An FHA loan is a home mortgage backed by the government — specifically, by the Federal Housing Administration. The term “FHA loan” is actually somewhat of a misnomer because the FHA doesn’t actually lend money to would-be homeowners. Rather, it insures the loans made by private lenders. So while we’ll use the term “FHA loan” for simplicity, an “FHA-backed loan” is more accurate.
An FHA loan aims to put homeownership within reach for many Americans who wouldn’t otherwise qualify for a conventional, non-FHA-backed mortgage. You may be able to get an FHA loan with a lower credit score, lower down payment, and a higher debt-to-income ratio than you could have for a conventional mortgage.
Why are FHA lenders willing to relax their requirements? Simple: If the homeowner can no longer pay his or her loan, Uncle Sam is on the hook instead of the lender. That means the lender can offer loans to home buyers they would otherwise deem too risky.
Best FHA Lenders
There are many, many participating FHA lenders out there, with some small, local banks in your area likely among them. But here are some of the best FHA lenders offering FHA loans nationwide:
Quicken Loans: If you want to apply for your FHA loan in your pajamas, Quicken Loans is known as an excellent online mortgage company — it’s taken the top spot in JD Power’s mortgage satisfaction survey for nine years running. Like all FHA lenders, they’ll extend mortgages to people with credit scores at least as low as 580. And it’s not as if you’d be borrowing from some fly-by-night startup: Quicken recently surpassed Wells Fargo as the No. 1 mortgage lender in America.
Guild Mortgage: This West Coast mortgage lender has expanded nationally, and it offers a number of mortgage products — including a 1% down first-time buyer loan that requires a credit score of 680 or better, but also FHA loans that are available to borrowers with pretty bad credit (we’re talking into the low 500s). It also rated among the best mortgage lenders in JD Power’s customer satisfaction survey.
TD Bank: “America’s most convenient bank” isn’t necessarily known for mortgages, but it’s an all-round good bank with plenty of happy customers: It rated well above average in every region it appeared in JD Power’s 2018 banking satisfaction survey. You may want to check out their HomeReady program, which offers a 15- to 30-year fixed-rate mortgage with a 3% down payment (you will need a credit score of 620 or above, though).
New American Funding: You aren’t likely to go wrong here. And if you’re self-employed, you probably know it can be hard to convince a lender to loan you money for a house because of your fluctuating income. Fortunately, this company has a good reputation of working with freelancers.
If you’re a legal resident of the U.S., chances are you can apply for an FHA loan.
Perhaps you’ve heard that FHA loans are for first-time or low-income homebuyers. While helping first-time and lower-income buyers are certainly two aims of the program, you don’t have to be buying your first home or earn under a certain amount of money to get an FHA loan.
You do, however, have to be seeking a loan for your primary residence — the rule here is that you have to live there for at least half the year. In most cases, that excludes investment properties, with one important loophole: You can buy up to a four-unit dwelling with an FHA loan as long as one of the units will be your primary residence.
You may even have more than one FHA loan — common qualifying circumstances include relocating to an area outside reasonable commuting distance from the first FHA-backed property, or a family simply outgrowing the first property.
FHA Loan Requirements
Let’s run through the requirements of getting an FHA loan. There are, after all, certain guidelines you’ll want to meet.
- Down payment: An FHA loan requires you to put down at least 3.5% of the purchase price. (Conventional lenders typically ask for 20%, although it’s possible to put as little as 3% down, or even less, through a first-time homebuyer program). That down payment can come from a relative or government program, but you must offer proof of where the money came from, if it didn’t come from you.
- Your credit score: This is where FHA loans really shine: While most lenders want to see a credit score in the high 600s or better for conventional mortgages, you may be able to qualify for an FHA loan with a credit score as low as 500. If you have a FICO score of 500-579, your down payment will need to be 10% or higher; to make a lower down payment, you’ll need a credit score of 580 or better.
