What Is a Federal Housing Administration (FHA) Loan?
A Federal Housing Administration (FHA) loan is a home mortgage that is insured by the government and issued by a bank or other lender that is approved by the agency.
FHA loans require a lower minimum down payment than many conventional loans, and applicants may have lower credit scores than is usually required.
The FHA loan is designed to help low- to moderate-income families attain homeownership. They are particularly popular with first-time homebuyers.
KEY TAKEAWAYS
- FHA loans are mortgages intended for certain borrowers who find it difficult to obtain loans from private lenders.
- The federal government insures FHA loans.
- FHA borrowers tend to be riskier, and so must pay higher interest rates and pay PMI.
- Because they are insured, banks are more willing to loan money to homebuyers with relatively low credit scores and little cash to put down on the purchase.
- First-time homebuyers may find that an FHA loan is the most affordable mortgage option.
How Does an FHA Loan Work?
If you have a credit score of at least 580, you can borrow up to 96.5% of the value of a home with an FHA loan, as of 2022. That means the required down payment is only 3.5%.
If your credit score falls between 500 and 579, you can still get an FHA loan as long as you can make a 10% down payment.
With FHA loans, the down payment can come from savings, a financial gift from a family member, or a grant for down payment assistance.
The Bank’s Role in an FHA Loan
The FHA doesn’t actually lend anyone money for a mortgage. The loan is issued by a bank or other financial institution that is approved by the FHA.
The FHA guarantees the loan. That makes it easier to get bank approval since the bank isn’t bearing the default risk. Some people refer to it as an FHA-insured loan for that reason.
Borrowers who qualify for an FHA loan are required to purchase mortgage insurance, with the premium payments going to the FHA.
History of the FHA Loan
Congress created the FHA in 1934 during the Great Depression. At that time, the housing industry was in trouble: Default and foreclosure rates had skyrocketed, 50% down payments were commonly required, and the mortgage terms were impossible for ordinary wage earners to meet. As a result, the U.S. was primarily a nation of renters, and only one in 10 households owned their homes.
The government created the FHA to reduce the risk to lenders and make it easier for borrowers to qualify for home loans.
The homeownership rate in the U.S. steadily climbed, reaching an all-time high of 69.2% in 2004, according to research from the Federal Reserve Bank of St. Louis. In the first quarter of 2022, the rate stood at 65.4%.
FAST FACT: Though principally designed for lower-income borrowers, FHA loans are available to everyone, including those who can afford conventional mortgages.
In general, borrowers with good credit and strong financials will be better off with a conventional mortgage, while those with poorer credit and more debt can benefit from an FHA loan.
Types of FHA Loans
In addition to traditional mortgages, the FHA offers several other home loan types.
Home Equity Conversion Mortgage (HECM)
This is a reverse mortgage program that helps seniors ages 62 and older convert the equity in their homes to cash while retaining the home’s title. The homeowner can withdraw the funds in a fixed monthly amount, a line of credit, or a combination of both.
FHA 203(k) Improvement Loan
This loan factors the cost of certain repairs and renovations into the amount borrowed. It’s great for those willing to buy a fixer-upper and put some sweat equity into their home.
FHA Energy Efficient Mortgage
This program is similar to the FHA 203(k) improvement loan program, but it’s focused on upgrades that can lower your utility bills, such as new insulation or solar or wind energy systems.
Section 245(a) Loan
This program works for borrowers who expect their incomes to increase. The Graduated Payment Mortgage (GPM) starts with lower monthly payments that gradually increase over time. The Growing Equity Mortgage (GEM) has scheduled increases in monthly principal payments. Both promise shorter loan terms.
| The 5 Types of FHA Loan | |
|---|---|
| FHA LOAN TYPE | WHAT IT IS |
| Traditional Mortgage | A mortgage that finances a primary residence. |
| Home Equity Conversion Mortgage | A reverse mortgage that allows homeowners ages 62+ to exchange home equity for cash. |
| 203(k) Mortgage Program | A mortgage that includes extra funds to cover the cost of repairs, renovations, and home improvements. |
| Energy Efficient Mortgage Program | A mortgage that includes extra funds to pay for energy-efficient home improvements. |
| Section 245(a) Loan | A Graduated Payment Mortgage (GPM) has a low initial monthly payment that increases over time. A Growing Equity Mortgage (GEM) has scheduled increases in monthly principal payments to shorten the loan term. |
What Are FHA Loan Requirements?
Your lender will evaluate your qualifications for an FHA loan as it would any mortgage applicant, starting with a check to see that you have a valid Social Security number, reside lawfully in the U.S., and are of legal age (according to your state laws).
FHA loan criteria are less rigid in some ways than a bank’s loan criteria. However, there are some more stringent requirements.
Whether or not it’s an FHA-guaranteed loan, your financial history will be examined when you apply for a mortgage.
Credit Scores and Down Payments
FHA loans are available to individuals with credit scores as low as 500.3 That is within the “very bad” range for a FICO score.
