What Is An FHA Loan And Who Qualifies?
Need a loan to finance the purchase of a new home but worried that your credit score might be too low? Don’t know if you can come up with the thousands of dollars you’ll need for a down payment?
A loan insured by the Federal Housing Administration may be a good option.
What is an FHA loan? It’s a type of mortgage designed to help people with less-than-stellar credit qualify for the financing they need to purchase a home. And – good news for cash-strapped buyers – FHA loans may require lower down payments, too.
Key Takeaways:
- FHA loans are backed by the Federal Housing Administration, which allows lenders to loosen the eligibility requirements.
- FHA loans can be cheaper than conventional loans if you have a low credit score and don’t have much saved for a down payment.
- FHA loans are available with a down payment as low as 3.5%.
How Does An FHA Loan Work?
FHA loans are home loans that are insured by the Federal Housing Administration and, as a result, pose less risk to lenders. This means lenders can loosen their eligibility requirements.
FHA loans differ from conventional loans, which aren’t insured by any government agency. Though the government insures FHA loans, it doesn’t originate them. So, if you’re interested in applying for this type of loan, you’ll work with a private mortgage lender.
You can qualify for an FHA loan with a lower credit score than most lenders require for a conventional mortgage. FHA loans also require a low down payment, making them a good fit for borrowers who haven’t saved as much money before buying a home. You’re also able to roll your FHA loan closing costs into your loan amount, so you don’t have to pay as much upfront (though you will have to pay interest on them, in that case, and your monthly payment will increase). However, there are other specific requirements for this type of loan, including for the property you intend to buy.
What Type Of Borrower Is An FHA Loan Best For?
An FHA loan can be helpful for first-time home buyers with lower credit scores who can’t afford to make a sizable down payment. For example, your credit score typically needs to be over 620 to qualify for a conventional loan, but you can be eligible for an FHA loan with a score as low as 500. You can also still qualify for an FHA loan if you’ve had a bankruptcy or other major financial issue.
How To Apply For An FHA Loan
If you think an FHA loan might be right for you, you can find an FHA lender using this tool from the U.S. Department of Housing and Urban Development. If you have questions or need advice about FHA loans, you can talk to a HUD housing counselor by calling 800-569-4287.
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FHA Mortgage Requirements
Knowing what you need to qualify for an FHA loan can help ensure a smooth home buying process.
FHA Mortgage Loan Limits
FHA loans come with limits that are set each year by HUD. The FHA loan limit will depend on where you’re looking to buy. For 2024, the FHA loan limit for a one-unit property is $498,257 in most areas and $1,149,825 in high-cost areas. The ceiling for FHA loans in Alaska, Hawaii, Guam and the U.S. Virgin Islands is $1,724,725 to account for higher construction costs. You will not be able to take out an FHA loan larger than the limit in your area.
Credit Score
You can qualify for an FHA loan with a credit score as low as 500, depending on your lender. You will need a 10% down payment if your score is between 500 and 579. With a score of 580 or higher, you can make a lower down payment of 3.5%. Keep in mind that many lenders have their own minimum credit score requirements.
Down Payment
One of the main reasons to apply for an FHA loan is the FHA’s low down payment requirements. You can qualify for an FHA loan with a down payment of 3.5% if your credit score is 580 or higher. So, if your home costs $350,000, you’d need a down payment of at least $12,250. If your credit score is 500 to 579, you’ll have to provide a minimum down payment of 10% of your home’s purchase price. For that $350,000 house, you’d need a down payment of at least $35,000.
Debt-To-Income Ratio
Your debt-to-income ratio is another figure lenders use to determine if you can afford your mortgage. It compares how much you owe in monthly debt to how much you earn before taxes. You can calculate your DTI ratio by adding up all your monthly debt payments, dividing that by your gross monthly income and multiplying the result by 100. The maximum DTI ratio for an FHA loan is 57%. However, some lenders may impose stricter limits closer to 40%.
FHA Appraisal
Before you can close on the purchase of a home, you must get an appraisal of the property by an FHA-approved appraiser. There are two goals with this step. First, the appraiser will make sure that the home meets safety standards. Second, the appraiser will determine the home’s current market value. This is important because your lender won’t let you borrow more than the home is worth. The appraisal lets your lender determine that you aren’t paying too much for your new home.