- Employment history: Generally, FHA lenders like to see many years of steady employment or, at the very least, two years of solid work experience. That said, there tends to be a lot of wiggle room. If you were in college or the military for some of those two years, you’ll probably be fine. If you’ve been employed for years, but in a series of odd jobs or freelance gigs, and your work history doesn’t appear stable… you may run into trouble.
- Proof of income: That is, pay stubs, federal tax returns, bank statements… they won’t just take your word for it that you’ve made X amount of dollars over the years.
- Primary residence requirement: An FHA loan can only be used to purchase your primary residence — in other words, no FHA loans for second homes or a house you plan to rent out and make some money on.
- Property appraisal: The home must be appraised by an FHA- approved appraiser, and it has to meet HUD property guidelines.
- Debt-to-income ratio: Your front-end debt ratio (that would your monthly non-mortgage debt payments, like a car loan, student loan, or credit card payment) can’t be more than 31% of your gross monthly income. Your total, back-end debt ratio (which includes the mortgage) can’t be over 43% of your gross monthly income. Borrowers with very low credit scores may need to come in even lower, while those with excellent credit can occasionally get away with slightly higher debt-to-income ratios.
- Bankruptcies and foreclosures: If you’ve declared bankruptcy, it needs to be at least two years in the rearview mirror before you can apply for an FHA loan, and you’ll need to wait three years after a foreclosure. Occasionally, if you’ve had extenuating circumstances, lenders may waive the waiting period.
How do FHA loans work?
You probably picked up the gist from the above, but in case it isn’t clear, it’s just a home loan like any other – but with one big difference. It’s like you’re co-signing with the federal government.
If something goes wrong, and you can’t pay for your loan, the federal government will step in so the bank doesn’t absorb the loss. Obviously, because you want to keep your house, you’ll do everything you can to pay the lender. But because the federal government takes on some of the risk, it makes lenders more likely to lend you money, even if your credit isn’t unblemished. Otherwise, these loans work in the same way a conventional loan works.
FHA Loan Application
You don’t apply for an FHA loan through the FHA — you apply the same way you would for any mortgage. You begin with a local or online loan originator, a mortgage broker, or at your local bank or credit union.
Ask about financing and mention that you’re interested in an FHA loan (and keep an open mind, if they talk about other loans that might suit your situation, too). You’ll need to provide all the usual documentation: Pay stubs, tax returns, bank statements, debt balances — the works.
Types of FHA loans
As we’ve discussed, an FHA loan is a lot like getting a conventional mortgage. There are several types of FHA loans, just as there are several types of non-FHA loans. So here are the main types, in a nutshell:
- Fixed-rate FHA loans: This is your most common type of FHA loan, and probably the one you should try to get. Whether the loan term is for 15, 20, or 30 years, the interest rate won’t change, ever — which means your base mortgage payment won’t change, either (although your property taxes and homeowners insurance will probably inch upward).
- Adjustable-rate FHA loans: These can be attractive because the interest rate and monthly payments are often lower than the fixed-rate one… at first. So what’s not to like, right? Well, if the economy changes and interest rates start to go up, your monthly payment could climb, too. If you don’t do well with unpleasant surprises, it’s probably best to stick with the fixed-rate FHA loan.
- Reverse FHA loan (home equity conversion mortgage): This is basically just the FHA version of a reverse mortgage; you need to be 62 years or older to apply. Whether you’re interested in this or not really depends on how you feel about reverse mortgages.
- Section 245(a) – graduated payment mortgage or growing equity mortgage FHA loans: This is something to consider and talk over with a lender if you have a limited income, but you expect your current income to go up over the years. You’d start off with lower payments, but the payments would slowly increase.
It should also be noted that you can get FHA loans for condominiums and mobile homes as well. It doesn’t have to be a regular, conventional ranch or two-story house.
