What is an FHA loan?
An FHA loan is a mortgage 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 FHA 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 or FHA mortgage.
Many homebuyers who may not qualify for a conventional mortgage find FHA loans especially appealing. Qualifying FHA borrowers can put down as little as 3.5% 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 Housing 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: preapproval, application, property appraisal, underwriting and final mortgage approval. You also have to meet FHA loan requirements in order to successfully apply.
- Preapproval: In this step, the lender reviews the borrower's finances to determine if they qualify for an FHA home loan, and, if so, for how much.
- Loan application: Borrowers must complete the Uniform Residential Loan Application (Fannie Mae Form 1003), usually after they've found a home. Borrowers must submit information about the type of loan they’d like and the property’s address. They may have to pay a mortgage application fee.
- Property appraisal: The lender hires a licensed appraiser to estimate the property's value in the current market. Essentially, an FHA lender wants to know your home's potential resale value in case they have to resell the property in the future.
- Underwriting: The mortgage lender's underwriter analyzes your paperwork, income and credit score, among other things, to determine if the loan is sound. Homebuyers don't usually deal with the underwriter directly.
- 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.
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FHA loan pros and cons
FHA loans make homeownership a possibility for many people who may not otherwise qualify, and they offer many benefits — but there are drawbacks.
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% of the loan amount, FHA allows contributions of up to 6%.
Unlike most conventional loans, FHA loans are assumable. This means that if a homebuyer finances a 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
One problem with FHA loans is the mortgage insurance structure. Unless borrowers put down at least 20%, the mortgage insurance on a 30-year loan will last as long as the loan does.
There are also two required mortgage insurance premiums, or MIPs:
- Upfront mortgage insurance premiums require 1.75% of the loan amount immediately when the borrower receives the loan.
- Annual mortgage insurance premiums can range from 0.45% to 1.05% of the loan. They vary depending on the loan term, loan amount and initial LTV (loan-to-value ratio). Annual FHA MIPs are paid in monthly installments over the course of a year.
Other disadvantages borrowers must consider include higher interest rates and premiums, FHA loan limits and minimum property standards. If borrowers are considering a fixer-upper or a home that needs substantial repairs, an FHA appraiser may not approve the loan.
FHA loan vs. conventional loan
An FHA loan is typically 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. Conventional loans often have fixed terms and interest rates. A conventional loan requires a higher credit score and, in some cases, more money down, but these loans do not have as many provisions.
FHA-insured loans may allow homebuyers to get a mortgage and move into their home sooner, but borrowers may save money over the life of their loan if they qualify for a conventional loan.
| Conventional Mortgages | FHA Loans | |
|---|---|---|
| Minimum credit score | Usually no lower than 620 | Ranges from 500 to 580 |
| Minimum down payment | 3% to 20% of sale price | 3.5% with good credit |
| Mortgage insurance | Monthly 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: Is an FHA loan right for me?
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 often good choices for first-time homebuyers, people with less optimal credit scores or those who can't make a large down payment. Conventional loans may be better for those who qualify for them them, as they can save borrowers money in the long-term.
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