Saving up for a big down payment on a home could be the kind of financial obstacle that prevents first-time homebuyers with little savings from ever becoming homeowners. Fortunately, government-backed Federal Housing Administration (FHA) loans can help potential homebuyers who want a home but struggle to pull together a large down payment.
This guide will cover the pros and cons of using an FHA loan to purchase a home and how homebuyers can begin the process of shopping and getting approved for these loans.
Part I: Understanding FHA Loans
What is an FHA loan?
FHA loans are insured by the Federal Housing Administration, which means that the federal government makes a guarantee to the bank that the government will repay the borrower’s loan if the borrower stops making payments. This guarantee means banks are willing to provide funding to borrowers who may not otherwise be able to qualify for a home loan.
FHA loans are not funded or underwritten directly by the FHA, but rather by FHA-approved lenders. These lenders can be found using the Lender Search tool. Interest rates and fees vary by lender, even for the same type of loan, so it’s important to shop around.
Benefits of FHA loans
FHA loans are designed to promote homeownership and make it easier for people to qualify for mortgages. For that reason, they typically have more flexible lending requirements than conventional loans, including:
Lower minimum credit scores
Many loan programs require a credit score of at least 620 or 640, but FHA loans are available to borrowers with scores as low as 500.
Lower down payments
Borrowers can get FHA loans with as little as 3.5 percent down. However, borrowers with credit scores between 500 and 579 will need at least 10 percent down.
Not just for first-time homebuyers
Although their flexible terms and low down payments make FHA loans appealing to first-time homebuyers, they’re also available to repeat buyers as long as the proceeds are used to purchase a primary residence.
Seller assistance with closing costs
Yael Ishakis, the vice president of FM Home Loans in Brooklyn, N.Y., says another benefit of FHA loans is that they allow sellers to assist with up to 6 percent of sales price for closing costs, including origination fees, points and other closing costs. This helps borrowers struggling to come up with a down payment cover some of the additional costs involved in closing on a home loan. Sellers may not be willing to pay closing costs in a hot housing market, but in a down market, helping with closing costs can mean a faster sale. For conventional loans, the seller can contribute no more than 3 percent toward closing costs unless the buyer has a down payment greater than 10 percent.
Drawbacks of FHA loans
FHA loans are appealing to many borrowers, but they’re not always the best choice. Here are a few reasons you may want to look into alternatives.
FHA loans require mortgage insurance, a policy that protects the lender against losses from defaults on home mortgages. FHA loans require both upfront and monthly mortgage insurance from all borrowers, regardless of the amount of the down payment.
On a 30-year mortgage with a base loan amount of less than $625,500, the annual mortgage insurance premium would be 0.85 percent of the base loan amount, and the upfront mortgage insurance premium would be 1.75 percent of the base loan amount as of this writing.
With a conventional loan, the borrower can avoid mortgage insurance by putting at least 20 percent down. They can also request to have their mortgage insurance premiums removed from their monthly payment once the loan is at 78 percent of the home’s current value, as long as the borrower has been making on-time payments for at least one year. With an FHA loan, mortgage insurance is required for the life of the loan.
Ishakis says this aspect of FHA loans causes her to hesitate before offering FHA loan options to buyers. If an FHA borrower’s home goes up in value, the only way to have the mortgage insurance removed is to refinance to a conventional loan. The refi would require more paperwork, closing costs, and a potential increase to their interest rate if rates have increased. With a conventional loan, getting mortgage insurance removed simply requires sending a written request to the lender once you’ve met the requirements.
- Most recent two months of bank statements
- Most recent 30 days of pay stubs
- Most recent two years of W-2s
- Two years of tax returns
- Gift letter (if using gifted funds for the down payment or closing costs)
If you have been divorced in the past, declared bankruptcy, are self-employed, or earn income based on commissions, you may be required to provide even more documentation.