FHA Loans vs. Conventional Loans
Which should you go with, an FHA loan or conventional loan? There’s really no right or wrong answer. There are pros and cons to taking either route, and it really depends on what’s best for your pocket book. We don’t know what the answer is, since everybody’s situation is different, but this table may help put everything in perspective.
|Conventional Mortgages||FHA Loans|
|Minimum FICO credit score||If your credit score is 620 or better, you may want to go with a conventional loan.||As low as 500 (requires 10% or more down payment) or 580 (3.5% or more down payment).|
|Minimum down payment||You can get away with a down payment as low as 3%, but most lenders will be asking for 5% to 20% of the purchase price.||As low as 3.5%, if your credit score is 580 or higher.|
|Mortgage insurance||If you have a down payment of less than 20%, you’ll likely pay private mortgage insurance (PMI) until your loan-to-value ratio hits 80%.||You may have to pay the PMI for the entire loan through an upfront payment (1.75% of the loan).|
Advantages of an FHA Loan
Most of the benefits of an FHA loan relate to more lenient approval standards. Here are some specific advantages:
- You can make a lower down payment: This is the biggie. With an FHA loan, your down payment may be as low as 3.5% of the home’s purchase price. While you may be able to get a conventional mortgage with as little as 3% to 5% down, the closer you get to 20%, the more likely you are to be approved.
- Your credit doesn’t need to be perfect: FHA loans also offer a bit more wiggle room if your credit score isn’t top-notch. You can have a credit score as low as 580 and still nab an FHA loan with a low down payment. Some lenders even allow scores as low as 500 if you can make a larger down payment of at least 10%. Contrast that with a conventional loan, when approval becomes much less likely once your credit score drops below 700.
- You can have more debt: As with credit scores, you may be able to nab an FHA loan with a less-than-ideal (i.e. higher) debt-to-income ratio, or DTI. If the ratio of your monthly debt payments to gross income is higher than 45%, you may have a hard time getting a conventional loan. However, you may still be able to get an FHA loan at 50% or higher if the rest of your application is solid.
- Someone can gift you all the money for closing costs: Unless you put at least 20% down, you’ll need to use at least some, if not all, of your own money for the down payment on a conventional loan. In most cases, with an FHA loan, all of your down payment can come from a gift, though you will have to document the source.
- You can have a recent bankruptcy, foreclosure, or other serious financial hardship: These black marks make it all but impossible to get a conventional loan for several years after the fact, but the FHA has recently relaxed its own rules, which were already a bit more lenient. Its “Back to Work” program waives what was a three-year waiting period after foreclosure and two-year waiting period after bankruptcy. To qualify, you’ll have to meet several standards, including the ability to demonstrate full financial recovery, complete housing counseling, and document at least a 20% reduction in household income related to the financial hardship.
- Your FHA loan is assumable: Unlike most conventional loans, FHA loans are assumable. That means that when you sell your house, the buyer can take over your loan at its current terms instead of getting a new one. This can be a big selling point if interest rates have zoomed up since you received the loan.
Disadvantages of an FHA loan
The FHA loan program is enormously popular, but there are some downsides. Here’s what you need to know before you decide an FHA loan is your best bet:
- There’s an upfront mortgage insurance premium: When you get an FHA loan, you’ll have to cough up 1.75% of the loan amount, which will then be rolled into your payments. This isn’t the case with conventional mortgages.
- You’ll always have to pay monthly mortgage insurance: With conventional loans, you won’t be required to pay private mortgage insurance, or PMI, if you have a traditional 20% down payment. Even if you don’t put 20% down, you may be able to get your PMI cancelled once you’ve paid enough of your loan and built up some equity. With FHA loans, an annual mortgage insurance premium is required every month — and this is in addition to the upfront premium — for a minimum of 11 years, though most borrowers will pay it for the entire mortgage term.
- There is a cap on how much you can borrow: You won’t be able to finance a palace with an FHA loan. That’s because loans are capped at a set limit that varies depending on where you live. In my case, it’s $271,050 in Knox County, Tenn. — enough for a nice single-family home, certainly, but not a mansion by any means. On the other hand, you can get a jumbo loan conventionally, assuming you can qualify for the amount you need.
