How Does an FHA Loan Work?

Thinking about buying a home soon? There’s more to home loans than meets the eye. There are different types of mortgages with different terms and requirements. You might have heard of an FHA loan, but might be unfamiliar with the specifics. No worries — we’re here to break it down into plain English.

FHA Loan Basics

First and foremost, an FHA loan is a mortgage insured by the Federal Housing Administration or FHA. One selling point is that it allows for down payments as low as 3.5% with a 580 FICO score. In other words, FHA loans are helpful for buyers with modest savings or lower credit scores.

As with most types of government-backed loans, there are specific requirements homebuyers need to meet to qualify. For instance, an FHA home loan can be used to buy or refinance single-family houses, two- to four-unit multifamily homes, condominiums, and certain manufactured homes.

However, the barrier to entry isn’t as steep as a conventional loan because those aren’t insured by the federal government. Plus, as mentioned above, FHA loans allow for lower credit scores than conventional loans and, in some cases, lower monthly mortgage insurance payments. FHA rules are also more accommodating in terms of allowing for gifts of down payment money from family, employers, or charitable organizations. On the other hand, FHA loans may come with closing costs that aren't required by conventional loans.

Types of FHA Loans

Another important facet is that the FHA offers a variety of loan options, from fairly standard purchase loans to more sophisticated products. Here's an overview of the most common ones:

Mortgage 203(b)

This loan can be used to purchase or refinance a primary residence with a low minimum down payment. However, it can’t be used to buy a property that needs more than $5,000 in repairs.

203(k) Rehab Mortgage

Do you have your eye on a fixer-upper? This might be the right loan for you. Renovation costs must exceed $5,000, but repairs can’t take more than six months to complete. The work also must be executed by a qualified professional.

Construction Loan

This type of loan product is intended to fund the purchase of land and finance building a new home. It’s more difficult and time-consuming to qualify for this kind of loan, so potential homeowners should be mindful of that factor.

Title 1 Property Improvement Loan

This one can be used to address home improvements and can supplement a 203(k) loan. You can get this loan without refinancing. However, be aware that you may only borrow up to $25,000 for a single-family property (or $25,090 for mobile homes that include land) and $60,000 for a multifamily home.

Energy-Efficient Mortgage

Going green? This loan product can be used to make upgrades that make the home more energy-efficient. The property must be professionally assessed to qualify and the scope of work must be deemed cost-effective.

Qualifying for an FHA Loan

As a potential homeowner, you’ll be expected to meet certain requirements to qualify for an FHA loan. Know that lenders may have additional stipulations, so allow plenty of time and planning to get things in order. To make sure you find the best loan product, shop around and compare the offerings.

FHA Loans and Credit Score

As with any loan product, you’ll need to make sure your credit score is to be considered. The minimum credit score for an FHA loan is 500. Keep in mind that if your score falls between 500 and 579, you can still qualify, but a more sizable down payment will be required. Take into account that individual lenders can opt to require a higher minimum credit score.

An important note: Though the FHA has not changed its requirements, the one-two punch of the COVID-19 pandemic and recession have prompted many FHA lenders to raise their minimum required credit scores for FHA loans. For instance, many lenders currently ask for a credit score of at least 620.

Down Payment Funds

A high credit score will come in handy if you’re looking at an FHA loan. That’s because if you boast a credit score of 580 or higher, your FHA down payment can be as low as 3.5%. Conversely, a credit score that's between 500 and 579 means you'll need to come up with 10% of the purchase price.

If this isn’t in the cards, know that It doesn't all have to come from savings. You can use gift money for your FHA down payment, provided that the donor supplies certain information. You might also put in the time to research state and local down payment assistance programs for first-time homebuyers. In your search, you might come across low- or no-interest loans, or even grants to help offset the down payment cost.

Debt-to-Income Ratio

Credit score is the only variable you’ll need to consider when applying for an FHA home loan. The FHA requires a debt-to-income (DTI) ratio of less than 50 — your total monthly debt payments can't exceed 50% of your pretax income.

Property Approval

The FHA has certain rules regarding the type of home you can buy with such a loan. To that end, you’ll need an appraisal that's separate (and different from) a home inspection. The reason is they want to ensure the home is a good investment and meets basic safety and livability standards.

If it’s an FHA 203(k) renovation loan, you may be required to commission two separate appraisals. An "as is" appraisal will evaluate the current state, and an "after improved" appraisal reflects the increased value once the work is completed.

Mortgage insurance

FHA mortgage insurance is factored into every loan. Once the loan is originated you’ll make an upfront mortgage insurance payment (which can be rolled into the total amount of the loan), and make monthly payments thereafter.

If you start with a down payment of less than 10%, you can expect to pay mortgage insurance for the life of the loan. However, if you elect to put down 10% as a down payment, you’ll pay FHA mortgage insurance for 11 years.

This is a lot of information at once. If you’re unsure which direction to go, know that we’re here to offer expert advice and guidance. We love working with first-time home buyers! We can help you find the right type of mortgage to help you realize your home buying dreams. We'll help you compare, learn about the pros and cons of each financing option and make an educated decision based on your unique financial situation. Even if you can't purchase a home immediately, we'll help you understand why and see a path forward and onward to homeownership in the future.