What is an FHA Loan?

If you’re in the market for a mortgage, chances are you’ve heard of an FHA loan. An FHA loan is a government-backed loan insured by the Federal Housing Administration and offered by approved lenders. Many first-time homebuyers can get into a home with an FHA mortgage, with benefits like highly competitive interest rates and small down payment requirements. Though, FHA loans do have a few conditions.

Let's look into how FHA loans work, the requirements needed, and the benefits for borrowers.

How does an FHA loan work?

The FHA provides approved credit unions, banks, and other mortgage lenders with a guarantee for certain loans made to homebuyers (they don't have to be first-time buyers) that cover the mortgage lender in case of default.

These FHA loans require a smaller minimum down payment than would be required with a conventional loan, and borrowers can also be approved with more competitive interest rates. These differences mean that FHA loans have been designed to help those with low-to-moderate incomes become homeowners, making them especially popular with first-time buyers. 

FHA loan limits 

The number one thing to keep top of mind with an FHA loan is to ensure you’re not looking at a home that exceeds the lending limits. 

Loan limits vary depending upon the property's location, and change annually. The U.S. Department of Housing and Urban Development (HUD) provides a page that allows you to look up the FHA loan limits based on geographic area.

Compared to conventional loans, the FHA limits for the majority of the country are much lower. You can compare an example of spending limits between them using the chart below:

Are FHA loan interest rates lower?

For the most part, the average FHA loan interest rate will be lower than a conventional mortgage rate under the same circumstances. (Meaning—same loan size, credit score, down payment, etc.) It’s always best to take time to research and compare your options.

It’s also important to note, even though the interest rate is lower, added FHA requirements, including mortgage insurance, will increase your monthly payments. So, when you're comparing an FHA interest rate vs. a conventional interest rate, make sure to compare payments that include the mortgage insurance.

FHA mortgage insurance premiums

FHA loans require a mortgage insurance premium (MIP). This type of insurance protects the lender, not the borrower. An annual MIP amount can range between 0.15% to 0.75% of your loan. For a $300,000 loan—it can add a few hundred dollars per month to your payment and can last for 11 years or the life of the loan, depending on how much you put down. (In comparison, there is no mortgage insurance on a conventional mortgage if you put down 20%.)

FHA Loan Requirements

FHA loan property requirements

While not all lenders lend on every type of property, there are different varieties of homes FHA loans can be used to purchase or refinance, including:

• Single-family homes
• Duplexes, triplexes, and fourplexes
• Condominiums (on approved condo list)
• Some manufactured homes on permanent foundations
• There are also FHA loan options for new construction, renovating existing homes, and buying a property to renovate

FHA loans have limits that vary by county for single-family properties, multi-family dwellings, and homes needing renovations. The FHA loan must be for a principal residence with a borrower occupying the property within 60 days of closing. It cannot be for investment, except for a multi-family with the borrower occupying at least one unit. And unless it is a renovation, the property must meet minimum property standards.

FHA loan borrower requirements

FHA loans have less stringent requirements that borrowers must meet to be eligible compared to conventional loans.

While FHA loans have no minimum or maximum salary requirements for qualification, buyers must have:

• Minimum of two established credit accounts (credit cards, auto, student loans)
• No delinquent federal debt or any debt from another FHA-insured mortgage
• Down payment gifts must be verified in writing by the donor

FHA credit and down payment requirements

One of the best benefits of FHA loans is the credit score requirements are much lower than conventional mortgages. If your credit score is 580 or above, the FHA allows you to borrow up to 96.5% of the home's value with an FHA loan, meaning you may only need 3.5% down payment.

Product guidelines vary by lender. An FHA loan is still possible for borrowers with scores between 500 and 579, but a 10% or greater down payment is needed. The lowest credit score the FHA will insure a loan for is 500, but keep in mind that most lenders still require a minimum credit score of 620 or higher.

Compared to conventional mortgages, FHA loans are more lenient on derogatory credit or credit events such as bankruptcy or foreclosure. But additional requirements apply including waiting periods after credit events and supporting written explanations documenting past events.

FHA debt requirements

FHA lenders look at two debt ratios:

1. Total mortgage payment to effective income ratio (PTI or "front-end debt ratio") is the value of the proposed mortgage divided by income.
2. Debt-to-income ratio (DTI) is the percentage of pre-tax income spent on monthly debt payments (mortgage/rent, credit cards, student loans, and other debts).

Borrowers should be aware that meeting all FHA minimum requirements does not guarantee FHA loan approval. While FHA guidelines must be met, FHA-approved lenders determine final underwriting standards for their organizations so minimum credit scores, interest rates, and other factors will vary by lender.

Is an FHA mortgage the right home loan for you?

FHA loans are a great resource for the right buyer and property. If you and your desired property fit into the criteria suitable for FHA loans, they can be a great way to get into a new home or refinance your current home. Although, you may find better terms (lower down payment, higher existing debt allowance) if your credit score is higher with a conventional loan. And the mortgage rates will also be better with a more robust credit score saving you thousands over the life of the loan.

It is good to shop around and find the best deal that fits your needs and capabilities. For a more in-depth look, visit our eBooks page to download our free eBook about FHA lending.