If your credit score is between 500 and 579, you may be able to secure an FHA loan, assuming you can afford a down payment of 10%. Meanwhile, if your credit score is 580 or higher, you can get an FHA loan with a down payment of as little as 3.5%.
By comparison, applicants typically need a credit score of at least 620 in order to qualify for a conventional mortgage. The down payment required by banks varies between 3% and 20%, depending on how eager they are to lend money at the time you apply.
Tip: As a general rule, the lower your credit score and down payment, the higher the interest rate you’ll pay on your mortgage.
History of Honoring Debts
A lender will look at your work history for the past two years as well as your payment history for bills such as utility and rent payments.
People who fall behind on federal student loan payments or income tax payments will be rejected unless they agree to a satisfactory repayment plan. A history of bankruptcy or foreclosure may prove problematic, too.
Typically, to qualify for an FHA loan—or any type of mortgage—at least two or three years must have passed since the borrower experienced bankruptcy or foreclosure. However, exceptions can be made if the borrower demonstrates having worked to re-establish good credit and get their financial affairs in order.
Proof of Steady Employment
Mortgages must be repaid, and the FHA-approved lender will want assurances that the applicant can achieve this. The key to determining if the borrower can make good on their commitment is evidence of recent and steady employment.
This can be documented by tax returns and a current year-to-date balance sheet and profit-and-loss statement.
If you’ve been self-employed for less than two years but more than one year, you may still qualify if you have a solid work and income history in the same or a related occupation for the two years before becoming self-employed.
Sufficient Income
Your mortgage payment, HOA fees, property taxes, mortgage insurance, and homeowners insurance should be less than 31% of your gross income. Banks call this the front-end ratio.
Meanwhile, your back-end ratio, which consists of your mortgage payment and all other monthly consumer debts, should be less than 43% of your gross income.
| FHA Loans vs. Conventional Loans | ||
|---|---|---|
| FHA LOAN | CONVENTIONAL LOAN | |
| Minimum Credit Score | 500 | 620 |
| Down Payment | 3.5% with a credit score of 580+ and 10% for a credit score of 500 to 579 | 3% to 20% |
| Loan Terms | 15 or 30 years | 10, 15, 20, or 30 years |
| Mortgage Insurance | Upfront MIP + annual MIP for either 11 years or the life of the loan, depending on LTV and length of the loan | None with a down payment of at least 20% or after the loan is paid down to 78% LTV |
| Mortgage Insurance Premiums | Upfront: 1.75% of the loan + annual: 0.45% to 1.05% | PMI: 0.5% to 1% of the loan amount per year |
| Down Payment Gifts | 100% of the down payment can be a gift | Only part can be a gift if the down payment is less than 20% |
| Down Payment Assistance Programs | Yes | No |
FHA Mortgage Insurance Premiums (MIPs)
An FHA loan requires that you pay two types of mortgage insurance premiums (MIPs)—an upfront MIP and an annual MIP, which is paid monthly. In 2022, the upfront MIP is equal to 1.75% of the base loan amount.
You can either pay the upfront MIP at the time of closing, or it can be rolled into the loan.
For example, if you’re issued a home loan for $350,000, you’ll pay an upfront MIP of 1.75% x $350,000 = $6,125.
These payments are deposited into an escrow account that the U.S. Treasury Department manages. If you end up defaulting on your loan, the funds will go toward the mortgage repayment.
Despite its name, borrowers make annual MIP payments every month, with the payments ranging from 0.45% to 1.05% of the base loan amount. The payment amounts differ depending on the loan amount, the length of the loan, and the original loan-to-value (LTV) ratio.
Let’s assume you have an annual MIP of 0.85%. In that case, a $350,000 loan would result in annual MIP payments of 0.85% x $350,000 = $2,975 (or $247.92 monthly). These monthly premiums are paid in addition to the one-time upfront MIP payment. You will make annual MIP payments for either 11 years or the life of the loan, depending on the length of the loan and the LTV.
You may be able to take a tax deduction for the amount you pay in premiums. You have to itemize your deductions—rather than take the standard deduction—in order to do this.
| How Long You Will Pay the Annual Mortgage Insurance Premium (MIP) | ||
|---|---|---|
| TERM | LTV% | HOW LONG YOU PAY THE ANNUAL MIP |
| ≤ 15 years | ≤ 78% | 11 years |
| ≤ 15 years | 78.01% to 90% | 11 years |
| ≤ 15 years | > 90% | Loan term |
| > 15 years | ≤ 90% | 11 years |
| > 15 years | > 90% | Loan term |
Homes That Qualify for an FHA Loan
Usually, the property financed must be your principal residence and must be owner-occupied. In other words, the FHA loan program is not intended for investment or rental properties.
Detached and semi-detached houses, townhouses, rowhouses, and condominiums within FHA-approved condo projects are all eligible for FHA financing.
Also, you need a property appraisal from an FHA-approved appraiser, and the home must meet certain minimum standards. If the home doesn’t meet these standards and the seller won’t agree to the required repairs, you must pay for the repairs at closing. (In this case, the funds are held in escrow until the repairs are made.)
