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FHA Mortgage Loans Defined – What Is the Best Type to Qualify For?

If you’re like most Americans, buying a house is the largest single investment you make in your life. It’s also likely you’re financing the purchase with a mortgage loan. But mortgages come in many varieties, most of which aren’t appropriate for your situation.

If you have limited savings or less-than-perfect credit, a Federal Housing Administration-insured mortgage loan could be an option. The FHA loan is a popular alternative to conventional mortgages and has many subtypes with varying suitability.

If you’re considering an FHA loan, familiarize yourself with its requirements and limits and learn whether it’s right for you.

What Is an FHA Mortgage Loan?

Private lenders, including credit unions and traditional banks, issue FHA loans. The Federal Housing Administration insures the loans and limits them to owner-occupied residences, not rental properties or vacation homes.

Contrary to popular belief, the federal government doesn’t lend FHA loans directly. But if a borrower defaults, the Federal Housing Administration’s insurance policy protects the lender from financial losses. The government has insured more than 40 million residential real estate loans since 1934. 

Thanks to low down payment requirements and lax underwriting standards for borrowers with imperfect credit, the program is popular with first-time homebuyers, those with limited personal savings, and borrowers with poor credit scores. You can get an FHA loan with a down payment as low as 3.5% of the purchase price and a FICO score under 600.

But FHA loans have some notable downsides, including pricey private mortgage insurance or mortgage payment protection plans. FHA borrowers also experience sale price restrictions that can affect buyers in high-cost markets. And FHA loans are generally reserved for primary residences. Though there are some exceptions, they’re typically forbidden for investment properties.

How Much Do FHA Loans Cost?

Like most mortgage loans, FHA loans come with various closing costs. Expenses vary significantly by lender, geographic location, market conditions, and down payment. You can expect to pay some or all of the following closing costs on your FHA loan:

  • Mortgage Insurance: FHA loans require an upfront insurance premium equal to 1.75% of the financed amount — for instance, $3,500 on a $200,000 loan. Ongoing mortgage insurance premiums, which you must pay for at least 11 years after closing, represent a separate charge. 
  • Prepaid Property Taxes: In most cases, you need to prepay the property taxes you’ll accrue between closing and your next tax due date. Depending on your home’s value, local tax rates, and closing date, it could be hundreds or thousands of dollars.
  • Prepaid Hazard Insurance: This covers your first year’s homeowners insurance premiums, which can range from a few hundred to a few thousand dollars. You typically don’t pay it at closing, but you still need to factor it into your budget.
  • Property Survey: Property surveys can vary in scope and comprehensiveness. Basic plat surveys can cost less than $500, while more detailed boundary surveys can surpass $5,000. Fortunately, boundary surveys are rarely necessary.
  • Property Appraisal: Your lender-commissioned property appraisal verifies that the home is worth what the seller is asking. That reduces the lender’s risk in the event of foreclosure. Appraisals are typically mandatory and often cost less than $500.
  • Home Inspection: A home inspection covers the primary home structure and any habitable outbuildings. Though it’s not a binding warranty, it can identify potential hazards or necessary repairs. While not usually required, inspections are strongly recommended, especially for older homes. Expect to pay $200 to $500.
  • Title Search: This essential step verifies your property’s chain of title and ownership for the entire length of its existence, ensuring the seller has the right to sell the property to you. Expect to pay anywhere from $100 to $400.
  • Title Insurance: Title insurance covers the cost of fixing issues (such as latent liens and covenants) discovered in the title search and provides ongoing protection against claims on the property. Title insurance costs vary significantly from state to state, but $1,000 is a good rule of thumb.
  • Recording and Transfer: The jurisdiction in which the property is located, usually the city or county, requires that every home sale be recorded. In most cases, it also requires transfer stamps (fees). Depending on the jurisdiction and property value, expect to pay several hundred dollars.
  • Flood Determinations and Environmental Assessments: A flood determination helps show whether flood insurance is necessary. It usually costs less than $100 at closing, though ongoing flood insurance can cost substantially more. Some regions may require other types of environmental assessments, such as for fire hazard.
  • Origination Fee: The origination fee is often used as a catch-all to bundle miscellaneous closing costs like courier fees, document fees, escrow charges, and attorney’s fees. They can exceed 1% of the purchase price, adding significantly to your required cash at closing. 

