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What is an FHA loan?

Profile picture of Michele Lerner
by Michele Lerner Mortgage & Real Estate Contributing Editor
couple signing papers at the banks

An FHA loan is a mortgage that is insured by the federal government through the Federal Housing Administration (FHA). The FHA is part of the Department of Housing and Urban Development (HUD), which sets the program’s rules and requirements. The program’s full name is the HUD 203(b) Mortgage Insurance Program, although this type of mortgage loan is more commonly known as an FHA loan.

Many homebuyers who may not qualify for a conventional mortgage find FHA loans especially appealing. Qualifying borrowers can put down as little as 3.5 percent of the home’s purchase price or appraisal price, whichever is lower. Conventional or regular home loans often require much larger down payments.

What does FHA stand for?
FHA stands for Federal Housing Administration. The Federal House Administration is a federal agency created in 1934 whose aim is to stimulate the housing market by providing affordable home loans.

How do FHA loans work?

Getting an FHA loan approved typically follows five steps: pre-approval, application, property appraisal, underwriting and final mortgage approval. You also have to meet FHA loan requirements in order to successfully apply.

  1. Pre-approval: In this step, the lender reviews the borrower’s finances to determine if they qualify for an FHA loan, and, if so, for how much.
  2. Loan application: Borrowers must complete the Uniform Residential Loan Application (Fannie Mae form 1003), usually after they have found a home. Borrowers submit information about the type of loan they seek and the property address. They may have to pay a mortgage application fee.
  3. Property appraisal: The lender hires a licensed appraiser to estimate the property’s value in the current market. Essentially, the lender wants to know your home’s potential resale value in case they have to resell the property in the future.
  4. Underwriting: The lender’s underwriter analyzes paperwork, income and credit score, among other things, to determine if the loan is sound. Homebuyers don’t usually deal with the underwriter directly.
  5. Mortgage approval: When the underwriter affirms that borrowers meet the lender’s requirements and the Federal Housing Administration’s guidelines, borrowers can proceed with the closing process and receive funding.

FHA loan pros and cons

Benefits of FHA loans
Many borrowers find the path to homeownership easier with an FHA loan. Some of the most appealing advantages of FHA loans include low down payments, small reserve requirements and backing by the federal government. FHA loans also offer relaxed credit requirements and an increased allowance for closing costs. While standard loan programs limit seller contributions to 3 percent of the loan amount, FHA allows contributions of up to 6 percent

Unlike most conventional loans, FHA loans are assumable. This means that if a home buyer finances his home with an FHA loan and later sells the house at a time when interest rates are higher, the potential buyer can assume the FHA loan at the same original low-interest rate.

Disadvantages of FHA loans
Although FHA loans provide many benefits, drawbacks also exist. One problem with FHA loans is the mortgage insurance structure. Unless borrowers put down more than 20 percent, the mortgage insurance on a 30-year loan will last as long as the loan does.

There are also two required mortgage insurance premiums:

  • Upfront mortgage insurance premiums require 1.75 percent of the loan amount immediately when the borrower receives the loan.
  • Annual mortgage insurance premiums can range from 0.45 percent to 1.05 percent of the loan. They vary depending on the loan term, loan amount and initial LTV (loan-to-value ratio). Mortgage insurance premiums are paid in monthly installments over the course of a year.

Other disadvantages borrowers must consider include higher interest rates and premiums, loan limits and minimum property standards. If borrowers are considering a fixer-upper or a home needing substantial repairs, an FHA appraiser may not approve.

FHA loan vs. conventional loan

An FHA loan is easier to obtain than other types of mortgage loans, but borrowers must pay mortgage insurance. A conventional loan is a mortgage that is not guaranteed or insured by any government agency like the FHA is. It is often fixed in its terms and interest rate. A conventional loan requires a higher credit score and, in some cases, more money down but does not have as many provisions.

FHA loans may allow homebuyers to get a mortgage and move into their home sooner, however borrowers save a substantial amount of money over the life of their loan if they qualify for a conventional loan.

Conventional MortgagesFHA Loans
Minimum FICO credit scoreUsually no lower than 620Range from 500 to 580
Minimum down payment3–20% of sale price3.5% with good credit
Mortgage insuranceMonthly payments if down payment is less than 20%; insurance can be canceled when loan-to-value ratio reaches 80%Upfront and monthly payments, sometimes for the duration of the mortgage term

Bottom line

When deciding whether an FHA loan or a conventional loan is the right option, consider your credit score and financial situation to determine how much you can comfortably put down on a house. FHA loans are good choices for people with less than optimal credit scores, including first-time homebuyers. Conventional loans are better for those who are able to obtain them, as they save borrowers more money in the long-term.

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Profile picture of Michele Lerner
by Michele Lerner Mortgage & Real Estate Contributing Editor

Michele Lerner, author of “HOMEBUYING: Tough Times, First Time, Any Time”, has been writing about personal finance and real estate for more than two decades. Michele writes for regional, national and international publications in print and online for a variety of audiences including consumers, real estate investors, business owners and real estate professionals.