Federal Housing Administration (FHA) Loan

What Is a Federal Housing Administration Loan (FHA) Loan?

A Federal Housing Administration (FHA) loan is a mortgage that is insured by the Federal Housing Administration (FHA) and issued by an FHA-approved lender. FHA loans are designed for low-to-moderate-income borrowers; they require a lower minimum down payment and lower credit scores than many conventional loans.

In 2020, you can borrow up to 96.5% of the value of a home with an FHA loan. This means you'll need to make a down payment of 3.5%. You'll need a credit score of at least 580 to qualify. If your credit score falls between 500 and 579, you can still get an FHA loan as long as you can make a 10% down payment. With FHA loans, your down payment can come from savings, a financial gift from a family member, or a grant for down-payment assistance.

Because of their many benefits, FHA loans are popular with first-time homebuyers.

Understanding Federal Housing Administration (FHA) Loans

It's important to note that with an FHA loan, the FHA doesn't actually lend you money for a mortgage. Instead, you get a loan from an FHA-approved lender, like a bank or another financial institution. However, the FHA guarantees the loan. Some people refer to it as an FHA-insured loan, for that reason.

In order to secure the guarantee of the FHA, borrowers that qualify for an FHA loan are also required to purchase mortgage insurance, and premium payments are made to FHA. Your lender bears less risk because the FHA will pay a claim to the lender if you default on the loan.

While Federal Federal Housing Administration Loans (FHA Loans) require lower down payments and credit scores than conventional loans, they do carry other stringent requirements.

How Long You Pay the Annual Mortgage Insurance Premium (MIP)

HOW LONG YOU PAY
THE ANNUAL MIP

78.01% to 90%

> 15 years

> 15 years

78.01% to 90%

> 15 years

History of the Federal Housing Administration (FHA) Loan

Congress created the Federal Housing Administration in 1934 during the Great Depression. At that time, the housing industry was in trouble: Default and foreclosure rates had skyrocketed, loans were limited to 50% of a property's market value and mortgage terms — including short repayment schedules coupled with balloon payments — were difficult for many homebuyers to meet. As a result, the U.S. was primarily a nation of renters, and only approximately 40% of households owned their homes.

In order to stimulate the housing market, the government created the FHA. Federally insured loan programs that reduced lender risk made it easier for borrowers to qualify for home loans. The homeownership rate in the U.S. steadily climbed, reaching an all-time high of 69.2% in 2004, according to research from the Federal Reserve Bank of St. Louis. As of the second quarter of 2020, it's at 67.9%.

Types of FHA Loans

In addition to traditional mortgages, the FHA offers several other loan programs.

Home Equity Conversion Mortgage (HECM)

This is a reverse mortgage program that helps seniors aged 62 and older convert the equity in their homes to cash while retaining title to the home. You choose how to withdraw the funds, either as a fixed monthly amount or a line of credit (or a combination of both).

FHA 203(k) Improvement Loan

This loan factors in the cost of certain repairs and renovations into the loan. This one loan allows you to borrow money for both home purchases and home improvements, which can make a big difference if you don't have a lot of cash on hand after making a down payment.

FHA Energy Efficient Mortgage

This program is a similar concept to the FHA 203(k) Improvement Loan program, but it’s aimed at upgrades that can lower your utility bills, such as new insulation or the installation of new solar or wind energy systems. The idea is that energy-efficient homes have lower operating costs, which lower bills and make more income available for mortgage payments.

Section 245(a) Loan

This is a program for borrowers who expect their incomes to increase. Under the Section 245(a) program, the Graduated Payment Mortgage starts with lower initial monthly payments that gradually increase over time, and the Growing Equity Mortgage has scheduled increases in monthly principal payments that result in shorter loan terms.