Minimum credit score
Varies based on credit score
Borrowers who are able to qualify for a conventional loan may be better off choosing a conventional loan rather than an FHA loan. Conventional loans can require a slightly lower down payment and do not require any upfront mortgage insurance, and borrowers can request to have their monthly mortgage insurance payments removed once they have at least 20 percent equity in the home and have made on-time payments for one year. That can all add up to significant savings over the life of the loan.
Part II: FHA Loan Requirements
With their flexible requirements and low barriers to approval, FHA loans are some of the easiest loans to qualify for. Here’s a look at FHA loan requirements.
Minimum credit score requirements
The minimum credit score for an FHA loan with a 3.5 percent down payment is typically 580. If your credit score is between 500 and 579, you may be approved for an FHA loan, but you will need to put at least 10 percent down.
These are FHA guidelines, but individual lenders may have their own requirements, referred to as lender overlays. A particular lender may require a minimum credit score of 640 or higher, so if you are turned down for an FHA loan by one bank, it’s a good idea to try others.
The FHA does not have minimum or maximum income requirements. However, borrowers must have sufficient income to be able to afford the mortgage payments and their other obligations. Part of the approval process involves verifying your employment and income, but the amount you earn is not as important as the amount of income you have left over after paying your other monthly bills.
Debt-to-income ratio requirements
Debt-to-income (DTI) ratio is another key metric FHA-approved lenders consider when determining whether you can afford a mortgage. DTI measures the amount of debt you have compared to your income, and it is expressed as a percentage.
Lenders look at two debt-to-income ratios when determining your eligibility:
- Housing ratio or front-end ratio. What percentage of your income would it take to cover your total monthly mortgage payment? According to Kevin Miller, Director of Growth at Open Listings, lenders like to see a front-end ratio below 31 percent of your gross income, although approval with a percentage up to 40 percent is possible depending on the circumstance.
- Total debt or back-end ratio. Shows how much of your income is needed to pay for your total monthly debts. Miller says lenders prefer a back-end ratio of less than 43 percent of your gross income, although approval with a percentage of up to 50 percent is possible.
Down payment requirements
FHA loans require a down payment of at least 3.5 percent of the purchase price, or 10 percent if your credit score is below 580. In addition to the down payment, the borrower may have to pay other upfront costs including appraisal and inspection fees, upfront mortgage insurance, real estate taxes, homeowners insurance, homeowners association dues, and more.
However, the FHA allows sellers to cover up to 6 percent of closing costs and allows closing costs to be gifted from friends or family members.
Clear CAIVRS report
Any federal debt that hasn’t been repaid and has entered default status can prevent you from getting an FHA loan. The government keeps track of people who default on all types of federal debts, like government-backed mortgage loans, SBA loans, and even federal student loans.
The system they use to track defaults is called the Credit Alert Verification Reporting System (CAIVRS). Borrowers do not have access to CAIVRS, so you’ll have to consult an FHA-approved lender to learn whether you are in the system.
If the delinquency was for a prior FHA-backed loan, you’ll have to wait three years from the time that the Department of Housing and Urban Development (HUD) paid the mortgage lender’s insurance claim.
FHA loan limits
The FHA puts a cap on the size of a mortgage that it will insure. These loan limits are calculated and updated annually and announced by HUD near the end of each calendar year.
Because the cost of living can vary widely throughout the country, FHA loan limits differ from one county to the next. The national maximum for an FHA loan is currently $636,150, but in low-cost areas, the maximum can go as low as $275,665 for a single-family home. You can look up the limit in your area using HUD’s FHA Mortgage Limits lookup tool.
FHA mortgage limits are calculated based on 115 percent of the median home price in the county, as determined by the Federal Housing Finance Agency.
FHA loans are only available when the borrower intends to use the property as a primary residence — investment properties are not eligible.
In addition, the property you intend to purchase must meet certain requirements to qualify for an FHA mortgage. Every FHA loan requires the property to be appraised and inspected by a HUD-approved home appraiser to verify the current market value of the property and ensure it meets HUD’s minimum property standards.
