What is an FHA loan and how does it work?

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In a Nutshell

You may qualify for an FHA loan with a down payment as low as 3.5%, even if your credit is less than perfect. These loans are typically easier to qualify for than conventional loans because they’re insured by the Federal Housing Administration. But even though they’re backed by the government, you still need to shop around for the best mortgage because FHA loans are issued by private lenders with different requirements and terms.
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An FHA loan is a federally insured home loan that allows you to make a down payment as low as 3.5% if you qualify.

FHA loans can be helpful for first-time homebuyers, but you don’t have to be a first-time buyer to qualify. They also may be a good option if you have less-than-perfect credit since they have an easier qualifying process than most conventional home loans.

But you should be aware that there are some downsides to FHA loans. The amount you can borrow is capped — and if you’re taking out an FHA loan to take advantage of the low down payment, you’ll have to buy mortgage insurance, which can make FHA loans more costly than some other types of mortgages.

Read on to learn more about FHA loans and how they work.

What is an FHA loan?

An FHA loan is a type of mortgage insured by the Federal Housing Administration that may let you make a down payment as low as 3.5% and that has less-restrictive credit requirements than many conventional home loans.

You can use FHA loans to buy a home, refinance your mortgage or renovate a home.

You’ll still apply with traditional financial institutions like banks and credit unions, since they administer the loans. And while FHA loans are federally insured, that protects the lender — not you — in case you default on the loan.

What are the requirements for an FHA loan?

When you apply for an FHA loan, your lender has to follow certain regulations. The lending process will vary based on your credit scores and down payment amount.

To qualify for an FHA loan, you must meet these rules.

  • Minimum credit scores You’ll need minimum credit scores of at least 580 to qualify for a loan with a 3.5% down payment. You’ll need minimum credit scores of 500 to qualify for one with a 10% down payment.
  • Mortgage type You’ll also need to buy, refinance or renovate a home with between one and four units and plan to use the residence as your primary home.
  • Debtto-income ratio Your total monthly debt payments, including any mortgage, typically can’t be more than 43% of your gross income.
  • Financials Your lender will verify your credit and income as well as the value of the property you want to purchase.

Keep in mind that interest rates and loan terms can vary. You should shop around to see which lender offers you the most favorable terms for your situation.

What are the types of FHA loans?

If you’re thinking about applying for an FHA loan, you’ve got a few options to consider.

  • FHA’s 203(b) Basic Home Mortgage loan This option provides mortgages from participating lenders to buy or refinance either a single-family home or multifamily property for one-to-four-unit homes.
  • FHA’s 203(k) program  If the home you want to buy needs some work, this program provides up to $35,000 — rolled into a mortgage for the purchase or refinance of a home — to rehabilitate it.
  • Construction to permanent loan If you don’t want to buy an existing home, an FHA loan can also help you finance the purchase of a home you build.  
  • Energy-efficient mortgage This program lets you make “cost-efficient” energy improvements to your home, either for a new home or refinancing your current loan.

Many different lenders offer FHA loans. The Department of Housing and Urban Development provides a “Lender List Search” on its website where you can look for lenders. You can search by a specific lender’s name, by location or type of lender.

Here are some FHA lenders worth a look.

  • Rocket Mortgage This lender has a fully online application, and you can call or chat with a representative seven days a week. Rocket Mortgage offers 15- and 30-year FHA loans with either fixed or variable rates.
  • Wells Fargo This big bank publishes sample rates for several categories of home loans, including FHA loans, and you can get a rate estimate without a hard credit inquiry.
  • U.S. Bank U.S. Bank provides sample rates for 30-year FHA loans online, and its calculator allows you to explore possible monthly payments and amortization schedules for different loans. This lender offers an online application, or you can get started over the phone or by meeting with a local loan officer.
  • Chase Chase offers grants of $2,500 to $5,000 to qualifying homebuyers in certain areas, and customers applying for FHA loans may be eligible. Existing Chase customers may be eligible for a closing guarantee that pays you if closing is delayed.
  • Better Mortgage This online lender offers around-the-clock customer support. Better Mortgage says that you can get preapproved in as little as three minutes and that its time to closing is 10 days shorter than other lenders on average.

How do FHA loans work?

If you think an FHA loan may be a good option for you, you can start by saving for a down payment and researching potential lenders with HUD’s search tool.

Once you’re ready to apply, there are a few things you’ll want to keep in mind.

