The Complete Guide to FHA Loans

Lots of first-time homebuyers say that a Federal Housing Administration (FHA) loan opened the door to their dreams, but what exactly is this program? If you are thinking of taking the plunge into homeownership and applying for an FHA loan, you'll need to get a good understanding of FHA loans, what's so great about them, whether you're eligible, and how to apply.

"FHA" stands for "Federal Housing Administration," which is a federal government agency. This agency doesn't loan money itself (although the popular use of the term "FHA loan" might lead you to believe otherwise). An FHA loan is a mortgage loan issued by a bank, credit union, or other lender and insured by the FHA. This insurance protects the lender in case the buyer defaults (when they can't pay back the loan), meaning that the lender doesn't need to worry as much about borrower default risk.

With FHA insurance in place, lenders can offer home loans to borrowers who have a lower income, lower credit score, and lower down payment than what is typically required for a conventional loan. It's possible for a borrower to get an FHA loan with 3.5 percent down and a credit score of 580. That explains the popularity of these loans among first-time homebuyers, who can use them to purchase, build or refinance single-family homes, small multiunit buildings, condos and even some mobile homes. Not every lender qualifies to issue FHA loans; the only lenders authorized to offer the loans are those approved by the FHA.

Today, the Federal Housing Administration is incorporated into the U.S. Department of Housing and Urban Development. However, the agency was actually created decades before as part of the New Deal, a program set up to help Americans recover from the Great Depression of the 1930s.

The FHA was the centerpiece of the National Housing Act of 1934. During that period, some 50 percent of Americans who owned homes were in default on their mortgages and risked foreclosure. This dire situation occurred when the housing market bubble burst, hitting the country hard just after the stock market tanked.

The FHA was created to put the brakes on foreclosures and to encourage and support homeownership. It did so by making it easier for individuals to buy or refinance homes. It dropped the standard down payment from where it then stood at 50 percent of the purchase price to the more affordable 20 percent by insuring mortgages up to 80 percent of the value of a home. The program was a success and currently insures loans for some 8 million single-family homes.

It's easier to understand the benefits of FHA loans when you compare them to conventional loans. Conventional loans are regular mortgage loans not guaranteed by the FHA that banks, other financial institutions and nonbank lenders make to qualified borrowers. Three differences to compare initially are the requirements for credit score, down payment, and debt-to-income ratio.

A credit score is a three-digit number that reflects your credit history and is based on your record of paying your debts. Credit scores range from a low of 300 to a high of 850. Conventional loans usually require you to have a credit score between 620 and 850, and lower scores will usually mean that the lender will offer a loan with a higher interest rate.

Those applying for FHA loans will find that credit scores are tied to down payments. If you have a credit score of 500, you can get an FHA loan with a down payment of 10 percent. If you have a credit score of 580 or above, you can get a loan with a down payment of 3.5 percent. While it is possible to get a conventional loan with a down payment as low as 3 percent, these offers are reserved for those with a credit score close to 700 or better.

Debt-to-income ratio (DTI) is a comparison of your monthly debt and monthly income. For a conventional mortgage, lenders prefer that debt not take up more than 43 percent of monthly income. The FHA allows a DTI ratio of 50 percent.

A mortgage lender wants to be sure it will get back the money it loans. A mortgage lender holds a security interest in the real property, which means if you don't make the mortgage payments, the lender can take over the house and sell it to pay off the loan. The lender doesn't finance 100 percent of the property because if the value goes down and the borrower defaults, the lender is not likely to get enough from a sale to repay the loan.

For that reason, conventional lenders prefer you to put down 20 percent of the cost of a home. That way, the lender has a 20 percent value cushion on which to rely. If you want to put less than 20 percent down, you must buy private mortgage insurance (PMI) to protect the lender. PMI is paid with the monthly payments together with interest, property tax and homeowners' insurance. Generally, you must continue paying this PMI until your equity in the property reaches 20 percent or, put another way, until your loan-to-value ratio reaches 80 percent. The cost of the insurance depends in part on credit scores, and those with lower scores pay more.

Since borrowers can qualify for an FHA loan with a 3.5 or 10 percent down payment, you may wonder whether you have to buy mortgage insurance. The answer is yes, but it is termed "mortgage insurance premiums (MPI)" instead. A borrower on an FHA loan must buy mortgage insurance and keep it current for the life of the loan (as opposed to it being canceled once you reach 20 percent equity on a conventional loan). The only way to get rid of the MPI payment is to refinance with a conventional mortgage.

All mortgage lenders are subject to a maximum-amount limitation set by the federal government. Conventional loans must comply with the conforming loan limit set by the Federal Housing Finance Agency that can vary from county to county. It is adjusted annually, and for 2021, it is $548,250 for most areas of the country. Any loans over that amount are called "jumbo loans" and have their own rules.

There are also limits on the amount of FHA loans, and these are adjusted annually. Limits differ depending on whether the market is considered low cost or expensive. For 2021, the limit for low-cost areas is $356,362, and for expensive markets, the limit is $822,375.

Although it is far easier for a borrower with a low credit score to get an FHA loan, that doesn't mean that it is a better alternative for everyone. Who will do better with a conventional loan? Generally, those with tip-top credit scores may want to move conventional loans to the top of the list.

That's because it's possible to get a conventional loan with only 3 percent down if you have excellent credit. The lowest-possible FHA down payment is 3.5 percent. In addition, it is usually possible to eliminate your private mortgage insurance when you have 20 percent equity in the property, while the FHA insurance stays on for the life of the loan (meaning you'll end up paying that extra 0.45 percent to 1.05 percent of the loan amount until you pay off the house).

Likewise, you can borrow more money on a conventional loan than an FHA loan in low-cost areas. If you want to purchase a home for half a million dollars in a low-cost area, you can get a standard conventional loan for this amount but not an FHA loan. Finally, FHA home loans are only available when buying primary-residence homes. A buyer looking to purchase a vacation home or an investment property will need a conventional loan.

Are you thinking of applying for an FHA loan? The application process can seem intimidating, especially to a first-time homebuyer. It's a good idea to start early and get your finances in line before you jump into the fray.

First, you should take a hard look at your monthly income and your monthly bills. The debt-to-income ratio is one factor in getting a loan, and it's something on which you should have a handle early. List your monthly bills and compare them to your income. How much is left? This provides a parameter for how much of a mortgage you may be able to afford.

Next, obtain your credit reports from the three big credit bureaus: Experian, Equifax and TransUnion. You have the legal right to get one free report from each of these bureaus every year, and it's important to see what your credit score is and check the information on each report. You have the right to identify errors and ask to have them corrected, and you should do this. The better your credit score, the more options and the better options you have.

Finally, save up for a down payment. You will need at least 3.5 percent for an FHA loan as well as money to pay closing costs (which are generally 3 to 5 percent of the loan amount). It's also important to have an emergency fund that will provide for your basic needs for three to six months if the bottom falls out from under your job.

Only after you've saved at least 3.5 percent plus closing costs should you start talking to lenders. Keep in mind that the FHA does not loan money; it just insures loans from banks and lenders. The fact is that most banks and mortgage lenders offer FHA-insured loans, but you will definitely not get the same deal from everyone. The fees and rates are not uniform and will vary considerably among lenders. Shop around and compare terms before you actually submit an application.

After selecting your lender, you can get a paper application, fill it out and submit it with all supporting documents for review by a loan officer. Alternatively, most banks let you apply for an FHA loan online by logging on to the lender's website, completing the application and attaching backup documentation electronically.