The appraiser will look at the roof, foundation, lot grade, ventilation, mechanical systems, heating, electricity, and crawl space in the home. Their standards are outlined in great detail in HUD’s Single Family Housing Policy Handbook, but essentially the property must not be hazardous or threaten the health and safety of the buyer who will live in the home.
Safety hazards noted during the appraisal will not automatically disqualify the property from an FHA loan. If the issue can be corrected before final inspection — such as the seller repairing a leaking roof — the loan can move forward.
Part III: Types of FHA Loans
There are several types of FHA loans to meet the needs of different homeowners. Here’s a look at the options available.
Fixed-rate mortgages are the most common type of FHA loans. The borrower chooses a loan term between 10 and 30 years, and the interest rate will not change over the life of the loan.
Adjustable-rate mortgages (ARMs) also have terms between 10 and 30 years, but as the name implies, the interest rate can change periodically, so the payments can go up or down. The initial interest rate on an ARM is lower than that of a fixed-rate mortgage, so this can be a good option for a borrower who plans to own their home for only a few years.
Many ARMs are hybrids, meaning there is an initial period during which the rate is fixed. After that, the rate changes at regular intervals. Most ARMs have caps that limit how much the rate can change at any one time and throughout the life of the loan.
FHA loans offer the following interest rate cap structures for ARMs:
- One- and three-year ARMs may increase by 1% annually after the initial fixed-rate period and 5% points over the life of the loan
- Five-year ARMs may either allow for increases of 1% points annually and 5% points over the life of the loan, or increases of 2% points annually and 6% points over the life of the loan
- Seven- and 10-year ARMs may only increase by 2% annually after the initial fixed-interest rate period, and 6% over the life of the loan
FHA reverse mortgages
Seniors with a paid-off mortgage or significant equity in their home may be able to access a portion of their home’s equity with an FHA Home Equity Conversion Mortgage (HECM), commonly referred to as a reverse mortgage.
The loan is called a reverse mortgage because instead of the borrower making monthly payments to the lender, as with a traditional mortgage, the lender makes payments to the borrower. The borrower is not required to pay back the loan unless the home is sold or otherwise vacated.
Many seniors use reverse mortgages to supplement Social Security income, meet unexpected medical expenses, make home improvements, and more.
Energy Efficient Mortgages
The FHA’s Energy Efficient Mortgage (EEM) program is designed to help homeowners save on utility bills by financing energy-efficient improvements with an FHA loan. The program is available as part of a home purchase or by refinancing the current mortgage.
To qualify for an EEM, the borrower must first get a Home Energy Rating Systems Report performed by a professional rater. The rater inspects everything in the home, from insulation to appliances and windows. Once the property’s current energy efficiency is calculated, the inspector makes recommendations for energy-efficient upgrades.
EEMs are available for $4,000 or 5 percent of the property value up to $8,000. If the EEM is included in the initial home purchase, you do not need to come up with a larger down payment.
FHA 203(k) loans
Homebuyers looking to buy a fixer-upper may be interested in an FHA 203(k) mortgage. This program allows homeowners and homebuyers to finance up to $35,000 into their mortgage for repairs and improvements.
These loans often make it possible for buyers to purchase and rehabilitate properties that other lenders won’t touch because the property is in such bad shape. The loan includes money to purchase the property, enough to make necessary improvements, and, in certain cases, enough to cover rent or the borrower’s existing mortgage for up to six months so the buyer has another place to live while the home is being renovated.