The 5 Types of FHA Loan

FHA LOAN TYPE

WHAT IT IS

Traditional Mortgage

A mortgage used to finance a primary residence

Home Equity
Conversion
Mortgage

A reverse mortgage that allows homeowners aged 62+ to exchange home equity for cash

203(k) Mortgage
Program

A mortgage that includes extra funds to pay for energy-efficient home improvements intended to lower your utility bills

Energy Efficient
Mortgage Program

A mortgage that includes extra funds to pay for energy-efficient home improvements intended to lower your utility bills

Section 245(a) Loan

A Graduated Payment Mortgage (GPM) with lower initial monthly payments that gradually increase (used when income is expected to rise), and a Growing Equity Mortgage (GEM) where scheduled increases in monthly principal payments result in shorter loan terms

Federal Housing Administration (FHA) Loans vs. Conventional Mortgages

FHA loans are available to individuals with credit scores as low as 500. If your credit score is between 500 and 579, you may be able to secure an FHA loan if you can afford a down payment of 10%. If your credit score is 580 or higher, you can get an FHA loan with a down payment for as little as 3.5% down. By comparison, you'll typically need a credit score of at least 620, and a down payment between 3% and 20%, to qualify for a conventional mortgage.

When it comes to income limitations and requirements for FHA home loans, there is no minimum or maximum.

For an FHA loan — or any type of mortgage — at least two years must have passed since the borrower experienced a bankruptcy event (unless you can demonstrate that the bankruptcy event was due to an uncontrollable circumstance). You must be at least three years removed from any mortgage foreclosure events, and you must demonstrate that you are working toward re-establishing good credit. If you're delinquent on your federal student loans or income taxes, you won't qualify.

FHA Loans vs. Conventional Loans

FHA LOAN

CONVENTIONAL LOAN

Minimum Credit Score

Down Payment

3.5% with credit score of 580+ and 10% for credit score of 500 to 579

Loan Terms

15 or 30 years

10, 15, 20, or 30 years

Mortgage Insurance

Upfront MIP + Annual MIP for either 11 years or the life of the loan, depending on LTV and length of loan

None with down payment of at least 20% or after loan is paid down to 78% LTV

Mortgage Insurance Premiums

Upfront: 1.75% of the loan + Annual: 0.45% to 1.05%

 PMI: 0.5% to 1% of the loan amount per year

Down Payment Gifts

100% of down payment can be a gift

Only part can be a gift if down payment is less than 20%

Down Payment Assistance Programs

Special Considerations

Mortgage Insurance Premiums

An FHA loan requires that you pay two types of mortgage insurance premiums (MIP) — an upfront MIP and an annual MIP (which is charged monthly). In 2020, the upfront MIP is equal to 1.75% of the base loan amount.

You can either pay the upfront MIP at the time of closing or it can be rolled into the loan. For example, if you’re issued a home loan for $350,000, you’ll pay an upfront MIP of 1.75% x $350,000 = $6,125. These payments are deposited into an escrow account that is set up by the U.S. Treasury Department; if you end up defaulting on your loan, these funds are used to make mortgage payments.

Although the name is somewhat misleading, borrowers actually make annual MIP payments every month. (In other words, annual MIP payments are not made annually.) The payments range from 0.45% to 1.05% of the base loan amount. The payment amounts also differ depending on the loan amount, length of the loan, and the original loan-to-value ratio (LTV). The typical MIP cost is usually 0.85% of the loan amount.

For example, if you have a $350,000 loan, you will make annual MIP payments of 0.85% x $350,000 = $2,975 (or $247.92 monthly). These monthly premiums are paid in addition to the one-time upfront MIP payment.

You will make annual MIP payments for either 11 years or the life of the loan, depending on the length of the loan and the LTV.

You may be able to deduct the amount you pay in premiums; however, you have to itemize your deductions — rather than take the standard deduction — in order to do this.

Qualifying for an FHA Loan

Your lender will evaluate your qualifications for an FHA loan as it would any mortgage applicant. However, instead of using your credit report, a lender may look at your work history for the past two years (as well as other payment-history records, such as utility and rent payments). As long as you've reestablished good credit, you can still qualify for an FHA loan if you've gone through bankruptcy or foreclosure. It's important to keep in mind that, as a general rule of thumb, the lower your credit score and down payment, the higher the interest rate you'll pay on your mortgage.