- Inspection standards can be strict: All homes financed with an FHA loan must meet extensive FHA minimum property standards, which evaluate the safety, security, and structural integrity of a home. Your loan won’t be approved until any issues that run afoul of these standards are remedied.
FHA Loan Interest Rates
There isn’t much difference between average interest rates on FHA loans and conventional mortgages. The rates may even be slightly lower, which many may find surprising given that they tend to go to less credit-worthy individuals and come with more forgiving terms.
Even if rates are slightly lower, though, remember to factor in the cost of mortgage insurance — typically pricier with FHA loans — to determine whether the FHA loan is truly cheaper. Your lender should be able to provide a detailed comparison to help you make a decision.
Alternatives to FHA loans
If you’re considering an FHA loan, be sure to investigate your alternatives before pulling the trigger. There’s always a chance one of the options below will be a better fit for your situation.
If you’re active-duty military, a veteran, a reservist or national-guard member, or an eligible military spouse, you’ll want to look into Veterans Affairs loans. The VA backs these low-interest-rate loans, which are actually made by private lenders.
Like FHA loans, borrowers don’t have to be first-time buyers, and they can benefit from the program more than once. The loans are also assumable. Unlike FHA loans, VA loans often require no down payment, and there is no mortgage insurance requirement. However, there is a funding fee of up to 3.3%.
If you’re hoping to buy a home in a rural area (or even a suburban area, in some cases), you may be able to benefit from an ultra-low-rate loan backed by the U.S. Department of Agriculture. These USDA loans often require no down payment. You will, however, have to earn below a certain amount to be eligible for the program, unlike with FHA loans.
Limits are stricter for the USDA’s Single Family Direct Homeownership Loan, which is aimed at low-income buyers who truly can’t get a loan elsewhere. Another program, the Single Family Guaranteed Loan Program, allows up to moderate-income buyers. There is a 2% upfront mortgage insurance premium and an annual fee of 0.40%.
- Related: USDA Loans: Not Just for Farmers
Conventional loans with low down payments
Though this myth still lingers, you don’t need a 20% down payment to get a conventional mortgage. It’s simply the amount you’ll need to avoid paying private mortgage insurance every month.
So if you can qualify otherwise (for instance, you have good credit and a low debt-to-income ratio), don’t discount conventional loans. While most lenders will still require at least 5% down, Fannie Mae and Freddie Mac will allow as little as 3% for qualified borrowers through the Conventional 97 program — yes, that’s even less than the FHA.
Whether you’ll benefit most from a Conventional 97 or an FHA loan depends on several factors. The latter will be easier to qualify for if you have a lower credit score; if you have a higher score and plan to be in your home for awhile, Conventional 97 could be a good pick because your interest rate and mortgage insurance will be less costly.
It’s also worth remembering the benefits of conventional loans in general: Inspections may not be as rigid, which is important if you have your eye on a fixer-upper. You may also be able to borrow more, assuming you qualify. Finally, you won’t have an upfront insurance premium, and if you do have to pay private mortgage insurance, it may be for a shorter time than you would pay the annual mortgage insurance premium with an FHA loan.
Bottom Line: Is an FHA loan right for you?
Generally, you’ll benefit most from an FHA loan if you simply can’t qualify for a conventional mortgage, whether that’s because you have a lower credit score, skimpy down payment, or other extenuating financial circumstances. But the pricey upfront and annual insurance premium make it less of a deal for those who can qualify for conventional mortgage loans at decent rates.
To get an FHA loan, you’ll need to do business with an FHA-approved lender. This won’t be tough: Given the program’s popularity, almost every major lender has gotten the OK to issue FHA loans. The Department of Housing and Urban Development offers a searchable database of FHA-approved lenders.
Remember: Just because a lender is FHA-approved doesn’t mean they’ll offer you the same loan terms as another FHA-approved lender. You’ll want to shop around, just as you would with a conventional mortgage.