Part IV: Shopping for FHA Loans
As mentioned previously, FHA loans are notorious for requiring a lot of documentation. Here’s a list to get you started:
- Address of your place of residence
- Social Security number(s)
- Names and locations of your employer(s)
- Gross monthly salary at your current job(s)
- Two years of completed tax returns (three if you are self-employed)
- Two years of W-2s, 1099s, or other income statements
- Most recent month of pay stubs
- Recent statements for all open loans (such as student loans or car loans)
- A year-to-date profit-and-loss statement for self-employed individuals
- Most recent three months of bank, retirement, stocks, and/or mutual fund statements
- Contact information for your landlord or current mortgage lender
- Bankruptcy and discharge papers (if applicable)
- Copies of driver’s license(s)
- Social Security card(s)
- Copy of divorce decree (if applicable)
- Letters of explanation for any past credit issues, bankruptcies, or foreclosures (if applicable)
- Gift letter if your down payment or closing funds are a gift from friends or family members
- If you are refinancing or you own another property, you will also need:
- Note and deed from current loan
- Property tax bill
- Homeowners insurance policy
Your lender will also have you sign multiple documents, including authorization to pull your credit report, verify your employment, and obtain a transcript of your tax return from the Internal Revenue Service.
As you get closer to your closing date, you may need to update many of these documents. For instance, if you provided a January bank statement and pay stubs when you started your loan process and your loan doesn’t close until March, your loan officer will likely need a copy of your February bank statement and pay stubs to finalize your loan.
Where can you compare FHA loan rates?
As mentioned above, FHA loans are not provided directly by the FHA, but by FHA-approved lenders, so rates can vary depending on which bank you work with. For that reason, it’s a good idea to shop around for the best rate.
Fortunately, some resources allow you to do a lot of your initial mortgage rate shopping online.
Check out LendingTree’s FHA loan rates here. By filling out an online form with questions about the type of property you’re purchasing, city, state, and a few other details, you can compare personalized rates from several lenders. Note: LendingTree is the parent company of MagnifyMoney.
Part V: The FHA Closing Process
The HUD Handbook 4155.2 explains the FHA loan process in detail, from identifying a lender to the lender’s responsibilities after the loan is closed. The time it takes to close on an FHA loan is pretty comparable to other types of loans. According to a recent Origination Insight Report from Ellie Mae, in August of 2017, FHA loans for new purchases took an average of 44 days to close, compared to 42 days for conventional loans.
Here are the steps that apply to borrowers:
- Lender identification. Contact a HUD-approved lender to find out if you are eligible for an FHA loan. All of the major banks and many smaller, regional lenders participate in the FHA loan program.
- Loan application. The lender will help you complete a loan application and request a variety of financial documents.
- Case number assigned. Every FHA mortgage is assigned a case number that identifies the individual loan and borrower.
- Property appraisal. The lender will order a property appraisal from a HUD-approved appraiser to verify the market value of the home and that it meets all of HUD’s property requirements.
- Mortgage underwriting. The underwriter reviews your file in accordance with HUD’s guidelines to determine whether you have the ability to repay the loan. They’ll take a close look at your credit history, employment situation, income stability, debt-to-income ratio, and other factors.
- Underwriting decision. If your application is approved, you are “clear to close” and will move on to the closing process. If your file is rejected for some reason, the lender will notify you of the underwriter’s decision and will likely tell you why the underwriter came to that decision.
- Closing process. The lender “closes” the loan by having all documents signed and ensuring that all money is distributed to the appropriate parties. Borrowers should review all loan documents carefully to ensure accuracy. This is also the time when you’ll need to present a cashier’s check or wire funds from your bank to cover closing costs.
Before you sign
The closing process can be a ceremonious event. It may take place in your lender’s or realtor’s office. You’ll be handed a pen and a big stack of documents that require your signature. A notary will likely be present to witness your signature. But don’t let the pomp and circumstances distract you from the task at hand: making one of the largest financial transactions of your life.
Before you get to closing, you should receive a loan estimate that lays out the important information about your loan, including the loan amount, projected interest rate, estimated monthly payment, and estimated funds required to close. Your interest may be locked in. This means your rate won’t change between the offer and closing date, as long as there are no changes to your application and you close within the specified time frame.