By law, the seller can pay up to 6% of the sale price toward closing. That’s usually more than sufficient to cover closing costs. In buyer’s markets, motivated sellers willing to kick in thousands of dollars toward closing costs have an easier time completing their transactions, but the practice is far less common in seller’s markets.

Types of FHA Loans

FHA mortgage loans come in several subtypes depending on your age, assets, income, and current home equity.

203(b) Home Mortgage Loan

You can structure the most popular type of FHA purchase loan, a 203(b), multiple ways, but fixed-rate terms of 15 and 30 years and an adjustable-rate mortgage with a rate that stays steady for the first five years, then may change yearly based on prevailing rates (called a 5/1 adjustable-rate mortgage). 

The FHA insures adjustable-rate mortgages with interest rates that can rise by no more than 1 percentage point per year and no more than 5 percentage points over the full term. Borrowers receive notice of pending rate increases at least 25 days before the increase.

Whether the rate is fixed or adjustable, 203(b) interest rates tend to be lower than comparable conventional mortgages. You can get them on one-family to four-family homes.

Condominium Loans

Known as Section 234(c) loans, FHA condominium loans are 30-year fixed-rate products that finance the purchase of individual condominium units within developments larger than four units. 

There’s no strict occupancy requirement for condominium loans, so borrowers may be able to use FHA condo loans to earn rental income. 

Construction-to-Permanent Loan

This type of FHA mortgage finances the cost of purchasing land and constructing a new home. Unlike some construction loans, it’s a long-term mortgage, typically with terms of 15 years or more.

Rehabilitation Mortgage

Known as a Section 203(k) loan, an FHA rehab mortgage covers the cost of renovating an existing home. You can structure a rehab loan as a cash-out refinance loan if you’re renovating a property you already own or as a purchase loan if you’re buying a fixer-upper.

Secure Refinance Loan

FHA secure refinance loans help borrowers with conventional mortgage loans refinance into fixed-rate, FHA mortgages. Delinquency is not necessarily disqualifying, though it must result from higher monthly payments on a conventional adjustable-rate mortgage. Nondelinquent borrowers can refinance any type of conventional loan. 

Standard qualification requirements apply, including steady income, acceptable credit rating, and reasonable debt-to-income ratios.

Home Equity Conversion Mortgages 

Popularly known as a reverse mortgage, a home equity conversion mortgage enables owner-occupant seniors aged 62 or older to tap their home equity and pay off the remainder of their existing mortgages without making monthly mortgage payments or moving away. 

For seniors with limited savings and fixed incomes, these government-backed reverse mortgages are excellent sources of tax-free cash. But they do have significant legal and financial consequences for homeowners and their heirs.

Graduated Payment Loan

Known as Section 245 loans, graduated payment loans are designed for owner-occupants who expect their incomes to grow substantially in the medium term, such as aspiring medical professionals or engineers in the later stages of training. 

Graduated payment loans’ monthly payments increase over five or 10 years, after which they remain constant for the remaining term. Annual increases range from 2.5% to 7.5% on five-year plans and 2% to 3% on 10-year plans.

Growing-Equity Loan

Known as a Section 245(a) loan, the growing-equity loan is similar to the graduated payment loan. However, it’s more versatile. You can apply it to purchases of owner-occupied one-family to four-family homes, condominiums, shares in cooperative housing, and housing destined for renovation or rehabilitation

Monthly payments are subject to annual increases of between 1% and 5%, and loan terms cannot exceed 22 years.

How to Qualify for an FHA Loan

To qualify for an FHA loan, you and the home you want to buy must meet certain qualifications. 

Credit Score

You can get an FHA loan with a credit score as low as 500. If your FICO credit score is below 580, you must put down at least 10% of the purchase price. If your FICO score is above 580, you can put as little as 3.5% down.

Down Payment

Borrowers with fair or better credit can qualify for an FHA loan with as little as 3.5% down. Most others can qualify for an FHA loan with as little as 10% down. However, a higher down payment typically means a lower mortgage insurance premium and a lower monthly payment overall.

Debt-to-Income Ratio

You can get an FHA mortgage loan with a debt-to-income ratio as high as 43%. It’s the ratio of your total monthly debt payments — all revolving and installment payments — to your gross monthly income. For example, if your monthly gross income were $10,000 and the sum of all your required monthly debt payments were $4,300, your debt-to-income ratio would be 43%.

