What is an FHA loan?

If you’re buying a home and don’t qualify for a conventional loan, an FHA loan may help you reach your dreams of homeownership. FHA loans are one of the most popular mortgage options available — they make up roughly one-quarter of all home loans.

Backed by the federal government, these loans are more accessible to lower-income borrowers and those with poor or fair credit (scores from 500 to 669). FHA loans also feature conventional loan-like interest rates.

However, because of added costs that come with FHA loans like mortgage insurance (even if you make a large down payment), they may ultimately be more expensive. Also, an FHA loan might not be a fit if you need funding beyond its borrowing limits or are eyeing a true fixer-upper.

What is an FHA loan?

An FHA loan is a type of mortgage that’s backed by the Federal Housing Administration (FHA). FHA loans have more relaxed requirements than many other mortgages, including lower credit score rules and flexible debt-to-income ratio requirements (more about eligibility, below).

How do FHA loans work?

Private lenders offer FHA loans, but the federal government insures them by promising to protect lenders against losses if borrowers don’t repay the loans. As a result, lenders can offer loans to borrowers who may not otherwise qualify for mortgages.

There are several different FHA loan programs, but the primary program is the Basic Home Mortgage Loan 203(b), which could help you buy a primary residence. Other types of FHA loans can help you refinance or renovate your home.

How do FHA loans differ from conventional loans?

An FHA loan is guaranteed by the federal government. Meanwhile, the term conventional loan refers to any mortgage that isn’t backed by a government agency. Conventional loans are the most popular type of mortgage, making up well over half of all loans underwritten each year.

Below are some of the key differences between FHA loans and conventional loans:

	FHA loan	Conventional loan
Minimum credit score, down payment	500 with a 10% down payment, or 580 with 3.5% down	620 and a 3% down payment
Loan limits	$472,030 for most geographical areas and $1,089,300 for high-cost areas	$726,200 for most areas and $1,089,300 for high-cost areas for conforming loans (which Fannie Mae and Freddie Mac can purchase from lenders); no limits on non-conforming loans (which don’t meet Fannie Mae, Freddie Mac standards)
Mortgage insurance	Required for all loans	Typically required for loans with a down payment of less than 20%
Type of homeownership	Primary residence only	Primary residence or second home
Interest rates	Typically lower interest rates	Typically higher interest rates
Refinancing	Streamlined (see below)	Conventional

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Types of FHA loans

The most common type of FHA loan is the 203(b) mortgage insurance program’s Basic Home Mortgage Loan. This type of loan allows you to finance single-family homes and multi-family homes with up to four units.

There are a few other FHA loan options to choose from, including:

• 203(k) Rehabilitation Mortgage: This loan program allows you to borrow up to $35,000 to renovate a single-family home.
• Streamline Refinance: If you already have an FHA loan, you can use a streamlined refinance that’s simpler than a traditional refinance loan.
• Home Equity Conversion Mortgage (HECM): This loan program offers reverse mortgages that help seniors pull equity from their homes without having to sell.

• Energy-Efficient Mortgage Program: With this loan program, you can finance energy-efficient improvements to your home.

How to qualify for an FHA loan

The requirements to qualify for an FHA loan differ from those needed to qualify for other loans. Here’s what you’ll need to be eligible for an FHA loan:

Credit score and down payment

FHA loans have both credit score and down payment requirements and the two are closely related.

To qualify for the minimum 3.5% down payment on an FHA loan, you’ll need a credit score of at least 580. Though you can qualify for an FHA loan with a credit score between 500 and 579, you’ll need a down payment of at least 10% of your home’s purchase price.

Proof of income

There’s no minimum income required to purchase a home with an FHA loan. However, you must have verifiable income that can be reasonably expected to continue.

When you apply for an FHA loan, you’ll have to provide proof of income, such as pay stubs, W-2 and other tax forms.

Debt-to-income ratio

For FHA loans, your lender must consider both your front-end and back-end debt-to-income ratio (DTI).

Your front-end DTI is the percentage of your gross, monthly income that you spend on your mortgage payment. Your front-end DTI can’t exceed 31%.

Your back-end DTI is the percentage of your income that you spend on all debt (including credit card balances and outstanding loans), including your mortgage payment. The maximum back-end DTI on an FHA loan is 43%.

A lender can accept a higher front-end or back-end DTI if you have certain “compensating factors,” such as:

• A demonstrated ability to pay the proposed monthly housing expense or higher throughout the past one to two years.
• A down payment of at least 10%.
• A demonstrated ability to accumulate savings.
• A conservative attitude toward using credit.
• An ability to devote more of your income toward housing.
• Compensation or income that’s not included in your monthly income (including government benefits).
• A minimum increase in your housing expense.

