Takeaways
- FHA loans are insured by the Federal Housing Administration to expand homeownership.
- FHA-insured loans are issued by banks, credit unions, and financial institutions.
- FHA loans require lower down payments, closing costs, and credit qualifications.
- FHA loans supplement the conventional home loan market by expanding financing access.
- FHA loans can finance purchasing multiple property types, including condominiums.
With high inflation and low inventory, participating in the housing market can feel challenging for most people. If you are considering buying your first home or upsizing to a larger home, it is a smart money move to consider all your options. One of those options is a FHA loan, which is a loan administered by the Federal Housing Administration. While it is often a lesser-known financing option, here we will explore the specifics of FHA loans, analyzing their requirements and how they compare to conventional loans. We will also consider the different types of FHA loans, their loan limits, the application process, and their advantages and disadvantages.
What Is an FHA Loan?
An FHA loan is a mortgage insured by the Federal Housing Administration. FHA loans provide opportunities for homeownership to individuals who may not meet traditional lending standards. With flexible underwriting standards, lower down payment requirements, and more flexible allowances for lower credit scores, FHA loans provide a unique advantage to many prospective homeowners.
The FHA does not lend directly to consumers. Instead, approved lenders such as banks, credit unions, and other financial institutions issue the loans, and the FHA provides insurance against default. This works well for lenders because if a borrower does default on an FHA loan, the FHA will cover the lender's loss. Because of this, lenders are more willing to lend FHA loans.
Since FHA loans originated in the 1930s, they have experienced multiple changes and modifications1. Initially, they facilitated homeownership during the Great Depression when foreclosure rates were high. Over time, FHA loans have evolved into a vital part of the housing market, assisting first-time buyers, those with lower income, or buyers rebuilding credit.
FHA loans are not for everyone, and not every home purchase is eligible for an FHA loan. Certain requirements must be met, including the property's condition, location, and intended use. Furthermore, the FHA sets specific borrower requirements, including a minimum credit score and a maximum debt-to-income ratio.
What it comes down to is that an FHA loan is a government-insured mortgage that can offer more lenient borrowing criteria than conventional loans. They are a great financing option for first-time homebuyers, individuals with credit challenges, and if you cannot put down a large down payment (typically required by traditional lenders).
FHA Loan Requirements
To qualify for an FHA loan, you and the property you want to purchase must meet specific requirements. These guidelines help ensure that loans issued under the FHA program are on solid footing. Here are six different FHA loan requirements to consider:
1. Credit Score
The FHA requires a minimum credit score of 500 for loan eligibility. If your credit score is between 500 and 579, you can qualify with a 10% down payment. However, if your credit score is 580 or above, you can qualify with a down payment as low as 3.5%.
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2. Down Payment
As mentioned above, the down payment for an FHA loan can be as low as 3.5% of the purchase price if your credit score is 580 or above. The required down payment is significantly lower than many conventional loans, making the FHA loan attractive to numerous home buyers.
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3. Debt-to-Income Ratio
FHA loans also have a debt-to-income ratio ceiling for eligibility. Your total debt should not exceed 43% of your total gross income, though there can be some flexibility in this area. The FHA considers a borrower’s complete financial picture, and in some cases, higher debt-to-income ratios are approved.
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4. Property Guidelines
The home being purchased must be a primary residence, and it must meet the FHA’s minimum property standards. This happens when an FHA-approved appraiser inspects and formally approves the home. This appraisal will verify that the home meets the U.S. Department of Housing and Urban Development (HUD) minimum property standards and determines the property's market value.
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5. Mortgage Insurance
Two types of mortgage insurance premiums are required on all FHA loans. First, an upfront premium of 1.75% of the loan amount can be financed into the loan. Second, an annual premium is 0.45% to 1.05%, depending on the length of the loan, loan amount, and initial loan-to-value ratio.
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6. Employment History
If you are trying to secure an FHA loan, you must show consistent employment history. As part of this process, you demonstrate you have worked for the same employer for the last two years. Employment verification provides the FHA and lender with the comfort that you will have a consistent and steady cash flow to finance the mortgage.
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While FHA loan requirements are less stringent than conventional mortgages, there are still specific qualifications to be met. Having a clear understanding of these requirements can help you determine if an FHA loan is the best route for your home purchase.