Housing Ratio

You can get an FHA loan with a housing ratio as high as 31%. It’s the ratio of your total monthly mortgage payment, including taxes, insurance, and homeowners association fees, to your gross monthly income.

For example, if your gross monthly income were $10,000 and your current monthly rent payment were $3,100, your housing ratio would be 31%. Likewise, if your gross monthly income were $10,000 and your total principal, interest, and escrow payment were $3,100, your housing ratio would also be 31%.

Mortgage Insurance

All FHA mortgage loans require upfront mortgage insurance premium payments. This one-time payment works out to 1.75% of the loan amount.

FHA mortgage loans also require ongoing mortgage insurance premium payments, at least for part of the loan term. Unlike conventional loans, FHA loans require ongoing mortgage insurance payments regardless of the initial down payment amount.

Borrowers who put less than 10% down must pay mortgage insurance premiums for the entire loan term or until they pay off the loan. Borrowers who put more than 10% down must pay mortgage insurance premiums for at least 11 years. Unlike conventional mortgages, FHA loans don’t allow you to cancel mortgage insurance early. 

Premiums range from 0.80% to 1.05% on loans with terms greater than 15 years and from 0.45% to 0.90% on loans with terms less than or equal to 15 years, depending on the financed amount. 

FHA Loan Limits

FHA loans are subject to maximum and minimum value limits that vary by region. You can calculate your local maximum by multiplying your county’s median sale price by 1.15 (115%). In a Census-defined metropolitan statistical area, which often includes more than one county, the local FHA maximum is 1.15 times the median sale price in the most expensive county. 

FHA mortgage loan limits change annually. The U.S. Department of Housing and Urban Development publishes detailed guidance on limits in different parts of the United States.

FHA Loans vs. Conventional Mortgages

FHA loans differ from conventional mortgages in several important ways.

Credit Score Requirements

FHA loans have lower minimum FICO credit score requirements than conventional mortgages.

  • FHA Loans: 500
  • Conventional Loans: 620

Loan Amount Limits

Unlike conventional mortgages, FHA loan amounts must remain below predetermined maximum limits.

  • FHA Loans: Loan limits vary by geography, but the maximum in the highest-priced markets is $970,800 as of 2022. The maximum in the lowest-priced markets is $420,680 as of 2022.
  • Conventional Loans: There’s technically no limit on conventional loan sizes, but they become jumbo loans at $647,200 in most markets and $970,800 in Alaska, Hawaii, and a few high-priced continental U.S. metro areas as of 2022. Jumbo loans may have higher interest rates than regular mortgage loans.

Down Payment Requirements

FHA loans have different down payment requirements than conventional mortgages.

  • FHA Loans: As low as 3.5% for FICO scores above 580 and 10% for FICO scores between 500 and 579
  • Conventional Loans: As low as 3% from some lenders, but 10% is more common

Loan Terms

Both FHA loans and conventional loans come with various term options, but conventional mortgages can have shorter terms overall.

  • FHA Loans: 15- to 30-year terms
  • Conventional Loans: Eight- to 30-year terms

Mortgage Insurance

Unlike conventional loans, all FHA loans require mortgage insurance payments.

  • FHA Loans: 1.75% upfront mortgage insurance payment plus 0.45% to 1.05% of the loan amount per year in ongoing payments for at least the first 11 years, depending on the amount financed
  • Conventional Loans: Only required if the initial amount financed is over 80%, meaning a down payment of less than 20%, with a rate range of 0.58% to 1.86%, depending on the amount financed

Advantages and Disadvantages of FHA Loans

FHA loans have some clear upsides and downsides. Review them carefully to determine if this type of mortgage is right for you.

Advantages of FHA Loans

FHA loans have looser underwriting standards and more forgiving terms for borrowers with modest incomes. 

  1. Loose Credit Underwriting. The federal government insures FHA loans. That greatly reduces financial risk and allows them to loan to consumers with subprime credit, who likely wouldn’t qualify for conventional mortgages.
  2. Potential for Low Down Payment. One of the biggest selling points of FHA loans is the promise of a low down payment, just 3.5% for borrowers with FICO scores at 580 or better. Most conventional mortgage loans require down payments of at least 10%.
  3. Higher Allowable Housing Ratio. The FHA insures loans with housing ratios as high as 31%. Conventional mortgage loans are dicey above 28%.
  4. No Prepayment or Early Payoff Penalties. The law forbids most prepayment penalties on residential mortgages issued after Jan. 10, 2014. However, many conventional mortgages originated before that date do carry prepayment penalties. By contrast, the FHA loan program has long forbidden prepayment penalties.
  5. Sellers Can Pay a Greater Share of Closing Costs. Under FHA rules, sellers can pay closing costs up to 6% of the sale price. That’s usually more than enough to cover costs paid at closing. Conventional mortgages cap it at 3% of the sale price.

