FHA loans: Everything first-time homebuyers need to know

You can get a mortgage insured by the Federal Housing Administration, even if you have a low credit score or less cash for a down payment.

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An FHA loan is a mortgage insured by the US Federal Housing Administration that usually has less stringent requirements than a conventional loan. If you're a first-time borrower, or have a lower credit score or less money for a down payment, you may be a good candidate for an FHA loan. 

That noted, as with so many things, the coronavirus pandemic has impacted the availability of FHA loans, with some lenders having tightened their qualifications for approval. While the Department of Housing and Urban Development ultimately sets the ground rules for these types of loans, some lenders add their own specific conditions. As such, there may be differences in eligibility requirements from lender to lender. 

Given that the writing on federal websites is sometimes difficult to penetrate, we've rounded up everything you need to know about FHA loans here. Read on to learn more about FHA loans, loan requirements -- and whether an FHA loan is the right choice for you. 

What is an FHA loan?

FHA loans are similar to conventional mortgages in that they're issued by banks, credit unions or other lenders. The difference is that they're insured by the Federal Housing Administration, which sets the basic guidelines for eligibility. And because FHA loans are insured by the government, lenders are more willing to approve a borrower with a lower FICO score or less money for a down payment. If the borrower defaults on the loan, the lender can call on the insurance to bail them out. 

What are the differences between an FHA loan and a conventional loan?

FHA loans are designed for a borrower with a short credit history or a low credit score -- but they also "allow for financing sooner after a significant credit event such as a foreclosure, short sale or bankruptcy," according to Michael Mertz, operations manager for VIP Mortgage. 

And they can also help borrowers that have less cash for a down payment. With a conventional mortgage, you're required to buy private mortgage insurance only if your down payment is less than 20% of the sale price. And once your equity exceeds the 20% loan-to-value threshold, you can terminate it. 

In contrast, all FHA loans require mortgage insurance. If your down payment is 10% or higher, you must have a mortgage insurance policy for the first 11 years of your loan. And, if your down payment falls under the 10% threshold, you'll be required to maintain it for the life of the loan -- regardless of whether your loan-to-value level eventually exceeds 10%. 

What are the different types of FHA loans?

Like conventional mortgages, there are plenty of different types of FHA loans, covering all kinds of financial situations and home-buying scenarios. Here are some of the most common ones:

Basic home mortgage, 203(b)

This broad loan category includes both fixed- and adjustable-rate mortgages. Fixed rate means that you pay the same rate during the loan term, which can range from 15 to 30 years. An adjustable-rate mortgage, known as an ARM, features a low rate for an introductory period. After the initial period, the rate can change based on a number of financial indices. Though there are thresholds for how high or low the interest rate can go, ARM payments are likely to fluctuate over the lifetime of the loan.

FHA renovation mortgages, 203(k)

Designed for homeowners that want to make renovations, this mortgage combines a home's purchase price and renovations into one loan, so you don't have to take out a second mortgage or a separate home improvement loan.

Energy-efficient mortgage, or EEM

If you're looking to make your home more energy efficient, there's a specific FHA loan to help you cover the costs. 

Construction to permanent, or CP

If you're building a new home, this type of mortgage helps you finance both construction costs and the land -- provided you stay within the FHA loan limits. 

What are the FHA loan limits?

According to HUD rules, the FHA loan limit ranges from $356,362 to $822,375, depending on where you live. You can use the department's official lookup tool to see the specific limits for your area. 

What are the advantages and disadvantages of using an FHA loan?

The primary advantage of FHA loans is that they expand access to mortgages for borrowers with lower credit scores or shorter credit histories. But they can also pave the way for borrowers who have less cash for a down payment. In fact, if you have a FICO score of 580 or higher, you may be eligible to put down as little as 3.5% -- far less than the 20% down payment typically required for a conventional loan. 

It's worth noting that it's possible to get a conventional loan even if you can't put down 20%. "You can talk to your local lender about down payment options at 15, 10 or 5% for conventional financing. There are even some options for a 3% down payment," according to Mertz.

Still, if you put down less than 10% with an FHA loan, you'll be required to pay insurance for the entire life of the mortgage. (With a conventional loan, once you exceed the 20% loan-to-value threshold, you are no longer required to pay for mortgage insurance.) Though an FHA mortgage can help you get your foot in the door of homeownership, it can also add to the overall cost of your loan over the long term. You can always refinance from an FHA to a conventional loan.

How to qualify for an FHA loan

Though specific requirements vary from lender to lender, there are some basic qualifications set by HUD.

Credit score

Though you'd need a FICO credit score of 620 or higher to qualify for a typical conventional mortgage, you may be able to qualify for an FHA loan with a score as low as 500. That noted, if your score is lower than 580, you may have to make a larger down payment.

Down payment

If your credit score is 580 or higher, you may be able to qualify with a down payment as low as 3.5%. If your credit score is between 500 and 580, you'll likely need to put down 10%. 

But FHA loans also have less stringent requirements around the source of your down payment. Your relative can simply write a check for your down payment (along with a letter documenting the transaction) -- whereas with a conventional mortgage, you need to store the donated funds in a bank account for at least two statement periods. 

Debt-to-income ratio

This metric shows how much of your monthly (pretax) income goes to making your minimum debt obligations. It includes all of your debts -- even loans that are inactive or are being deferred. (Student loan debt, however, has a lower weight when calculating this ratio than other types of loans.) If your monthly minimum debt payment totals $700, for example, and you make $3,500 per month, your debt-to-income ratio is 20%. 

FHA lenders typically look for applicants with a debt-to-income ratio of 50% or lower. 

Property approval

FHA loans require an in-depth appraisal. If you're applying for a 203(k) construction mortgage, a lender might require two appraisals -- one before the renovation and another after you make improvements. 

Mortgage insurance

All FHA loans require mortgage insurance. If you make a down payment of 10% or more, you will pay mortgage insurance for the first 11 years of the loan. If you only make a down payment of less than 10%, you will have to pay for insurance until you pay off the loan -- or refinance with a conventional loan with at least a 20% down payment. 

How to apply for an FHA loan

There will be paperwork. FHA loans are available only to citizens of the US, and you will need to provide proof of citizenship such as a current driver's license, passport or other government-issued ID. You will also need a valid Social Security number and proof of income such as pay stubs, bank statements or tax documents. If you receive money from a family member for your down payment, you'll need to include a note indicating as much.