Pros of FHA loans

  • Low down payment requirements — You may be eligible for an FHA loan with a down payment as low as 3.5% if you have credit scores of at least 580. (You may have to put down 10% if your credit scores are between 500 and 579.)
  • Down payment help allowed — The FHA permits financial gifts or down payment assistance as long as you meet FHA requirements. Not all conventional loans allow gifts for down payments.
  • Good credit not required — The FHA allows loans with credit scores as low as 500. That can be helpful if your credit history is shaky.
  • Sellers can help with closing costs for an FHA loan — The FHA allows home sellers to pay up to 6% of the closing costs for a loan. Conventional lenders may cap a seller’s contribution at 3% of closing costs, although some allow sellers to pay up to 6%.

Downsides of FHA loans

  • Mortgage insurance can be costly. You may pay a price for making a small down payment. You’ll have to pay a one-time upfront mortgage insurance premium, as well as an annual premium that’s collected in monthly installments. The one-time premium is generally equal to 1.75% of the home purchase price and can be financed in the mortgage or paid for in cash — but not a combination. The annual premium depends on your loan amount and loan-to-value ratio.
  • There’s a limit to how much you can borrow. The FHA establishes loan limits based on median home prices in metro areas and counties. As of July 2020, the FHA maximum for a single-family home in a “low-cost area” is $331,760 while it’s $765,600 in a “high-cost area.” Alaska, Hawaii, Guam and the Virgin Islands are exceptions with a maximum of $1,148,400 for a single-family unit. These loan limits change periodically, so be sure to check for updated information. The Department of Housing and Urban Development has a search tool on its website to identify mortgage limits by county and state, so you can find out how much you’re able to borrow where you live.
  • Good credit? Consider other options. If you have strong credit and don’t have enough money for a large down payment, you still might want to consider other options because of FHA loan’s mortgage premiums. Just keep in mind that if you don’t put at least 20% down, you’ll likely have to pay private mortgage insurance, or PMI.

How does interest work on an FHA loan?

FHA loans can be either fixed- or adjustable-rate loans.

  • With fixed-rate loans, the rate doesn’t go up or down based an index rate, so your mortgage payment is more stable and predictable throughout the life of the loan.
  • Adjustable-rate mortgage loans, or ARMs, move along with a specific benchmark index interest rate, such as the London Interbank Offered Rate, or Libor, which is a rate used by some large banks to charge each other for short-term loans. That means the interest rate — and monthly payment — can adjust periodically.

Adjustable-rate loans may have lower initial rates than fixed-rate loans, but they can go up over time.

For example, an adjustable-rate loan may be structured as a 3-1 ARM. This would mean your interest rate would be fixed for the first three years and could change annually after the initial three-year period. The loan could be set up so its interest rate could increase by up to 1% each year, with a maximum increase of 5% over the life of the loan.

The length of your mortgage loan also affects the rate you pay. The Consumer Financial Protection Bureau has an online tool that lets you explore potential rates based on a number of factors, including where you live, loan type, down payment and loan term.

What are some FHA loan alternatives?

If you’re not sure if an FHA loan is right for you, there are a few other options to consider.

  • Conventional loan A conventional loan means your mortgage isn’t part of a government program. There are two main types of conventional loans: conforming and non-conforming. A conforming loan follows guidelines set by Fannie Mae and Freddie Mac such as maximum loan amounts. A non-conforming loan can have more variability on eligibility and other factors.
  • USDA loan A USDA loan, also called a rural development loan, may be an option for people with low-to-moderate incomes who live in rural areas. They can be attractive because they offer zero down payments, but you’ll have to pay an upfront fee and mortgage insurance premiums.
  • VA loan VA loans are made to eligible borrowers by private lenders but insured by the Department of Veteran Affairs. You may be able to make a low down payment (or even no down payment). You’ll probably have to pay an upfront fee at closing, but monthly mortgage insurance premiums aren’t required.

FHA vs. conventional mortgages

The main difference between FHA loans and conventional loans is that FHA mortgages are backed by the Federal Housing Administration, while conventional mortgages aren’t issued as part of a government program.

There are also some differences in eligibility requirements, mortgage insurance requirements and restrictions on the properties a borrower can buy with the loan.

 FHA loansConventional loans
GuaranteeFHA insuredNot insured by a gov’t agency
LendersPrivate FHA-approved lendersPrivate lenders
Applicable guidelinesFHA guidelinesFannie Mae and Freddie Mac guidelines for conventional loans that are also conforming loans; otherwise, details are up to lenders
Minimum down payment3.5% for borrowers with credit scores of at least 580; 10% for those with lower credit scoresTypically 3% to 5% for conforming loans; otherwise, minimums set by lenders
Minimum credit scores580; score may be as low as 500 with a 10% down paymentGenerally, 620 for conforming loans; otherwise, minimums set by lenders
Mortgage insuranceUpfront mortgage insurance premium equal to 1.75% of the loan amount, followed by annual premiums of 0.45% to 1.05% for 11 years or the entire life of the loanPrivate mortgage insurance typically required when equity is below 20%
Eligible propertiesProperty must meet the U.S. Department of Housing and Urban Development’s standards for durability; borrowers must use the property as primary homeRequirements depend on lender

Learn more about conventional loans vs. FHA loans.

