refinancing, the FHA also insures other loan programs offered by private lenders. Here’s a look at each of them.
FHA 203(k) loans help homebuyers purchase a home — and renovate it — all with a single mortgage. Homeowners can also use the program to refinance their existing mortgage and add the cost of remodeling projects into the new loan. FHA 203(k) loans come in two types:
- The limited 203(k) has an easier application process, and the repairs or improvements must total $35,000 or less.
- The standard 203(k) requires additional paperwork and applies to improvements costing more than $5,000, but the total value of the property must still fall within the FHA mortgage limit for the area.
The Home Equity Conversion Mortgage (HECM) is the most popular type of reverse mortgage and is also insured by the FHA. A HECM allows older homeowners (aged 62 and up) with significant equity or those who own their homes outright to withdraw a portion of their home’s equity. The amount that will be available for withdrawal varies by borrower and depends on the age of the youngest borrower or eligible non-borrowing spouse, current interest rates and the lesser of the home’s appraised value or the HECM FHA mortgage limit or sales price.
Energy Efficient Mortgage
The Energy Efficient Mortgage (EEM) program backed by the FHA allows homebuyers to purchase homes that are already energy-efficient, such as Energy Star-certified buildings. The program can also be used to buy and remodel older homes with energy-efficient, or “green,” updates and roll the costs of the upgrades into the loan without a larger down payment.
The FHA Section 245(a) loan, also known as the Graduated Payment Mortgage, is geared at borrowers whose incomes will increase over time. You start out with smaller monthly payments that gradually go up. Five specific plans are available: three plans that allow five years of increasing payments at 2.5 percent, 5 percent and 7.5 percent annually. Two other plans set payment increases over 10 years at 2 percent and 3 percent annually.
FHA loan relief
Loan servicers can offer some flexibility on FHA loan requirements to those who have suffered a serious financial hardship or are struggling to make their payments. That relief might be in the form of a temporary period of forbearance or a loan modification that would lower the interest rate, extend the payback period or defer part of the loan balance at no interest.
Is an FHA loan right for you?
An FHA loan might be the right choice for you if you have decent credit and don’t have a large down payment saved. The fact that you can get an FHA mortgage with just 3.5 percent down puts homeownership within grasp for many people, but that doesn’t mean FHA loans are the best option for everyone.
If you have strong credit, there’s a good chance you’ll be able to qualify for a conventional mortgage even if you can’t put 20 percent down. With a conventional loan, you’ll be able to get out of PMI once you’ve built sufficient equity.
Similarly, if you have a lot of money saved for a down payment, you may be able to get a conventional loan even if you have less than perfect credit.
FHA loan alternatives
If you need a mortgage but don’t have enough for a 20 percent down payment or have less-than-perfect credit, there are a few ways you can qualify.
If your credit score is the issue, you can try finding a co-signer who is willing to co-sign on your mortgage. If you’re applying with a partner or spouse who has good credit, it may make sense to have them apply for the loan alone so that your credit score doesn’t impact your approval chances.
The bottom line
FHA loans are a great option for borrowers who don’t have great credit or don’t have a lot of money to use for a down payment. However, keep in mind that the long-term costs of an FHA mortgage will be higher due to the unavoidable mortgage insurance payments involved.