What is an FHA loan and is it right for me?

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In a Nutshell

You can qualify for an FHA loan with a down payment as low as 3.5%, even if your credit isn’t the best. These loans are easier to qualify for because they’re insured by the Federal Housing Administration. 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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When you’re looking for a mortgage, taking out an FHA loan is one of your options.

FHA loans are issued by private lenders, including banks, credit unions and online lenders — but they’re guaranteed by the Federal Housing Administration, a government agency. That guarantee, which protects lenders against losses if you default, means borrowers who may not have great credit or who don’t have a big down payment have an easier time qualifying.

A lot of first-time homebuyers opt for FHA loans, but you don’t need to be a first-time buyer to get one. Any borrower can benefit from the easier qualifying process, as long as you’re buying a house or a multifamily residence where you’ll live most of the time.

But you should be aware there are some downsides with 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 what you need to know about FHA loans.

Qualifying requirements
  • Minimum credit score of 580 for 3.5% down payment
  • Minimum credit score of 500 for 10% down
  • Purchasing a primary home
  • Documented proof of employment to verify stability of income
Mortgage insurance requirements
  • Annual and upfront mortgage insurance premiums required

What is an FHA loan?

An FHA loan is a specific kind of mortgage you can use to purchase a home, refinance an existing home loan or rehabilitate a home in need of repairs.

FHA loans get their name because the Federal Housing Administration provides insurance for lenders that issue these loans. These loans are the U.S. government’s “flagship initiative” intended to make low-cost home financing available to borrowers.

With an FHA loan, if you don’t pay your mortgage, the lender can file a claim with the FHA for payment of the remaining balance once foreclosure is complete. Since lenders have this backup option, they’re more willing to lend to you even if you don’t have perfect qualifications as a borrower. The criteria to be approved isn’t as stringent as it would be if you got a loan without government backing, which is known in the industry as a conventional mortgage or conventional loan.

It’s important to understand that borrowers aren’t protected by the FHA guarantee, though. If you don’t pay your mortgage, you still get foreclosed on — and the insurance doesn’t pay you anything for your losses.

How do FHA loans work?

It’s possible to get an FHA loan to buy a home, refinance an existing loan for your primary home, add to your mortgage to finance repairs, or finance repairing your existing home.

  • The FHA’s 203(b) program provides mortgages from qualified lenders to buy or refinance either a single-family home or multifamily property for one to four families.
  • The FHA’s 203(k) program provides up to $35,000 — rolled into a mortgage for the purchase or refinance of a home — to rehabilitate a home.

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 a lender to borrow from. You can search by a specific lender’s name, by location or type of lender.

How does an FHA loan differ from a conventional mortgage?

An FHA loan is different from a conventional mortgage in important ways. A conventional mortgage is not insured by the FHA, so it’s harder for you to qualify if you’re not the type of ideal buyer lenders look for.

Some of the key differences between an FHA loan and a conventional mortgage include the following:

  • FHA loans have different down payment requirements. You can get an FHA loan with a down payment as low as 3.5%. Most conventional lenders require you to put at least 5% down, although a few lenders will let you get a mortgage with just 3% down.
  • You can get more down payment help with an FHA loan. The FHA permits financial gifts or down-payment assistance from an approved source to provide up to 100% of the down payment, while some conventional lenders restrict the amount of your down payment that can come from a gift.
  • You can qualify for an FHA loan with a lower credit scores. Many lenders require credit scores of 640 or higher to obtain a loan, while the FHA allows loans with credit scores as low as 500.
  • FHA loans typically have lower interest rates. When interest rates are lower, your loan can cost less over time.
  • FHA loans have different insurance requirements. Borrowers who get an FHA loan must pay an upfront mortgage insurance premium and annual mortgage insurance premiums. With a conventional loan, private mortgage insurance is typically required if a borrower puts less than 20% down — but there’s just one premium paid on a monthly basis. There are also different rules for when you can stop paying insurance, and you usually have to pay insurance for longer with an FHA loan.
  • 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. Many conventional lenders cap a seller’s contribution at 3% of closing costs, although some allow sellers to pay up to 6%.

What is the interest rate 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 any 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. So the interest rate — and monthly payment — can adjust periodically.

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

An adjustable-rate loan may be structured, for example, 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 can also impact the rate you pay. Many websites show up-to-date interest rates on different kinds of loans. Go online to check out the latest rates.

What are the rules for a down payment and mortgage insurance?

The FHA permits qualifying borrowers to put down only 3.5% of the price of the home you’re buying and to obtain a loan for the remaining 96.5% of the home’s value. The ratio of the amount you borrow versus the value of the home is called the loan-to-value ratio or LTV for short.

But with a down payment that small you’re required to pay for mortgage insurance, which protects the government and lenders in case of default. You must pay both an up-front and annual premium for this insurance coverage.

The up-front mortgage insurance premium cost is equal to 1.75% of the borrowed amount. If you borrow $200,000, you’d pay a premium of $3,500. The annual premium varies based on how much you borrowed and your LTV. It typically ranges between 0.80% and 0.85% of the borrowed amount, depending upon your LTV. There’s a table on the Department of Housing and Urban Development website that shows exactly how much your mortgage insurance premiums would be based on how much you borrow.

The amount of time you’re required to pay mortgage insurance is also determined on your loan-to-value ratio. You’ll need to pay mortgage insurance premiums for either 11 years, or for the entire time you have the mortgage, if your LTV is more than 90%.

Because of the mortgage insurance costs, FHA loans can be more expensive than conventional loans, even with the lower interest rates.

What’s the maximum you can borrow?

The FHA establishes loan limits by county. In most geographic areas, the maximum amount you can borrow for single-family homes ranges from $294,515 to $679,650 as of October 2018. However, in Alaska, Guam, Hawaii and the U.S. Virgin Islands, you can get an FHA loan for a single-family home for up to $1,019,475.00. 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.

Applying for an FHA loan

When you apply for an FHA loan, your lender has to follow certain regulations. The loan approval process will vary based on your credit scores and down-payment amount. However, every potential borrower needs to fill out an application and provide financial information.

Not all FHA lenders have the same requirements — some are more strict than others about who they’ll approve. There can also be variation in interest rates and loan terms. You should shop around among different lenders to see which will loan you money with the most-favorable terms.

Who can qualify?

To qualify for an FHA loan, you must meet the following:

  • Have a minimum credit score of at least 580 to obtain a loan with a 3.5% down payment or a minimum credit score of 500 to get one with a 10% down payment.
  • Be buying, refinancing or renovating residential housing with between one and four units, and be planning to use the housing as your primary home.
  • Provide proof of employment to verify stability of income.

The total monthly payment on your debts, including your mortgage costs, can’t be more than 43% of your gross income. The percentage of your monthly income that goes toward your debt is called your debt-to-income ratio.

Since lenders do have differing requirements, if one lender doesn’t approve you for a loan, you can try to apply with a different FHA lender.

Bottom line: Is an FHA loan right for you?

An FHA loan may be an ideal choice if you want a low down payment, if your credit score isn’t perfect, or if you otherwise can’t qualify for a conventional loan. But be aware that mortgage insurance costs may make an FHA loan more expensive than a conventional mortgage. You should shop carefully among lenders to find the loan that’s best for your situation.