What You Need To Know About FHA Loans

The Federal Housing Administration, or FHA, helps make buying real estate easier and more affordable for many Americans. Considering an FHA loan? Here's what you need to know.

By: Aly Yale

FHA Loans

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The FHA, or Federal Housing Administration, is a government agency that insures mortgage loans across the United States. This insurance protects mortgage lenders in the event the property owner falls behind on their loan. 

Thanks to the FHA's financial protection, FHA-approved lenders are able to offer mortgage loans to borrowers with lower credit scores and lower down payments than other loan programs allow.

What is the FHA?

The Federal Housing Administration is an agency that guarantees FHA mortgage loans -- U.S. mortgage loans originated by FHA-approved lenders. The group falls under the purview of the U.S. Department of Housing and Urban Development and is funded via the mortgage insurance premiums it collects from borrowers. The FHA's current leader is commissioner Brian Montgomery.

History of the FHA

The FHA was created by President Franklin Roosevelt in 1934 (during the Great Depression) by way of the National Housing Act. The agency has played many roles over the years, first helping to finance military and veteran housing during World War II, then helping to spearhead construction efforts for low-income housing in the '50s, '60s, and '70s. 

Since its launch, the FHA has insured millions of American mortgages. As of October 2019, the agency insures over 8 million single-family mortgages, 12,000 multifamily mortgages, and thousands of mortgages for residential care facilities and hospitals. 

What are FHA Loans?

FHA loans are mortgage loans that are originated by FHA-approved lenders and insured by the Federal Housing Administration itself. An FHA mortgage loan must adhere to the agency's strict lending guidelines, which dictate the safety of the property being purchased, the financial capabilities of the borrower, the balance of the loan in relation to local incomes, and more.

FHA loans are designed for low- and moderate-income earners, as they allow for lower down payments and lower credit scores than conventional loan options. They can be used for single-family homes, multifamily properties (up to four units), manufactured and mobile homes, and condos. The FHA also insures mortgage loans for hospitals and care facilities.

According to the mortgage technology provider Ellie Mae, 16% of all mortgage loans in September 2019 were FHA loans. The majority of those (72%) were purchase loans, while just over a quarter (28%) were refinances.

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Types of FHA loans

There are several different FHA mortgage loan programs to choose from, depending on the type of property you're purchasing (or refinancing) and your long-term goals for it. 

Here's a breakdown of all the FHA loan programs you can choose from:

Fixed-rate FHA loans

Most FHA loans fall into the fixed-rate category, meaning they come with a consistent, fixed interest rate for the entirety of the loan's term. Fixed-rate loans are ideal if you have limited or fluctuating income, as they allow you to easily predict and budget for your monthly payments. On fixed-rate FHA loans, the interest rate will never change unless you decide to refinance.

Adjustable-rate FHA loans

There are also adjustable-rate FHA loans, which offer lower up-front interest rates than fixed-rate loans. The catch? Those rates can increase over time. With adjustable-rate loans, you'll typically have a low, fixed interest rate for three, five, seven, or 10 years. After that fixed period expires, your interest rate can increase, taking your monthly payment up with it.

Adjustable-rate mortgages (ARM) can be a good way to lower your homebuying costs at the beginning, but they're not ideal if you plan to stay in the property for the long haul. If you're simply investing in a property and plan to live in it only temporarily, then an ARM might be a good way to save on initial expenses. Just make sure you sell the home or refinance your loan before your interest rate rises.

Reverse mortgages

The FHA also has a reverse mortgage program, called a Home Equity Conversion Mortgage, or HECM, for short. HECMs are reserved for homeowners aged 62 and older who have a significant amount of equity in their home -- meaning they've already paid off their loan or at least paid it down quite a bit.

With a HECM, older homeowners can convert a portion of their equity into a line of credit, which they can pull from for the remaining time they're in the home. HECM borrowers also have the option to take the credit in equal monthly payments.

These loans are designed to provide supplemental income to aging Americans who may not have access to other funds. They also allow seniors to stay in their homes essentially mortgage-free. Once they pass on or leave the property, the principal and interest on the loan is paid off via the sale proceeds from the home. Anything left over is paid by FHA mortgage insurance.

203b loans

The 203b loan is FHA's standard mortgage loan. It can be used to purchase a property or refinance an existing mortgage and must be issued by an FHA-approved lender. 203b loans can only be used on single-family homes (new or old) that are one to four units in size. They come in 15- and 30-year terms.

203k loans

If you're looking to purchase and renovate a multi-unit rental property, this is the FHA loan you'd look to. Designed to help finance both your home purchase and the renovation costs that will come with it, the 203k loan is made for those bargain-basement properties that just need a little TLC. Just keep in mind, FHA loans can't be used for straight-up investment properties. The property (at least one unit of it) has to be your primary residence in order to qualify.

