FHA Loans: Your Guide to Affordable Homeownership & Requirements

An FHA loan is a federally insured home loan that allows you to make a down payment as low as 3.5% if you qualify.

FHA loans can be helpful for first-time homebuyers, but you don’t have to be a first-time buyer to qualify. They also may be a good option if you have less-than-perfect credit since they have an easier qualifying process than most conventional home loans.

But you should be aware that there are some downsides to FHA loans. The amount you can borrow is capped — and if you’re taking out an FHA loan to take advantage of the low down payment, you’ll have to buy mortgage insurance, which can make FHA loans more costly than some other types of mortgages.

Read on to learn more about FHA loans and how they work.

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• What is an FHA loan?
• What are the requirements for an FHA loan?
• What are the types of FHA loans?
• How do FHA loans work?
• How does interest work on an FHA loan?
• What are some FHA loan alternatives?

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What is an FHA loan?

An FHA loan is a type of mortgage insured by the Federal Housing Administration that may let you make a down payment as low as 3.5% and that has less-restrictive credit requirements than many conventional home loans.

You can use FHA loans to buy a home, refinance your mortgage or renovate a home.

You’ll still apply with traditional financial institutions like banks and credit unions, since they administer the loans. And while FHA loans are federally insured, that protects the lender — not you — in case you default on the loan.

What are the requirements for an FHA loan?

When you apply for an FHA loan, your lender has to follow certain regulations. The lending process will vary based on your credit scores and down payment amount.

To qualify for an FHA loan, you must meet these rules.

• Minimum credit scores — You’ll need minimum credit scores of at least 580 to qualify for a loan with a 3.5% down payment. You’ll need minimum credit scores of 500 to qualify for one with a 10% down payment.
• Mortgage type — You’ll also need to buy, refinance or renovate a home with between one and four units and plan to use the residence as your primary home.
• Debt–to-income ratio — Your total monthly debt payments, including any mortgage, typically can’t be more than 43% of your gross income.
• Financials — Your lender will verify your credit and income as well as the value of the property you want to purchase.

Keep in mind that interest rates and loan terms can vary. You should shop around to see which lender offers you the most favorable terms for your situation.

What are the types of FHA loans?

If you’re thinking about applying for an FHA loan, you’ve got a few options to consider.

• FHA’s 203(b) Basic Home Mortgage loan — This option provides mortgages from participating lenders to buy or refinance either a single-family home or multifamily property for one-to-four-unit homes.
• FHA’s 203(k) program — If the home you want to buy needs some work, this program provides up to $35,000 — rolled into a mortgage for the purchase or refinance of a home — to rehabilitate it.
• Construction to permanent loan — If you don’t want to buy an existing home, an FHA loan can also help you finance the purchase of a home you build.  
• Energy-efficient mortgage — This program lets you make “cost-efficient” energy improvements to your home, either for a new home or refinancing your current loan.

Many different lenders offer FHA loans. The Department of Housing and Urban Development provides a “Lender List Search” on its website where you can look for lenders. You can search by a specific lender’s name, by location or type of lender.

How do FHA loans work?

If you think an FHA loan may be a good option for you, you can start by saving for a down payment and researching potential lenders with HUD’s search tool.

Once you’re ready to apply, there are a few things you’ll want to keep in mind.

Pros of FHA loans

• Low down payment requirements — You may be eligible for an FHA loan with a down payment as low as 3.5% if you have credit scores of at least 580. (You may have to put down 10% if your credit scores are between 500 and 579.)
• Down payment help allowed — The FHA permits financial gifts or down payment assistance as long as you meet FHA requirements. Not all conventional loans allow gifts for down payments.
• Good credit not required — The FHA allows loans with credit scores as low as 500. That can be helpful if your credit history is shaky.
• Sellers can help with closing costs for an FHA loan — The FHA allows home sellers to pay up to 6% of the closing costs for a loan. Conventional lenders may cap a seller’s contribution at 3% of closing costs, although some allow sellers to pay up to 6%.

Downsides of FHA loans

• Mortgage insurance can be costly. You may pay a price for making a small down payment. You’ll have to pay a one-time upfront mortgage insurance premium, as well as an annual premium that’s collected in monthly installments. The one-time premium is generally equal to 1.75% of the home purchase price and can be financed in the mortgage or paid for in cash — but not a combination. The annual premium depends on your loan amount and loan-to-value ratio.
• There’s a limit to how much you can borrow. The FHA establishes loan limits based on median home prices in metro areas and counties. As of July 2020, the FHA maximum for a single-family home in a “low-cost area” is $331,760 while it’s $765,600 in a “high-cost area.” Alaska, Hawaii, Guam and the Virgin Islands are exceptions with a maximum of $1,148,400 for a single-family unit. These loan limits change periodically, so be sure to check for updated information. The Department of Housing and Urban Development has a search tool on its website to identify mortgage limits by county and state, so you can find out how much you’re able to borrow where you live.
• Good credit? Consider other options. If you have strong credit and don’t have enough money for a large down payment, you still might want to consider other options because of FHA loan’s mortgage premiums. Just keep in mind that if you don’t put at least 20% down, you’ll likely have to pay private mortgage insurance, or PMI.

How does interest work on an FHA loan?

FHA loans can be either fixed- or adjustable-rate loans.

• With fixed-rate loans, the rate doesn’t go up or down based an index rate, so your mortgage payment is more stable and predictable throughout the life of the loan.
• Adjustable-rate mortgage loans, or ARMs, move along with a specific benchmark index interest rate, such as the London Interbank Offered Rate, or Libor, which is a rate used by some large banks to charge each other for short-term loans. That means the interest rate — and monthly payment — can adjust periodically.

Adjustable-rate loans may have lower initial rates than fixed-rate loans, but they can go up over time.

For example, an adjustable-rate loan may be structured as a 3-1 ARM. This would mean your interest rate would be fixed for the first three years and could change annually after the initial three-year period. The loan could be set up so its interest rate could increase by up to 1% each year, with a maximum increase of 5% over the life of the loan.

The length of your mortgage loan also affects the rate you pay. The Consumer Financial Protection Bureau has an online tool that lets you explore potential rates based on a number of factors, including where you live, loan type, down payment and loan term.

What are some FHA loan alternatives?

If you’re not sure if an FHA loan is right for you, there are a few other options to consider.

• Conventional loan — A conventional loan means your mortgage isn’t part of a government program. There are two main types of conventional loans: conforming and non-conforming. A conforming loan follows guidelines set by Fannie Mae and Freddie Mac such as maximum loan amounts. A non-conforming loan can have more variability on eligibility and other factors.
• USDA loan — A USDA loan, also called a rural development loan, may be an option for people with low-to-moderate incomes who live in rural areas. They can be attractive because they offer zero down payments, but you’ll have to pay an upfront fee and mortgage insurance premiums.
• VA loan — VA loans are made to eligible borrowers by private lenders but insured by the Department of Veteran Affairs. You may be able to make a low down payment (or even no down payment). You’ll probably have to pay an upfront fee at closing, but monthly mortgage insurance premiums aren’t required.

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What’s next: Is an FHA loan right for you?

If you’re considering an FHA loan, here are a few more things to think about before you apply.

• What’s my budget for a home?
• How much money can I put toward a down payment?
• What’s my credit like?
• Do I want to buy a fixer-upper? A new build?
• Am I OK paying more each month for mortgage insurance?
• Do I have a preferred lender?

You should shop carefully among lenders to find the loan that’s best for your situation and consider all of your options before making a long-term commitment.