What is an FHA loan?

The information provided on this website does not, and is not intended to, act as legal, financial or credit advice. See Lexington Law’s editorial disclosure for more information.

If you’re about to buy a home, you’re likely thinking about your mortgage options. There are several ways you can finance purchasing a home, and you should explore all your options to find the best one for you. One of the most popular and affordable options for a mortgage is an FHA loan.

What is an FHA loan?

A Federal Housing Administration (FHA) loan is a government-backed mortgage provided by private lenders the FHA approves. Compared to a conventional mortgage, FHA loans have less strict financial requirements, making them popular among borrowers.

How do FHA loans work?

FHA loans are primarily intended for people with low to moderate incomes and less-than-ideal credit scores. Because of this, first-time home buyers often seek to get approved for FHA loans, though other people can and do benefit from them as well.

To get an FHA loan, you must contact an FHA-approved bank or other lender instead of the Federal Housing Administration itself. The FHA does guarantee the loan, which means the governmental agency will protect your lender from losses if you default. This insurance incentivizes your lender to offer you the more favorable terms that normally come with such a loan.

One thing to consider with FHA loans is that borrowers must pay two types of mortgage insurance: an up-front mortgage insurance premium (MIP) and an annual MIP. The up-front MIP is typically a one-time payment worth 1.75 percent of the loan amount, while the annual MIP is normally a monthly payment worth 0.15 percent to 0.75 percent of the loan amount. This is a significant way in which FHA loans differ from conventional loans.

FHA loans compared to conventional loans

To help you decide if an FHA loan might be right for you, review how it compares to a conventional loan in these seven categories:

1. Loan terms: FHA loans can last either 15 or 30 years, while conventional loans can last 10, 15, 20 or 30 years.
2. Credit score: In most cases, your credit score must be at least 500 to qualify for an FHA loan, but you need a score of at least 620 to be eligible for a conventional loan.
3. Down payment percentage:Your FHA loan down payment depends on your credit score. If you have a score of 500 to 579, your down payment can be around 10 percent—however, if your score is 580 or above, your down payment can be as low as 3.5 percent. With a conventional loan, you’re looking at a down payment of anywhere from 3 percent to 20 percent.
4. Down payment assistance: With an FHA loan, you can use gift money to cover your whole down payment, and you can—sometimes—get additional help from the seller. If you have a conventional loan, though, you may only be allowed to use some gift money, or none at all—and there’s no down payment assistance program.
5. Mortgage insurance: FHA loans require up-front and annual MIP payments. In contrast, conventional loans don’t require mortgage insurance if the down payment is over 20 percent.
6. Post-bankruptcy qualification: It can be easier to get an FHA loan than a conventional loan after you’ve declared bankruptcy. Once a certain amount of time has passed and you’ve met other requirements, you may be able to take advantage of the more flexible FHA loan program.
7. Loan purpose: Unlike conventional home loans, some FHA loans can be used for other expenses, such as home improvement and repair projects.

FHA loan types

There are several types of FHA loans:

• A fixed-rate loan:This is the standard loan used to finance someone’s primary residence when they don’t have a lot of money saved for a down payment. First-time home buyers typically benefit from this kind of loan.
• A secure refinance loan: This loan type is for those needing to refinance. Typically, people refinance because interest rates have decreased and they want to save money or they need to lower their mortgage payments by increasing their loan term length.
• An energy-efficient mortgage: Homeowners who want to modify their home to make it more energy-efficient and decrease utility bills may use this kind of loan.
• A reverse mortgage: This mortgage lets homeowners who are 62 and older exchange home equity for income or a line of credit.
• A condominium loan: As the name indicates, this loan is designed for those who want to buy a condo unit.

In addition, you can consider options such as an adjustable-rate mortgage (ARM), a graduated-payment mortgage and a growing equity mortgage. Talk to your FHA-approved lender to learn more.

FHA loan requirements

FHA loans have some requirements you should know about when it comes to your credit score, mortgage insurance and debt-to-income ratio. It’s important to understand them before you begin the process.

Average required credit score

You need a credit score of 500 or more to qualify for the FHA program. It’s even better if you have a score of at least 580 because, as we mentioned earlier, that means you’re eligible for a down payment of only 3.5 percent.

However, it’s important to note that individual FHA-approved lenders can require something more on top of the minimums set by the Department of Housing and Urban Development (HUD). You can find out what credit score requirements lenders have in the process of searching for a mortgage servicer to work with.

Mortgage insurance

You must be able to pay the up-front mortgage insurance premium and the annual mortgage insurance premium. How long you’ll have to make these payments is based on your loan-to-value (LTV) ratio, so make sure you understand the terms of your FHA loan before you officially commit to anything.

Debt-to-income ratio

Your debt-to-income ratio measures your total monthly debt payments versus your pretax income. The current  guidelines state that your DTI can be as high as 43 percent in most cases but can go up to 56.9 percent if there are compensating factors, such as a cash reserve, a high credit score or proof of steady employment. Potential lenders will look at your front-end DTI (your mortgage payment, insurance, taxes and MIP) and your back-end DTI (your total DTI), though the back-end DTI carries more weight.

FHA loan limits

Lending limits for FHA loans change annually and vary depending on what state and county you live in. Currently, the maximum amount you can borrow for a single-family home in low-cost areas is $498,257. In high-cost areas, the borrowing limit for a single-family home is set at $1,149,825.

Special exception areas—such as Alaska and Hawaii—have higher loan limits to match the higher construction costs. Wherever you live, you can look up the limits in your county specifically.

How to apply for an FHA loan

Once you decide an FHA loan is right for you, you’ll need to begin the application process. To do so, contact lenders to establish which are approved by the FHA and which you may want to work with. You should be able to find options in the forms of banks, credit unions, private mortgage brokers and national mortgage brokers.

You’ll likely need to provide some information, such as your Social Security number (SSN) and other documentation. Then, you can compare fees, loan terms and credit score requirements to determine which lender is the best for you. This process may be lengthy, but it’ll ultimately be worth it when you get a loan that fits your needs.

Improve your credit before applying

As you get ready to buy a home, remember that your credit will play a large role. The higher your credit is, the better loan terms you can receive. Your credit score also matters for your FHA loan application.

The first step is to check your credit and review your credit report. If you have negative items on your credit report that are hurting your credit unfairly, it can be worthwhile to challenge them. Not sure how to do that? Let the credit repair professionals at Lexington Law help. Start with a free credit assessment today.