Along with the credit score and down payment criteria, there are specific lending FHA mortgage requirements outlined by the FHA for these loans. Your lender must be an FHA-approved lender and you must have a steady employment history or have worked for the same employer for the past two years.

If you're self-employed, you need two years of successful self-employment history; this can be documented by tax returns and a current year-to-date balance sheet and profit and loss statement. If you've been self-employed for less than two years but more than one year, you may still be eligible if you have a solid work and income history for the two years preceding self-employment (and the self-employment is in the same or a related occupation). You must have a valid Social Security number, reside lawfully in the U.S., and be of legal age (according to your state laws) in order to sign a mortgage.

Usually, the property being financed must be your principal residence and must be owner-occupied. In other words, the FHA loan program is not intended to be used for investment or rental properties. Detached and semi-detached houses, townhouses, rowhouses, and condominiums within FHA-approved condo projects are all eligible for FHA financing.

Your front-end ratio (your mortgage payment, HOA fees, property taxes, mortgage insurance, and homeowner's insurance) needs to be less than 31% of your gross income. In some cases, you may be approved with a 40% ratio.

Your back-end ratio (your mortgage payment and all other monthly consumer debts) must be less than 43% of your gross income. However, it is possible to be approved with a ratio as high as 50%. Also, you need a property appraisal from an FHA-approved appraiser, and the home must meet certain minimum standards. If the home doesn’t meet these standards and the seller won’t agree to the required repairs, you must pay for the repairs at closing. (In this case, the funds are held in escrow until the repairs are made.)

Mortgage lending discrimination is illegal. If you think you've been discriminated against based on race, religion, sex, marital status, use of public assistance, national origin, disability, or age, there are steps you can take. One such step is to file a report to the Consumer Financial Protection Bureau or with the U.S. Department of Housing and Urban Development (HUD).

One limitation of FHA loans is that they have outside limits on how much you can borrow. These are set by the region in which you live, with low-cost areas having a lower limit (referred to as the "floor") than the usual FHA loan and high-cost areas having a higher figure (referred to as the "ceiling").

In addition, there are "special exception" regions — including Alaska, Hawaii, Guam, and the U.S. Virgin Islands — where very high construction costs make the limits even higher. Everywhere else, the limit is set at 115% of the median home price for the county, as determined by the U.S. Department of Housing and Urban Development.

The chart below lists the 2020 loan limits:

2020 FHA Loan Limits

PROPERTY TYPE

LOW-COST AREA
'FLOOR'

HIGH-COST AREA
'CEILING'

SPECIAL EXCEPTION
AREAS

One-Unit

Two-Unit

Three-Unit

Four-Unit

FHA Loan Relief

Once you have an FHA loan, you may be eligible for loan relief if you’ve experienced a legitimate financial hardship — such as a loss of income or increase in living expenses — or are having a hard time making your monthly mortgage payments. The FHA Home Affordable Modification Program (HAMP), for example, can help you avoid foreclosure by permanently lowering your monthly mortgage payment to an affordable level.

To become a full participant in the program, you must successfully complete a trial payment plan in which you make three scheduled payments — on time — at the lower, modified amount.

The Bottom Line

While an FHA loan may sound great, it's not for everybody. It won't help those with credit scores less than 500. For those with bad credit, a personal loan may be a better option to consider. On the opposite end, aspiring homeowners who can afford a large down payment may be better off going with a conventional mortgage. It's more likely that they'll be able to save more money in the long run through the lower interest rates and mortgage insurance premiums that conventional lenders provide.

FHA loans were not created to help potential homeowners who are shopping on the higher end of the price spectrum. Rather, the FHA loan program was created to support low- and moderate-income home buyers, particularly those with limited cash saved for a down payment."

When you buy a home, you may be responsible for additional out-of-pocket expenses, such as loan origination fees, attorney fees, and appraisal costs. One of the advantages of an FHA mortgage is that the seller, home builder, or lender may pay some of these closing costs on your behalf. If the seller is having a hard time finding a buyer, it's possible they might offer to help you out at the closing as a way of incentivizing the deal.