There are two forms of the 203k loan program, the limited 203k and the standard 203k. Here's how those differ:

Features Limited 203k Standard 203k
Loan limits $35,000 Up to the FHA limits for your county
Property condition Must be habitable during renovations Does not need to be habitable during renovations
Eligible renovations Minor repairs and renovations Major repairs, rehabilitation, and construction
Payments 50% up front, 50% after project has concluded Payments handled by a HUD consultant
Other differences No third-party inspection required More paperwork, requires a HUD consultant

Data source: U.S. Department of Housing and Urban Development.

245a loans

The 245a loan program is a little-talked about FHA product designed for low-income home buyers. The program allows you to make smaller mortgage payments up-front and larger ones as you get further into your loan term. They're ideal for buyers who know their income will increase in the future, but who can't afford a high payment quite yet. 

There are five 245a options to choose from:

  • Plan I -- A 2.5% increase in payments annually for five years
  • Plan II -- A 5% increase in payments annually for five years
  • Plan II -- A 7.5% increase in payments annually for five years
  • Plan IV -- A 2% increase in payments annually for 10 years
  • Plan V -- A 3% increase in payments annually for 10 years

Energy Efficient Mortgages

FHA's Energy Efficient Mortgage program (EEM) helps buyers purchase energy-efficient properties or properties they intend to make green home improvements to. These loans can also be used when refinancing, allowing existing homeowners to make energy-efficient upgrades on their properties.

There's no set maximum dollar amount for EEM loans, but buyers and homeowners can choose to either: 

  • Make the improvements recommended in a HUD-approved energy assessment (this assessment is required with EEMs)
  • Take 5% of the home's adjusted value, 115% of the area's median home price, or 150% of the county conforming loan limit (whichever is less)

The one caveat with EEM loans is that the intended improvements must be "cost effective" -- meaning their expense is equal to or less than the money saved on energy due to the upgrade.

The amount is then rolled into the FHA loan balance and spread across your monthly payments.

Other FHA mortgage loans

The FHA also offers mortgage loans for specific property types, including condo loans and mortgages for mobile and manufactured homes. There are also loans for disaster victims (called 203h loans) designed to help Americans who have lost their homes due to catastrophic events.

Qualifying for an FHA loan

Because FHA loans come with the financial safety net of government backing, lenders are able to loan money to riskier borrowers -- meaning borrowers who have lower credit scores or smaller down payments. In general, qualifying for an FHA loan is easier than it is for other loan programs -- particularly with conventional mortgages.

Maximum loan amount

In most areas, the maximum for an FHA loan on a single-family home is $314,827. Higher-cost areas, as well as multi-unit properties, have higher limits. Use the chart below or fill out this form to see the exact FHA mortgage limits for your area.

Property Size FHA Loan Limit
Single-family $314,827 ($726,525 in high-cost areas)
Two-unit $403,125 ($930,300 in high-cost areas)
Three-unit $487,250 ($1,124,475 in high-cost areas)
Four-unit $605,525 ($1,397,400 in high-cost areas)

Data source: U.S. Department of Housing and Urban Development.

Required credit scores

FHA's credit score requirements vary based on your down payment amount. If you put down the minimum amount (3.5%), then you'll need at least a 580 credit score in order to qualify. If you can make a down payment of 10%, then you may be able to qualify with a credit score as low as 500. 

Down payments

FHA mortgage down payments can go as low as 3.5% -- meaning 3.5% of the total loan balance ($7,000 on a $200,000 loan). The important thing to remember is that the smaller down payment you make, the higher your loan balance will be and the more you'll pay in interest in the long run. It also means a higher monthly payment.

Other eligibility requirements

To qualify for an FHA loan, you'll need a front-end debt-to-income ratio (DTI) of 31% or less, which includes only your projected mortgage payment. You'll also need a back-end DTI of 41% or lower, which includes your projected mortgage payments plus all your current debts. In some cases, you may be able to get an FHA mortgage with a back-end DTI as high as 50%, but only if you have good credit and compensating factors like substantial cash reserves. 

Here are the other requirements you'll need to meet in order to qualify for an FHA loan:

  • The home you're buying must be intended as your primary residence (at least one unit of it)
  • You must move into the home within 60 days of closing on your loan
  • The home must meet FHA's minimum property standards and be safe, secure, and sound
  • You must pay mortgage insurance premiums up-front and annually over the course of the loan term
  • You must have reliable income and two years of consistent employment
  • You must have the cash to cover your closing costs (usually 2% to 5% of the total purchase price of the home)

Keep in mind that these are only the minimums set by the FHA. Many lenders may have stricter lending policies than those noted above.

The FHA mortgage process

The FHA mortgage process starts with finding an FHA-approved lender. Most major banks and financial institutions offer FHA loans, or you can go to HUD's lender search tool to find one in your area. 

Once you've chosen a lender, you can get pre-approved for your loan. This requires a little bit of information about your income, debts, and the property you intend to purchase, but once you're done, the lender will give you a letter stating the loan amount you'll likely qualify for, as well as your interest rate. You can use this letter to guide your home search and give sellers more confidence in any bids you submit.