FHA Loan vs. Conventional Loan
While exploring your financing options when purchasing your house, it's essential to understand the differences between FHA loans and conventional loans. Each has advantages and disadvantages, and the best choice depends on your circumstances. Here are four critical differences to consider:
Down Payment
One of the biggest differences between FHA and conventional loans is the down payment requirement. As mentioned above, FHA loans allow a down payment as low as 3.5% of the purchase price of your home if your credit score is 580 or above.
Conventional loans, on the other hand, typically require a down payment of at least 5% to 20% (see Jumbo Loan requirements). For many first-time buyers or those without substantial savings, an FHA loan's lower down payment requirement can be a game changer.
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Credit Requirements
FHA loans are known for their more relaxed credit requirements. Even if your credit score is as low as 500, you may still qualify for an FHA loan, provided you can make a 10% down payment. This means that even if you still need to improve your credit score you could still enter the housing market with an FHA loan.
In contrast, conventional loans typically require a minimum credit score of 620, and the interest rates are often more favorable for those with higher scores.
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Mortgage Insurance
Both FHA and conventional loans require private mortgage insurance if the down payment is less than 20%. However, the insurance structure differs between the two. For FHA loans, borrowers must pay an upfront mortgage insurance premium (typically 1.75% of the loan amount) and an annual premium. The annual premium can vary between 0.45% to 1.05% of the loan amount, depending on the loan's specifics.
For conventional loans, private mortgage insurance (PMI) typically ranges from 0.5% to 1% of the entire loan amount each year.
Loan Limits
FHA loans have specific loan limits that differ based on where you are buying a home. Conventional loans also have limits, but they are typically higher than FHA limits.
In 2024, the conventional loan limit for most of the U.S. is $766,550, whereas the FHA limit varies depending on the county but is generally lower.
5 Types of FHA Loans
There are several types of FHA loan structures available, each designed to meet specific homebuyer needs. The five main primary categories include:
1. FHA 203(b) Loans
This is the most common type of FHA loan. It allows borrowers to purchase a home with a down payment as low as 3.5%, provided your credit score is 580 or above. It's often used by first-time homebuyers or those who don't have a substantial amount of money saved for a down payment.
2. FHA 203(k) Rehabilitation Loans
If you are interested in purchasing a fixer-upper or need funds to renovate your current home, an FHA 203(k) loan might be a good fit. This loan combines the purchase price and the cost of improvements into a single mortgage. It is an excellent financing option for transforming a house in need of work into your dream home.
3. FHA Energy Efficient Mortgage (EEM)
This type of FHA loan allows you to finance energy-efficient improvements to your home. If you are looking to reduce your spending, an EEM loan could be a great option. EEM loans allow you to affordably modernize your home, reduce your energy consumption, and save money on utility bills.
4. FHA Section 245(a) Loan
Also known as the Graduated Payment Mortgage, this FHA loan is designed for borrowers who expect their income to increase over time. Early payments are smaller and gradually increase over the loan term. If you have just graduated and expect to increase your income over time, this could be a perfect fit for your financial needs.
5. FHA Condominium Loans
These loans are specifically designed for those interested in purchasing a unit within a condominium complex that is approved by the FHA. This can be a fantastic option if you live in a large metropolitan area where purchasing a home might be more than you need.
Each FHA loan type has specific requirements and benefits so it's crucial to understand your needs, financial situation, and long-term financial goals when choosing which FHA loan is right for you. Consulting with a mortgage advisor or financial advisor can be a valuable step in this decision-making process.
FHA Loan limits
Every FHA loan is subject to specific lending limits. FHA loan limits are the maximum amounts the Federal Housing Administration will insure on a home purchase. These limits are set annually and vary by county, reflecting local home prices.
On November 28, 2023, the FHA issued Mortgage Letters 2023-21, which provided the mortgage limits for Title II FHA-insured forward mortgages and the maximum claim amount for FHA-insured Home Equity Conversion Mortgages (HECMs) for Calendar Year (CY) 2024.
In 2024, the base FHA loan limit for a single-family home in low-cost areas is $498,257, an increase from previous years, which reflects the rise in home prices across the country. The ceiling, or the upper limit, in high-cost areas, is $1,149,825 for a single-family home.
The FHA also provides higher limits for multifamily properties, and the HECM maximum nationwide claim amount will be $1,149,825 for all areas and is effective for all case numbers assigned on or after January 1, 2024, through December 31, 2024.