FHA Minimum Property Standards
Any home you buy with an FHA loan must also meet specific minimum property standards. These standards are concerned with safety, security and soundness. Any home you buy with an FHA mortgage should provide a safe environment, have no serious structural defects, and provide a secure place for owners to live.
FHA-approved appraisers will consider these requirements while inspecting the home you want to buy. If they find serious structural issues, for instance, and the seller doesn’t make the necessary repairs, you might be unable to use an FHA loan to buy the home.
Property Type
Although you can only purchase a primary residence with an FHA loan – not an investment property or second home, except in special cases – the FHA is otherwise flexible on the types of homes you can use this type of financing to purchase. They include:
- Single-family homes
- Multifamily properties of up to four units
- Condominiums
- Manufactured homes
FHA Mortgage Insurance
With an FHA loan, you’ll have to pay both an upfront and an annual mortgage insurance premium. Mortgage insurance protects your lender if you stop making your monthly payments.
Upfront Mortgage Insurance Premium
You’ll pay the upfront mortgage insurance premium at the closing or disbursement of your loan. This premium comes out to 1.75% of your loan amount. If you take out a loan for $325,000, for example, your upfront mortgage insurance premium will be $5,687.50.
You can either pay this as one lump sum when you close on your mortgage or add it to your total loan amount.
Annual Mortgage Insurance Premium
You’ll also pay an annual premium. The amount of your annual MIP is a percentage of your outstanding loan balance that varies depending on your loan’s amount, the term, the size of your down payment and your loan-to-value ratio, a measure comparing how much you owe on your mortgage to the current market value of your home. The standard amount for most FHA-insured mortgages is a 0.55% annual MIP.
Removing Mortgage Insurance
Depending on the size of your down payment, you might be unable to remove your annual mortgage insurance premium. If you make a down payment of at least 10% when you buy your home, after 11 years of monthly payments, you can stop paying the annual MIP. However, if you make less than a 10% down payment, you’ll have to pay your annual MIP throughout the life of your loan.
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FHA Loans vs. Conventional Loans: A Comparison
Wondering about the differences between FHA loans and conventional loans? The main difference is that while FHA loans are insured by the government, conventional loans are not insured by any government agency. Take a look at this table to compare the two further.
FHA Loans Vs. Conventional Loans
| Loan Requirement | FHA Loan | Conventional Loan |
|---|---|---|
| Credit score | 500 to 579 with a down payment of 10%, or 580 with a down payment of 3.5% | Typically 620, though it varies by lender |
| Down payment | 3.5% for borrowers with credit scores of 580 or higher; 10% for borrowers with credit scores of 500 to 579 | As low as 3%, depending on the mortgage program |
| Maximum debt-to-income ratio | Varies, but can go up to 57% | Varies, but can go up to 50% |
| Home appraisal | Required | Typically required |
| Property standards | The home must be your primary residence and meet FHA minimum property standards. It must be a single-family or multifamily dwelling with no more than four units. | It must be a single-family or multifamily dwelling with no more than four units. It must be located in a residential area. |
| Mortgage insurance | You pay an upfront mortgage insurance premium and then annual mortgage insurance monthly for either 11 years (with a down payment of 10%) or the life of your loan. | You must purchase private mortgage insurance if your down payment is less than 20%. You’ll pay it temporarily until your equity in the home is 20% or more. |
| Loan limits | In 2024, home buyers can borrow up to $498,257 for single-family homes in most parts of the country. In high-cost areas, buyers can borrow up to $1,149,825. In Alaska, Hawaii, Guam and the U.S. Virgin Islands, they can borrow up to $1,724,725. | Home buyers can borrow up to $766,550 for single-family homes and still qualify for a conventional mortgage in 2024 in most parts of the country. In certain high-cost areas, this limit increases to $1,149,825. |
Types Of FHA Loans
You can choose from several different FHA loans depending on your housing needs.
FHA 203(b) Loan
The FHA 203(b) loan is the basic FHA loan that most home buyers who apply for FHA financing take out. Here’s a quick recap:
- You can only use these loans to buy a primary residence of one to four units.
- The minimum down payment is 3.5% of your home’s purchase price with a credit score of 580 or higher and 10% with a credit score of 500 to 579.