Mortgage insurance

When you get an FHA loan, you’ll be required to pay a mortgage insurance premium (MIP). First, you’ll pay an upfront MIP of 175 basis points, or 1.75% of your loan amount.

You’ll also be required to pay an annual mortgage insurance premium, which varies depending on your loan amount and the size of your down payment. You’ll pay annual MIPs either for 11 years or for the entirety of your loan term, depending on your down payment.

Property standards

Just like other mortgages, an FHA loan requires an appraisal. The difference is that, in addition to determining the value of the property for lending purposes, the appraisal for an FHA loan is also required to assess the condition of the home.

All homes purchased with FHA loans must meet certain durability, safety and soundness standards. If there are any issues found within the home, one of the following must take place:

• The seller must fix the issue(s) before the sale is finalized.
• The buyer must put money into an escrow account earmarked for home repairs to be completed after the sale.

Occupancy

You can only use an FHA loan for a property where you plan to live. At least one borrower listed on the loan must reside there within 60 days of the purchase and must continue to live there for at least one year.

Though you can use an FHA loan for multi-family homes where you plan to rent out the other units, you can’t use one for a vacation home, a second home or an investment property you don’t plan to occupy.

FHA loan limits

Like with conventional loans, FHA loans have restrictions on how much you can borrow for a single-family home. FHA loan limits have both a floor and a ceiling:

• The floor represents the maximum loan amount for people in most parts of the country. For 2023, it sits at $472,030, which is 65% of the conforming loan limit.
• The ceiling (the limit for high-cost areas) is $1,089,300, or 150% of the conforming loan limit.

There are only 60-plus counties at the FHA loan ceiling, and they’re located in California, Colorado, Idaho, Massachusetts, Maryland, New Jersey, New York, Pennsylvania, Utah, Virginia, Washington, D.C., West Virginia and Wyoming.

There are also hundreds of counties throughout the country that fall between the floor and the ceiling, meaning they have FHA loan limits somewhere between $472,030 and $1,089,300.

To learn about limits for your county, consult the Federal Housing Finance Agency map.

Pros and cons of FHA loans

FHA loans come with some major benefits, but they aren’t right for everyone. These pros and cons can help you decide if an FHA loan is right for you.

Pros:

• Low credit score requirement: You may qualify for an FHA loan with a credit score as low as either 500 or 580, depending on the size of your down payment.
• Competitive interest rates: Because FHA loans are backed by the federal government, lenders offer interest rates that are competitive with or lower than other loans.
• Compensating factors are allowed: Lenders consider qualifying factors for borrowers who don’t meet debt-to-income ratio requirements.
• No income requirement: FHA loans don’t have a minimum income requirement, which allows low-income families to buy homes.

Cons:

• High potential down payment: FHA loans require a down payment of 3.5% — or 10% for borrowers with a lower credit score — compared with a minimum of 3% for conventional loans.
• Requires MIP: The mortgage insurance premium on an FHA loan expires when the loan has been refinanced or it has been 11 years since the loan origination.
• Low loan limits: Except for people who live in high-cost areas, the loan limit on an FHA loan is significantly lower than on a conventional conforming loan.
• Strict property requirements: An FHA loan can only be used to buy a home that meets certain durability, safety and soundness requirements — so it may not be a solution if your prospective property needs an extreme makeover.

How to get the best FHA mortgage rates

FHA loans have interest rates that are competitive with conventional loan APRs. As a borrower, you can take steps to ensure you snag the best rate for your situation.

1. Improve your credit scores

Perhaps the most important factor affecting your mortgage interest rate is your credit scores. Though you can qualify for an FHA loan with a credit score as low as 500, you’ll need a score in FICO’s “very good” or “exceptional” ranges (740 to 799 or 800-plus, respectively) to qualify for the best mortgage rates.

If you don’t have time before a home purchase to significantly increase your credit scores, even small improvements can save you a lot of money over the life of your mortgage. Consider paying down some of your outstanding debt to up your scores in the short term.

2. Save up for a larger down payment

Another way to improve your mortgage rate is to make a larger down payment. FHA loans are available with down payments as low as 3.5%.

Making a larger down payment can help you get a better interest rate. As an added bonus, a larger down payment can improve your DTI ratio.

3. Consider buying discount points

Discount points are added to mortgages as an upfront cost, and for each point you purchase, your interest rate will be reduced. While points will make your loan more expensive at first, you can save money in the long run.

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