After you've found a home and the seller has accepted your offer, you'll need to fill out the full loan application with your lender, submit a number of financial documents, and agree to a credit check. The lender will then order a property appraisal to ensure the home is worth the money it's lending you. Two scenarios can emerge from this:

  1. The home appraises for as much or more than what you've offered. Your loan proceeds forward.
  2. The home appraises for less than you've offered. Your lender will only loan you up to the appraised value, so you'll need to renegotiate with the seller or come up with the extra cash out of pocket.

When the appraisal is done, your loan will move into underwriting. This is when the lender analyzes your application and evaluates your qualifications for the loan. Many times, your lender will request additional documents during this stage or, in some cases, a letter of explanation detailing any large deposits or other suspicious activity. Once your loan makes it through underwriting, your loan will be approved and you'll be scheduled for closing. That's when you'll sign the paperwork, pay your closing costs and down payment, and receive your keys.

How much do FHA loans cost?

As with other mortgage loans, there are closing costs and a down payment associated with FHA loans. But more than this, you'll also need to pay mortgage insurance -- both up-front (paid at closing) and annually (paid with your monthly payment).

Here's how the costs of an FHA loan break down:

Charge Average Cost
Down payment Minimum 3.5% of the loan
Closing costs 2% to 5% of the purchase price
Mortgage insurance 1.75% of the loan up-front and 0.45% to 1.05% annually depending on your loan size and term

Data source: U.S. Department of Housing and Urban Development.

What is FHA mortgage insurance?

FHA mortgage insurance is designed to protect lenders in the event a borrower fails to repay their loan. When a borrower defaults, the lender will foreclose on the home and sell it off. Any of the outstanding loan balance not covered by the sales proceeds will be paid by the FHA insurance policy.

Mortgage insurance is required on all FHA loans and, in most cases, lasts for the entirety of the loan term. The only exception is on loans with a 10% down payment or more. On these, mortgage insurance is only required for 11 years. 

FHA mortgage insurance costs a flat-rate of 1.75% of the loan amount up-front, regardless of loan size or down payment. After that, you'll also have an annual charge. Here's what annual mortgage insurance costs on a 30-year, fixed-rate FHA loan:

Loan Amount Down Payment Annual MIP
$625,000 or lower 5% or less 0.85%
Over 5% 0.80%
Over $625,000 5% or more 1%
Less than 5% 1.05%

Data source: U.S. Department of Housing and Urban Development.
MIP is mortgage insurance premium.

Can I get rid of FHA mortgage insurance premiums?

If you made at least a 10% down payment, then you can cancel your mortgage insurance after 11 years. If your down payment was smaller than this, you'll need to pay mortgage insurance premiums for the rest of your loan term or consider refinancing (more on this below). 

Note: This is a major difference between FHA and conventional mortgages. On conventional loans, you can cancel your private mortgage insurance after your loan-to-value ratio falls to 80% or lower.

Refinancing an FHA loan

There are three types of FHA refinances that homeowners can take advantage of: streamline, simple, and cash-out. 

Streamline refinance

If you're looking to lower your interest rate or monthly payment, a streamline refinance is ideal, as it requires little paperwork, no credit check, and no home appraisal. Plus, it can be completed relatively quickly. In order to qualify for an FHA streamline refinance, you'll have to be at least 210 days past your closing date and be current on your mortgage payments for a minimum of the last three months.

Simple refinance

The FHA simple refinance can also help you lower your rate and monthly payment, and it allows you to roll your refinancing costs into your loan balance, so there are very few up-front costs. These loans do require a full credit and employment check, though, as well as more thorough documentation and a home appraisal. 

Cash-out refinance

If you need access to cash, a cash-out refinance may be a better option. This one allows you to take out a loan larger than your current loan balance, keeping the difference as a one-time, lump-sum payment. You can use it to make home repairs, pay for college tuition, or cover any other expenses.

With cash-out refinances, the loan amount can't exceed 80% of the home's value. You'll also need to be current on your mortgage payments for at least the last 12 months. FHA cash-out refinances require an appraisal, which usually costs between $300 and $400, though it may be more on larger, multi-unit properties.

Other options

You can also refinance into another type of loan, like a conventional mortgage, for example. By refinancing into a conventional loan, you may be able to avoid mortgage insurance altogether (as long as you have at least 20% equity in your home) or, at the very least, have the option to cancel your insurance later down the line.

If you qualify, you could also refinance into a USDA loan (only for eligible rural property purchases) or a VA loan, which is for military members and veterans only. Neither of these loans require a down payment. VA loans also don't require mortgage insurance.

The bottom line

FHA mortgages can be a solid option if you're planning on buying a home or multi-unit property (as long as you plan to live in one of the units). Not only can they lower your up-front costs, but they also make qualifying easier than other loan programs. Just make sure you understand the long-term expenses you'll incur due to the FHA's required mortgage insurance premiums, and know what your options are for refinancing your loan further down the line.

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