At least three business days before closing, you should receive a Closing Disclosure form listing all final terms of the loan you’ve selected and final closing costs. When you sit down to sign the loan documents at closing, double-check the details to ensure your final documents agree with the Closing Disclosure. The Consumer Financial Protection Bureau has an excellent interactive tool explaining all of the parts of your Closing Disclosure and the details you should review.
Your lender or realtor should give you a list of items to bring with you to the closing. This will likely include a cashier’s check or proof of wire transfer for the funds you need to close and your driver’s license.
Ask questions to ensure you feel comfortable with everything you’re signing and make sure you know when and where to send your first mortgage payment and when it will be due.
Closing costs to consider
Your Closing Disclosure will show all of the closing costs required to finalize your loan. Some of them may be financed into your loan, some may be paid by the seller, and some are your responsibility. Closing costs vary based on where you live and the property you buy. Here’s a list of some common ones:
- Application fee. Covers the cost of the lender to process your application.
- Appraisal. Paid to the appraisal company to confirm the value of your home.
- Attorney fee. Paid to an attorney to review the closing documents on behalf of the buyer or lender.
- Escrow fee. Paid to the title company or escrow company that oversees the closing of your home purchase.
- Credit report. The cost of pulling your credit report and credit score.
- Escrow deposits. You may be required to put down two months or more of property taxes and mortgage insurance payments at closing.
- Upfront mortgage insurance premium. FHA loans require an upfront mortgage insurance premium of 1.75 percent of the loan amount.
- Homeowners insurance. Homeowners insurance covers possible damage to your home. The lender may require that you pay the first year’s premium at closing.
- Origination fee. Covers the lender’s administrative costs.
- Prepaid interest. The lender may require you to prepay any interest that will accrue between your closing date and the date your first mortgage payment is due.
- Recording fees. Charges by your local city or county for recording public records.
- Title company search. A fee paid to the title company for doing a thorough search of the property’s records to ensure that no one else has a legal claim to the property.
Closing costs typically run 3 to 5 percent of the loan amount.
Still wondering whether an FHA loan is right for you? The following are some frequently asked questions about FHA loans that may help you decide.
Yes! FHA guidelines require borrowers to wait two years from the discharge of a Chapter 7 bankruptcy or one year from the discharge of a Chapter 13 bankruptcy before applying for an FHA loan. In addition to meeting the waiting period, borrowers with bankruptcies should be able to demonstrate that they’ve worked to re-establish good credit or chosen not to incur any new debts since the bankruptcy. Borrowers will also have to submit a letter of explanation detailing the circumstances that lead to the bankruptcy with their loan application.
Yes. Having a co-signer may improve your chances of getting approved for the loan, especially if it’s a high debt-to-income ratio holding you back from getting approved. The co-signer must also submit to an underwriter review of their income and credit as they will be liable for repayment of the loan if the borrower fails to meet their obligation.
Yes. You can refinance an existing mortgage to a new FHA loan in a streamline refinance as long as you’ve made at least six monthly payments on your current mortgage and it’s been at least 210 days since the closing of that loan. You cannot have any payments overdue by more than 30 days and no late payments in the past 90 days. If you qualify, the streamline refinance does not require an appraisal, credit qualification, or employment verification.
You can also refinance an FHA loan into a conventional loan. This is often a good option for borrowers whose home has increased in value substantially. Since some FHA loans require mortgage insurance be paid during the entire life of the loan, refinancing to a conventional loan can eliminate mortgage insurance.
No. While FHA loans are popular among first-time homebuyers due to their low down payments and flexible requirements, they are available to repeat buyers as long as the loan is being used to purchase a primary residence.
No. FHA loans are only available for purchasing a buyer’s primary residence. However, you can use an FHA loan to buy a property with up to four units, as long as you will live in one unit while renting out the others.
The FHA allows 100 percent of the down payment and closing cost funds to be gifted, as long as the donor signs a gift letter stating that the money is a gift and does not have to be repaid.