The specific FHA loan limits can vary by county, so it's essential to check the FHA Mortgage Limits Search on the Department of Housing and Urban Development (HUD) website or consult with a mortgage professional for accurate information. You can also refer to Mortgagee Letter 2022-21 for more detailed information [1].
7 Steps to Apply for An FHA Loan
Applying for an FHA loan involves similar steps to applying for a conventional mortgage. Here are seven steps to take when applying for an FHA loan.
1. Assess Your Financial Situation
Before starting the application process, thoroughly evaluate your financial situation to ensure you can afford a mortgage. Check your credit score, calculate your debt-to-income ratio, and examine your savings for a down payment and closing costs.
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2. Find an FHA-Approved Lender
Once you have evaluated your financial situation, the next step is to find an FHA-approved lender. Do your research and choose a financial institution that you work well with during the home-buying process. Check out approved lenders, such as a bank, credit union, or other financial institution, in your area.
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3. Get Pre-Approved
A pre-approval involves a lender checking your credit and financial information to determine how much you can borrow. Having a pre-approval in hand while you are house shopping can make you a more attractive buyer to sellers because it demonstrates you are a serious buyer who has taken the appropriate steps to start the process.
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4. Choose a Property
Once you are pre-approved, you can start house hunting. Remember, the property must meet FHA property requirements and appraised by an FHA-approved appraiser. An FHA-compliant property not only helps in loan approval but also ensures that the home you are buying is a safe, sound, and worthwhile investment.
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5. Complete the Loan Application
After your offer is accepted, you will complete the loan application. Your lender will guide you through this process, which includes providing documents like pay stubs, bank statements, and tax returns.
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6. Underwriting Process
During the underwriting process, the lender verifies your personal and financial information, as well as checks the property details. They may request additional documentation like recent financial statements or proof of insurance. The lender will then assess the risk of offering you the loan, considering your creditworthiness, the property's appraisal, and your ability to repay the loan. This step can take some time, so patience is essential.
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7. Closing
If your loan is approved, you will proceed to closing. Closing is the final step, where you sign legal documents, transfer your down payment, and pay any remaining closing costs. The documents you sign include the loan agreement and property deed. At this point, you also confirm and finalize the mortgage terms and interest rate. After all the paperwork is complete and the funds are disbursed, the house is officially yours.
Pros and Cons of FHA Loans
Now that we have explored how to secure an FHA mortgage, let’s discuss some pros and cons of FHA loans. Here are some of their advantages and disadvantages to consider when comparing FHA loans against the six types of conventional loans:
Pros of FHA Loans
Lower Credit Requirements: Compared to conventional loans, FHA loans have more lenient credit requirements, which makes them an attractive option for those with less-than-perfect credit. Even if you have a low credit score, FHA loans offer access to mortgage financing that would otherwise not be available.
Small Down Payment: Savings for a down payment is one of the highest barriers to entry into the housing market. Luckily, with FHA loans, a down payment as low as 3.5% allows many people the opportunity to become homeowners sooner. Buying a home can allow you to build home equity and increase your net worth over time.
Higher Debt-to-Income Ratios: FHA loans permit higher debt-to-income ratios, which can help borrowers with higher debt levels. Although this is a helpful ease of traditional loan standards, you want to ensure you are not taking out too much debt. If becoming debt-free is one of your financial goals, it could be a smart move to pay off existing debt first before applying for an FHA loan.
Cons of FHA Loans
Mortgage Insurance: Borrowers must pay an upfront and annual mortgage insurance premium, which adds to the total cost of the loan. Unlike conventional loans, this annual mortgage insurance premium is for the life of the loan if the down payment is less than 10%.
Loan Limits: FHA loans have specific limits, which may restrict the price of the home you can afford. The maximum loan limits may still prohibit you from buying a house you want in competitive real estate markets.
Property Requirements: Homes purchased with an FHA loan must meet specific standards, potentially limiting your home choices. FHA loan criteria act as a filtering mechanism to help financial institutions, credit unions, and banks determine which properties they think have a higher chance of mortgage repayment.
Smart Summary
Purchasing a home is one of the largest financial transactions you will make. An FHA loan from a traditional financial institution can help you reach your goal of homeownership, but it is a smart money move to research all your options. FHA loans have been expanding access to financing for millions of homebuyers and could make perfect sense for you. Make sure you are financially prepared for the cost of homeownership and that buying a home aligns with your long-term financial goals.
(1) U.S. Department of Housing and Urban Development. Maximum Mortgage Limits 2024. Last Accessed December 17, 2023.