Disadvantages of FHA Loans

FHA loans have some notable disadvantages, including hefty mortgage insurance requirements and restrictions on loan size and use.

  1. Mortgage Insurance Is Pricier. One of the biggest drawbacks of FHA loans is the mortgage insurance requirement. All FHA loans carry upfront and ongoing mortgage premium requirements. Conventional mortgages only require mortgage insurance if the down payment is less than 20%.
  2. The Purchase Price Is Subject to Restrictions. FHA loans are subject to maximum value limits that vary by region but generally can’t exceed $970,800 anywhere. Use HUD’s FHA mortgage limits calculator to find your local limits.
  3. Generally Not Available for Second Homes or Investment Properties. FHA loans are intended for primary residences. While there are some limited exceptions, such as for borrowers relocating for work, you can’t get an FHA loan for an investment property or vacation home.
  4. More Red Tape for Applicants. The FHA loan underwriting process is more involved than the one for conventional loans. It can take longer to close on an FHA loan as a result. 
  5. May Weaken Buyers’ Offers. In competitive markets, sellers may disfavor purchase offers contingent upon FHA financing since they take longer to close and may have a higher risk of falling through.

How to Apply for an FHA Loan

Applying for an FHA loan isn’t much different from applying for a conventional loan. 

Begin by using the U.S. Department of Housing and Urban Development’s FHA lender finder tool to locate lenders serving your area. If you prefer, use an online loan broker like LendingTree to source and compare multiple offers at once.

Once you’ve chosen the loan with the best rates, terms, and structure, lock your rate and apply. To move forward, provide your lender with:

  • A government-issued identification, such as a driver’s license, passport, or military ID
  • Pay stubs (or copies) for at least 30 days prior
  • Income statements, such as W-2 forms and 1099 forms for the most recent two tax years
  • Bank and investment account statements (or copies) for the most recent two months

If you’re self-employed or own a business, you must also provide:

  • A profit and loss statement for the current tax year up to the present date
  • Your two most recent tax returns, including all schedules

You may need to provide additional information as requested by your lender’s underwriting department. The lender won’t approve your application until the appraisal comes through, and a lower-than-expected value could jeopardize approval. 

FHA Loan Relief

If you have an FHA loan, you may be entitled to mortgage relief if you meet certain criteria. For example, if a federally declared disaster affects your home or livelihood, the government requires your lender to evaluate your situation and work with you to prevent foreclosure if possible. Depending on your circumstances, your lender may:

  • Modify your loan to make it more affordable
  • Place you in temporary forbearance so you don’t have to make regular payments on the loan
  • Delay foreclosure until the disaster expires
  • Help you secure financial assistance that keeps you in your home

If you’re not affected by a declared disaster, you may be eligible for federal loan relief through the Home Affordable Modification Program. It’s voluntary, meaning lenders don’t have to participate. But if yours does, it may reduce your monthly payment if you can show evidence of financial hardship and make at least three on-time payments at the lower amount.

Final Word

Whether you’re set on being the first occupant of a new-construction home, turning a shabby fixer-upper into the forever home of your dreams, or snagging a cozy condo in an up-and-coming urban neighborhood, chances are good that there’s an FHA loan program designed for you.

However, there’s no guarantee an FHA loan is the best option for your needs.

If you can afford a large down payment or live in an expensive housing market, a conventional mortgage may be the better financial choice. If you’re a military veteran, the VA loan program could reduce your homeownership costs better than any FHA loan.

Buying a home is a big deal. So when in doubt, don’t hesitate to ask a trusted financial expert for advice.

Brian Martucci writes about credit cards, banking, insurance, travel, and more. When he's not investigating time- and money-saving strategies for Money Crashers readers, you can find him exploring his favorite trails or sampling a new cuisine. Reach him on Twitter @Brian_Martucci.