How to find an FHA loan lender and apply for a loan

You can find an FHA lender using HUD’s search tool. You can also check with any banks where you’re a current customer to see if they offer FHA loans. And you could ask family and friends which lenders they’ve had a good experience with and find out if FHA loans are available from those lenders.

It’s a good idea to contact at least a few different mortgage lenders to learn about their loans. Compare quotes to see which lenders offer the best rates.

When you’re ready to apply for an FHA loan, ask the lender for an application or start one online if that’s an option. You’ll typically be asked for your ID, Social Security number and documentation if you’ve changed your name in the recent past.

You’ll generally also need your last two bank statements and your federal tax returns and W-2s from the past two years, along with your most recent paystub.

Lenders will want you to verify how you’re going to make your down payment. If you’re using savings, you can provide bank statements from the last couple of months to prove that the funds are yours.

If you’re getting help with your down payment, whoever is giving you the money will need to sign a mortgage gift letter. This document must include the donor’s name, address, and phone number and the amount they’re giving you. It also needs to say what their relationship is to you and make clear that they don’t expect you to repay the gift.

Is an FHA loan right for you?

If you’re considering an FHA loan, here are a few more things to think about before you apply.

  • What’s my budget for a home?
  • How much money can I put toward a down payment?
  • What’s my credit like?
  • Do I want to buy a fixer-upper? A new build?
  • Am I OK paying more each month for mortgage insurance?
  • Do I have a preferred lender?

You should shop carefully among lenders to find the loan that’s best for your situation and consider all of your options before making a long-term commitment.

Calculate your FHA loan

Find out how much your monthly mortgage could be with our FHA loan calculator.

FAQs about FHA loans

How does an FHA loan work?

When you take out an FHA loan, you borrow from a private lender like a bank or mortgage company, and the FHA insures the loan. This protects the lender, not you, in case you don’t pay the loan back.

What are the requirements for an FHA loan?

The requirements for an FHA loan generally include credit scores of at least 580, or 500 if you’re making a 10% down payment, and a debt-to-income ratio no higher than 43%. You also must intend to use the home as your main residence.

What credit scores do I need for an FHA loan?

If you’re putting 10% down, you may be able to qualify for an FHA loan with a credit score of 500. But if you’re making a smaller down payment, you’ll need credit scores of at least 580.

What are the benefits of an FHA loan?

Some of the benefits of an FHA loan are that low down payments are possible, gifts may be used for the down payment, and credit score requirements aren’t as strict as with some other types of loans.

What are the types of FHA loans?

The types of loans that lenders offer through the FHA’s programs include 203(b) Basic Home Mortgage loans and 203(k) loans, which provide funds for repairs or improvements. Other types of FHA loans are construction-to-permanent loans and energy-efficient mortgages.

How much down payment does an FHA loan need?

Borrowers with credit scores of 580 or above may be able to put just 3.5% down. Those with lower credit scores need a 10% down payment.

What is the downside of an FHA loan?

Some potential downsides of FHA loans are that mortgage insurance may be expensive and you can’t borrow more than the applicable loan limit for the area where you’re buying a home.

Is getting an FHA loan a good idea?

Getting an FHA loan might be a good idea if you’ve compared alternatives from several lenders and found that an FHA loan is affordable and offers features you want.

Is it hard to get approved for an FHA loan?

It may be easier to get approved for an FHA loan than for a conventional loan because credit score requirements for an FHA loan are typically less strict.

How does interest work on an FHA loan?

Some FHA loans have fixed interest rates, so that the rate stays the same over the loan’s lifetime. Other FHA loans have adjustable interest rates, and their rates go up or down at regular intervals depending on conditions in the economy.

What are some FHA loan alternatives?

Conventional loans offered by private lenders can be alternatives to an FHA loan. Other alternatives include USDA loans for borrowers in rural areas with low-to-moderate income and VA loans for members of the military, veterans and their qualifying spouses.

Is an FHA loan right for you?

An FHA loan might be right for you if you qualify and if it’s more affordable than your other options. That’s more likely if your credit scores are on the lower end and if you don’t have much money for a down payment.

About the author: Erin Dunn is an editor at Credit Karma who specializes in personal loans and is passionate about financial literacy and budgeting. She’s an award-winning business journalist and editor whose work has appeared in Busin… Read more.