Many Americans want to buy a home but have concerns about their ability to qualify for a mortgage. Are you worried that your credit score might prevent you from getting a home loan? Or that you won't be able to save up enough for a 20% down payment? An FHA loan might be your solution. Since 1934, the Federal Housing Administration (FHA) has been working to make homeownership more accessible through the FHA loan program.
In this article, you’ll learn all about FHA loans, including:
- What an FHA loan is and how it works,
- The benefits and potential drawbacks of an FHA loan,
- How to qualify for an FHA loan, and
- How to get an FHA loan.
What Is An FHA Loan?
An FHA loan is a government-backed mortgage with less rigorous financial requirements for homebuyers than conventional loans. Through an FHA loan, buyers can potentially qualify for a home loan with a lower credit score than would normally be required.
“Government-backed” means that the federal government insures the loan. This insurance protects the lender in case the borrower defaults on the loan. So, government-backed loans are less risky for lenders, which allows them to relax their qualification criteria and extend loans to those who might not qualify for a conventional loan.
How Do FHA Loans Work?
FHA loans work similarly to any of the other five main types of mortgage loans; you borrow a lump sum from a lender to purchase a home, then repay that loan balance, plus interest, over the loan term.
FHA loans allow homebuyers to borrow up to 96.5% of a home’s value. This means you could potentially buy a home with a down payment of as little as 3.5% through an FHA loan. Additionally, you could potentially for grant programs that effectively reduce the down payment even further.
However, not all borrowers who qualify for an FHA loan will qualify for this extremely low downpayment option. Depending on multiple factors, such as credit scores, annual income, and current debts, some qualified FHA borrowers may be required to put more money down.
It is important to note that all FHA loans require mortgage insurance. Mortgage insurance is an additional insurance policy, paid for by the homebuyer, that protects the lender against default. For FHA loans, this mortgage insurance is called MIP, which stands for Mortgage Insurance Premium. In many cases, this insurance is automatically provided, and the cost is rolled into the mortgage payment. This means you don't have to shop for this insurance or make a separate payment.
What Are The Advantages Of FHA Loans?
Many buyers choose FHA loans because of the benefits they offer, including:
- Lower credit score requirements. If your credit score is too low to qualify for a conventional loan, you might still qualify for an FHA loan. It may even be possible to qualify for an FHA loan with a bankruptcy, foreclosure, or other serious mark on your financial record.
- Lower down payment requirements. You might need only 3.5%-10% down to buy a home with an FHA loan.
- Lower closing costs. Closing costs are the fees you pay to close your real estate transaction. FHA closing costs could potentially be rolled into the loan, allowing you to pay less out-of-pocket to complete the home purchase.
Are There Potential Downsides To FHA Loans?
There are a few potential downsides to consider before applying for a home loan:
- Your buying options may be slightly limited. There are limits to how much you can borrow through an FHA loan, so high-priced homes might not be realistic candidates. Additionally, FHA loans can only be used to purchase a “primary residence” (the home you will live in), so they are not available for investment properties. Interestingly, you can use an FHA home loan to purchase a property with up to four units as long as you will be living in one of the units. Opting for a small multi-family property allows you to rent out the other units to help cover the mortgage expenses.
- Mortgage insurance is required. Mortgage insurance premiums add to your monthly housing expenses. However, mortgage insurance is not unique to FHA loans. Mortgage insurance of some type is required for any home purchase with a down payment of less than 20% (except for U.S. Department of Veterans Affairs (VA) loans, which are reserved for military service members, veterans, and their spouses). It is worth noting that, for FHA loans with a down payment of 10% or more, mortgage insurance can be cancelled after 10 years. FHA loan with a down payment under 10% must retain mortgage insurance for the life of the loan. However, you may be able to eliminate mortgage insurance earlier by refinancing the loan.
What Are The Requirements For An FHA Loan?
FHA loan requirements are as follows:
- Steady, verifiable income. Be prepared to provide pay stubs, bank account statements, and/or tax returns to confirm your income. As a general guideline, your income should be high enough that all your monthly debt payments, including the new mortgage, equal less than 45% of your monthly income. This is called a debt-to-income ratio (DTI).
- A qualifying credit score. While 500 is the minimum score allowed by the FHA program, many individual lenders require scores of at least 620.
- The loan amount cannot exceed the loan maximum. The loan maximums are applied locally, with higher limits in higher-value markets.
- The property must serve as a primary residence. You cannot use an FHA loan to buy a second home, vacation home, or investment property that you do not live in full-time.
- The home must be inspected and appraised. A home inspection evaluates the condition of the property, and an appraisal determines the current value of the property. FHA loan qualifications require the property to “pass” inspection by meeting minimum property standards. The appraisal must be conducted by an FHA-approved appraiser.
- You must move in within 60 days of closing. You need to be able to physically occupy the house within 60 days following the day you close on the home and officially become the owner.
How Do I Apply For An FHA Loan?
You can apply for an FHA loan with any FHA-approved lender. Many lenders even allow you to apply for an FHA loan online. You’ll simply answer some questions about your identity, employment, and finances, then upload relevant financial documents.
Once your application is submitted, the lender can review it to see if you qualify for a loan and, if so, to determine what loan terms they can offer you.
FHA Loan FAQs
What Is The Interest Rate On An FHA Loan?
Interest rates on FHA loans fluctuate with the market. You can check current rates online with PNC Bank.
Do FHA Loans Offer Lower Interest Rates Than Conventional Loans?
FHA loans can offer lower interest rates than conventional loans, but that’s not always the case. This depends on several factors, including your credit score, your debt-to-income ratio, and your lender.
Are FHA Loans For Low-Income Households?
Not necessarily. There is no income restriction, so FHA loans are open to buyers of any income range, so long as you make enough money to cover the mortgage payments (including property taxes and insurance) along with your other debt repayments. There are, however, loan amount restrictions. So FHA loans aren’t used to buy exceedingly high-value properties.
Can Self-Employed Workers Qualify For An FHA Loan?
Yes, as long as you meet the requirements. You would need to prove that your self-employment income is high enough to cover your existing debts plus the new mortgage. The net income on your annual tax returns could serve as proof of income.
What Is The Maximum Loan Term On An FHA Loan?
An FHA loan's maximum allowable loan term is 30 years.
How Much Is The MIP On An FHA Loan?
There is an upfront fee and an annual fee for mortgage insurance premiums. The upfront MIP expense is 1.75% of the loan amount (although this upfront amount can be rolled into the loan and repaid over time). The annual MIP expense is between .45% and 1.05% of the loan balance, depending on how long the loan term is, the size of the loan balance, and how much of the property’s value is financed.
Can FHA Loans Be Refinanced?
Yes. FHA loans are eligible for traditional refinancing. There is even a streamlined FHA refinance program available to speed up the process for qualified FHA mortgages. Refinancing your mortgage can be a useful way to reduce your mortgage payment or borrow against the value of your home in the future.
The Bottom Line
FHA loans are a useful mortgage type, particularly for first-time buyers and buyers who could benefit from the relaxed credit score criteria and low down payment requirement.
You can learn more about getting a home loan and even start your mortgage application online with PNC Bank.