- An FHA-approved appraiser must determine your home’s current market value and whether it meets all FHA safety standards.
FHA 203(k) Rehabilitation Loan
If you’re buying a home that needs significant repairs, you can apply for the FHA’s 203(k) rehabilitation mortgage, a type of FHA construction loan. With this loan, you can cover both your home’s purchase price and the renovation costs. So, if your home costs $200,000 and a licensed contractor estimates it will cost $50,000 to renovate it, you’d take out an FHA 203(k) rehab mortgage of $250,000. There are a few requirements, though:
- The home you’re buying must be at least 1 year old.
- The costs of improvements and repairs must be at least $5,000.
- You must work with a licensed contractor on a rehab plan that lists the estimated costs of repairs.
FHA Construction-To-Permanent Loan
You can use an FHA construction-to-permanent loan to build a new home. You can finance the purchase of the land on which your home will sit, the construction costs of your new home, and the permanent mortgage you’ll take out to pay for this new property.
Once the construction of your home is finished, this loan will automatically convert to a regular mortgage loan that you’ll pay back with interest via monthly installments. Here are some more details to consider:
- This loan requires just one closing date, meaning you only pay closing costs once.
- The FHA requires that you work with a licensed contractor to construct your home.
- The FHA also requires an appraisal to confirm that the home you’re building meets the minimum property standards.
FHA Energy Efficient Mortgage Program
If you want to make your current home more energy-efficient or add energy-efficient features to a home you’re buying, the FHA’s Energy Efficient Mortgage program can help.
Under this program, you’d apply for a mortgage larger than your home’s purchase price. You’d then use the extra dollars to fund updates that will boost the energy efficiency of a home you’re buying or your current home’s energy efficiency. A couple of things to keep in mind:
- The FHA requires that you work with a qualified home energy professional to identify the energy-efficient measures that will work best for your home.
- The FHA will only approve updates that it considers cost-effective.
FHA Cash-Out Refinance
With an FHA cash-out refinance, you refinance your current mortgage to a new loan insured by the FHA. But your new loan will be for more than what you owe on your current mortgage – exactly how much depends on the equity you’ve built in your home. You’ll then receive the extra money in a lump sum that you can spend on whatever you’d like, including home repairs, consolidating debt, or covering a child’s college tuition. Here are some more details:
- You’ll need an appraisal from an FHA-approved appraiser to determine the current market value of your home.
- You can borrow up to a certain percentage – usually 80% – of your home’s appraised value.
- You’ll need to meet all an FHA loan’s credit score and debt-to-income requirements.
FHA Streamline Refinance
Want a quick refinance that might not require much paperwork on your part? Consider an FHA Streamline refinance. This is when you refinance an existing FHA-insured mortgage to another FHA loan to achieve a net tangible benefit, whether it’s a shorter loan term, lower interest rate or lower monthly payment. Here are some other stipulations for this type of refinance:
- The loan you are refinancing must already be insured by the FHA.
- Your new loan must also be insured by the FHA.
- You must be current on the payments of your existing mortgage.
- This type of loan generally doesn’t require an appraisal.
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FHA Loans Pros And Cons
As with all mortgage types, there are pluses and minuses involved in applying for an FHA mortgage.
Pros Of FHA Loans
Some of the benefits of FHA loans include:
- FHA loans have low down payment requirements.
- They have flexible credit score requirements.
- They offer competitive interest rates.
- Closing costs can be rolled into your monthly payment.
- It can be cheaper than conventional loans if you have a low credit score.
Cons Of FHA Loans
Some of the potential downsides of FHA loans include:
- Mortgage insurance is unavoidable.
- You may get charged a higher interest rate if your credit score is low.
- There are strict property standards.
- The loan limits can be restrictive.
- It can be more expensive than conventional loans if you have good credit.
FAQ
If you’re considering this type of loan, you may still have some questions. Below are the answers to some of the most common questions about FHA loans.
The Bottom Line
While an FHA loan isn’t right for all borrowers, it might make sense for home buyers with lower credit scores and a smaller amount of savings. Its flexible requirements make homeownership more accessible for people who might otherwise have a difficult time buying a home.
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Rory Arnold contributed to the reporting of this article.