What Are the Federal Housing Administration Loan Limits?
FHA loans have limits on how much you can borrow. These are set by region, with lower-cost areas having a lower limit (referred to as the “floor”) than the usual FHA loan and high-cost areas having a higher figure (referred to as the “ceiling”).
There are “special exception” regions—including Alaska, Hawaii, Guam, and the U.S. Virgin Islands—where very high construction costs make the limits even higher.
Elsewhere, the limit is set at 115% of the median home price for the county, as determined by the U.S. Department of Housing and Urban Development (HUD).
The chart below lists the 2022 loan limits:
| 2022 FHA Loan Limits | |||
|---|---|---|---|
| PROPERTY TYPE | LOW-COST AREA ‘FLOOR’ | HIGH-COST AREA ‘CEILING’ | SPECIAL EXCEPTION AREAS |
| One-Unit | $420,680 | $970,800 | $1,456,200 |
| Two-Unit | $538,650 | $1,243,050 | $1,864,575 |
| Three-Unit | $651,050 | $1,502,475 | $2,253,700 |
| Four-Unit | $809,150 | $1,867,275 | $2,800,900 |
Federal Housing Administration (FHA) Loan Relief
When you get an FHA loan, you may be eligible for loan relief if you’ve experienced a legitimate financial hardship such as a loss of income or an increase in living expenses. The FHA Home Affordable Modification Program (HAMP), for example, can permanently lower your monthly mortgage payment to an affordable level.
To become a full participant in the program, you must successfully complete a trial payment plan in which you make three scheduled payments—on time—at the lower, modified amount.
Advantages and Disadvantages of FHA Loans
FHA loans are often the best source of a mortgage for certain borrowers that are unable to obtain financing through private lenders. Thus, you may qualify for an FHA loan with a lower credit score and/or greater amounts of debt (and higher debt-to-income),
However, because FHA borrowers are often riskier, FHA loans usually come with somewhat higher interest rates and require the purchase of PMI. FHA loans can only be used for your primary residence and come with certain borrowing limits.
Pros and Cons of FHA Loans
Pros
- Available to borrowers with lower credit scores
- Lower down payments
- Federally-backed
Cons
- Requires purchase of PMI and its ongoing premiums
- Cannot be used for second homes or investment properties
- Higher interest rates
- Not all properties qualify
How Do I Apply for an FHA Loan?
You apply for an FHA loan directly with the bank or other lender that you choose. Most banks and mortgage lenders are approved for FHA loans.
You can apply for pre-approval of an FHA loan with the lender you choose. The lender will gather enough financial information to issue (or deny) a pre-approval within a day or so. That will give you an idea of how much you can borrow while not committing yourself to anything.
All of the above is true for any mortgage application. If you want an FHA loan you should say that upfront.
What Is the Max Amount You Can Get From an FHA Loan?
That depends on where you live as well as on your ability to repay the loan. The maximum amount you will be able to borrow will be based on your financial circumstances.
The maximum amount anyone can borrow from the FHA varies by region.
In 2022, loan limits range from $420,680 for a one-unit property in a lower-cost area to $2,800,900 for a four-unit home in the country’s most expensive cities.
How Much Does FHA Mortgage Insurance Cost?
FHA loans include both an upfront premium fee, which can be rolled into the mortgage, and a monthly charge, which is added to your mortgage payment and goes directly to the FHA.
- The upfront fee is 1.75% of the loan amount.
- The monthly fee is based on the value of the home.
To estimate the costs, plug the numbers in an FHA Loan Calculator. For example, it will show that a 30-year FHA loan at an interest rate of 3.955% on a home valued at $250,000 will have a $1,166 monthly loan payment plus a $174 monthly mortgage insurance payment.
Most lenders require that borrowers have mortgage insurance if they’re putting less than 20% down on the loan. Once the borrower pays off enough of the loan to reach 20% ownership the insurance can be dropped.
How Do I Get Rid of My FHA Mortgage Insurance?
FHA mortgage insurance lasts for the life of the loan or for 11 years, depending on the length of the loan.
The only way to get rid of that mortgage insurance is to refinance the mortgage with a non-FHA loan. Your FHA loan will then be paid off in full. Assuming you own at least 20% equity in the home, you should no longer be required to have mortgage insurance.
What Are the Downsides of FHA Loans?
FHA loans usually feature higher interest rates than conventional mortgages and require borrowers to purchase mortgage insurance. FHA loans are also less flexible and have loan limits.
The Bottom Line
The FHA loan is a path to homeownership for people who the banks would probably otherwise reject. They may have little cash for a down payment or a less-than-stellar credit rating. They might not qualify without that government guarantee that the bank will get its money back.
However, those who can afford a substantial down payment may be better off going with a conventional mortgage. They may be able to avoid the monthly mortgage insurance payment and get a lower interest rate on the loan.
FHA loans were not created to help potential homeowners who are shopping at the higher end of the price spectrum. Rather, the FHA loan program was created to support low- and moderate-income homebuyers, particularly those with limited cash saved for a down payment.
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