FHA Loans May Save You Money. Here’s How They Work

An FHA home loan is a mortgage insured by the US Federal Housing Administration that caters to first-time homebuyers. It’s also easier to qualify for than a conventional mortgage. An FHA loan may be a good option if you have a lower credit or can’t make a sizable down payment. 

Considered a secure mortgage, FHA loans are backed by the US government. The Department of Housing and Urban Development sets the limits and requirements for FHA loans, but lenders may add their own specific conditions, so there may be differences in eligibility requirements depending on your mortgage lender.

The writing on federal websites is sometimes difficult to understand, so we’ve rounded up everything you need to know about FHA loans, their requirements and whether this mortgage type is right for you. 

What is an FHA loan?

FHA loans are similar to conventional mortgages in that they’re issued by banks, credit unions or other lenders. The difference is that they’re insured by the Federal Housing Administration, which sets the basic guidelines for eligibility. And because FHA loans are insured by the government, lenders are more willing to approve a borrower with a lower FICO score or less money for a down payment. If the borrower defaults on the loan, the lender can call on the insurance to bail them out. 

What are the differences between an FHA loan and a conventional loan?

FHA loans are designed for a borrower with a short credit history or a low credit score, but they also “allow for financing sooner after a significant credit event such as a foreclosure, short sale or bankruptcy,” according to Michael Mertz, operations manager for VIP Mortgage. 

Another big difference is that FHA loans require you to pay a Mortgage Insurance Premium regardless of down payment size, where a conventional mortgage only requires private mortgage insurance if you make less than a 20% down payment — and you can drop your PMI once you build up 20% equity in your home. You cannot get rid of MIP on an FHA loan even once you reach 20% equity in your home, unless your down payment was higher than 10% — and in this case you can only get rid of it after 11 years.

What are the different types of FHA loans?

Like conventional mortgages, there are different types of FHA loans, covering all kinds of financial situations and home-buying scenarios. 

Here are some of the most common ones:

Basic home mortgage, 203(b)

This broad loan category includes both fixed- and adjustable-rate mortgages. Fixed rate means that you pay the same rate during the loan term, which can range from 15 to 30 years. An adjustable-rate mortgage, known as an ARM, features a low rate for an introductory period. After the initial period, the rate can change based on a number of financial indices. Though there are thresholds for how high or low the interest rate can go, ARM payments are likely to fluctuate over the lifetime of the loan.

FHA renovation mortgages, 203(k)

Designed for homeowners that want to make renovations, this mortgage combines a home’s purchase price and renovations into one loan, so you don’t have to take out a second mortgage or a separate home improvement loan.

Energy-efficient mortgage, or EEM

If you’re looking to make your home more energy efficient, there’s a specific FHA loan to help you cover those costs. 

Construction to permanent, or CP

If you’re building a new home, this type of mortgage helps you finance both construction costs and the land — provided you stay within the FHA loan limits. 

What are the FHA loan limits?

According to HUD rules, the FHA loan limits for 2022 range from $420,680 to $970,800 depending on where you live. You can use the department’s official lookup tool to see the specific limits for your area. 

Pros and cons of FHA loans

The primary advantage of FHA loans is that they expand access to mortgages for borrowers with lower credit scores or shorter credit histories. But they can also pave the way for borrowers who have less cash for a down payment. In fact, if you have a FICO score of 580 or higher, you may be eligible to put down as little as 3.5%. And many states offer programs to help buyers with down payments or closing costs. Conventional loans, on the other hand, allow down payments as low as 3% but are harder to qualify for. 

The mortgage insurance requirement is the one downside to FHA loans. If you put down less than 10% with an FHA loan, you’ll be required to pay mortgage insurance for the entire life of the loan. (With a conventional loan, once you exceed the 20% loan-to-value threshold, you are no longer required to pay for mortgage insurance.) However, since FHA loan interest rates tend to be lower than conventional rates, even with MIP, that can still save you tens of thousands of dollars over the lifetime of your loan.

How to qualify for an FHA loan

Though specific requirements vary from lender to lender, there are some basic qualifications set by HUD.

Credit score

You may be able to qualify for an FHA loan with a score as low as 500, buy if your score is lower than 580, you have to make a minimum down payment of 10%. With a conventional loan, you need a FICO credit score of at least or 620 to qualify, 

Down payment

If your credit score is 580 or higher, you may be able to qualify with a down payment as low as 3.5%. If your credit score is between 500 and 580, you’ll likely need to put down 10%. 

But FHA loans also have less stringent requirements around the source of your down payment. Your relative can simply write a check for a down payment (along with a letter documenting the transaction). With a conventional mortgage, you need to store the donated funds in a bank account for at least two statement periods. 

Debt-to-income ratio

This metric shows how much of your monthly (pretax) income goes to making your minimum debt obligations. It includes all of your debts, even loans that are inactive or are being deferred. (Student loan debt, however, has a lower weight when calculating this ratio than other types of loans.) If your monthly minimum debt payment totals $700, for example, and you make $3,500 per month, your DTI ratio is 20%. 

FHA lenders typically look for applicants with a debt-to-income ratio of 43% or lower. 

Property approval

FHA loans require an in-depth appraisal. If you’re applying for a 203(k) construction mortgage, a lender might require two appraisals: one before the renovation and another after you make improvements. 

Mortgage insurance

All FHA loans require mortgage insurance. If you make a down payment of 10% or more, you will pay mortgage insurance for the first 11 years of the loan. If you only make a down payment of less than 10%, you will have to pay for insurance until you pay off the loan — or refinance with a conventional loan with at least a 20% down payment. 

How to apply for an FHA loan

There will be paperwork. FHA loans are available only to citizens of the US, and you will need to provide proof of citizenship such as a current driver’s license, passport or other government-issued ID. You will also need a valid Social Security number and proof of income such as pay stubs, bank statements or tax documents. If you receive money from a family member for your down payment, you’ll need to include a note indicating that.