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What Is an FHA Loan?

Updated
Matt Frankel, CFP®
Author: Matt Frankel, CFP®
Matt Frankel, CFP®
Matt Frankel, CFP®
Writer, Analyst

Matt is a Certified Financial Planner™ and investment advisor based in Columbia, South Carolina. He writes personal finance and investment advice for Motley Fool Money and its parent company The Motley Fool, with more than 4,500 published articles and a 2017 SABEW Best in Business award. Matt writes a weekly investment column for the Motley Fool ("Ask a Fool") that is syndicated in USA Today, and his work with Motley Fool Money has also been syndicated to MSN and Yahoo! Finance. He has been regularly featured on Fox Business and many other major outlets. He’s a graduate of the University of South Carolina and Nova Southeastern University, and holds a graduate certificate in financial planning from Florida State University.

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If you're planning to buy a home, it can be difficult to get a conventional mortgage without strong credit or a large down payment. If this describes you, an FHA loan could be just what you're looking for. In this article, we'll discuss what an FHA loan is, how it works, how to qualify, and the benefits and drawbacks of using this type of mortgage loan to finance your home purchase.

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What is an FHA loan?

FHA loans can be considerably easier to qualify for than conventional mortgages. FHA loans have significantly lower credit score requirements than other types of mortgages. They also require a down payment as low as 3.5% of the purchase price.

That's because an FHA loan is a special type of mortgage loan that is guaranteed by the Federal Housing Administration (a part of the Department of Housing and Urban Development, or HUD). If you can't pay your mortgage, the FHA will pay the lender back. (You'll still face significant financial consequences, though -- this protection just means the lender won't lose their money if you can't pay your mortgage.) As a result, lenders are more willing to lend to homebuyers with low credit scores or low down payments if the FHA guarantees the loan. You have to pay a monthly fee for this guarantee, though.

FHA loans are intended to make homeownership more accessible and affordable to U.S. home buyers who otherwise wouldn't be able to obtain financing at a reasonable cost. This type of loan is especially helpful if you're a first time home buyer.

How does a FHA home loan work?

You can get an FHA loan are at most U.S. financial institutions that have mortgage lending operations, including our best mortgage lenders, as well as other mortgage lenders. They are guaranteed by the FHA through mortgage insurance that the borrower is required to purchase.

Since FHA loans are designed to help everyday Americans buy homes, there are limitations to the amount of money that can be borrowed. In most areas of the U.S., the FHA loan limit for a single family home or condominium is $331,760 in 2020. This can be as high as $765,600 in certain high-cost real estate markets and is even higher in Alaska and Hawaii. There are also higher limits for multi-unit properties.

Buyers can use FHA loans to purchase properties with one to four housing units. There is an owner occupancy requirement, meaning that the buyer must live in the property. FHA loans can't be used to buy a vacation home.

An FHA loan can also cover the cost of a single unit of a condo or townhouse. Approval in these cases depends on whether or not the condo or townhouse is governed by a particularly restrictive HOA.

What are the different types of FHA loans?

There are several types of FHA loans, but the two most common are the FHA 203(b) and 203(k) loans. Here's the difference.

FHA 203(b) loans (standard FHA home loan)

If you're simply planning to purchase a home that's in good condition and want to move in right away, an FHA 203(b) loan is what you need. The 203(b) loan is the "standard" FHA loan that is used to purchase a home.

FHA 203(k) loans (FHA rehabilitation loan)

FHA 203(k) loans are designed to help buyers purchase homes in need of significant repairs or renovations. In other words, a 203(k) loan, which is also called an FHA rehabilitation loan, allows a homebuyer to buy a home and finance the cost of repairs in a single, easy-to-obtain loan.

As far as credit and down payment standards, FHA 203(k) loans are essentially the same as 203(b) loans, but lenders may charge some additional fees.

FHA loan requirements

  • 500 credit score - On the credit front, FHA loan requirements call for a score of at least 580 if you want to make the minimal 3.5% down payment. However, you can get an FHA loan with a FICO® Score as low as 500 if you can put 10% of the purchase price down. The question of how to get a mortgage with bad credit is a challenge for many home buyers, and FHA loans can be the solution.
  • 3.5% down payment - You'll need a minimum down payment of 3.5% to qualify for an FHA loan. You can choose to put more money down if you want, but this is the minimum. Up to 100% of your down payment can come from a down payment gift (though there are limits on who can give you money toward a down payment on an FHA loan).
  • Two years of continuous employment - You'll typically need at least two years of continuous employment in the same field.
  • Relatively low debt - Your income must be high enough to justify the new mortgage as well as any other debt payments you have. Most FHA lenders want to see a debt-to-income (DTI) ratio of 43% or less, but some may be willing to go higher. If you're spending half your income on debt payments, you may not qualify.

What's the difference between an FHA loan and a conventional loan?

A conventional loan is the most common type of mortgage used by U.S. home buyers.

The biggest difference between conventional and FHA loans is that while conventional loans must meet certain lending standards, they aren't guaranteed by any agency. FHA loans are guaranteed by HUD. This is why FHA loans have much easier credit requirements. They represent a significantly lower risk to the lender because of this guarantee.

Technically, a conventional loan refers to a standard mortgage that meets the lending standards of either Fannie Mae or Freddie Mac.

Pros and cons of FHA loans

Pros

  • Easy credit qualifications
  • Low down payment
  • Competitive interest rates
  • Buy multi-unit properties

Cons

  • High mortgage insurance premiums
  • Mortgage insurance cannot be cancelled

Easy to qualify

As mentioned, the biggest benefit to using an FHA loan versus a conventional loan when financing your home purchase is the easy credit and down payment qualifications.

While you can get a conventional loan with a credit score as low as 620, it can be very tough to get a competitive interest rate with a borderline credit score or low down payment.

On the other hand, you can obtain an FHA loan with a 580 FICO® Score and a 3.5% down payment that also has a reasonably low interest rate. Interest rates on FHA loans vary among borrowers, so compare FHA loan rates when you're ready to start the process.

Can be used for multi-unit properties

Another perk of using an FHA loan is that it can be used to purchase a property with more than one housing unit. While conventional loans can be used to buy multi-unit properties, you'll need a minimum of 25% down to do so. FHA loans have the same 3.5% down payment requirement for properties with as many as four housing units.

Higher cost

The biggest drawback of using an FHA loan is its cost -- specifically when it comes to FHA mortgage insurance.

In short, the government guarantee on an FHA loan isn't free. Borrowers have to pay for FHA mortgage insurance, which has both an upfront premium added to your FHA loan closing costs, as well as an ongoing cost. And unlike private mortgage insurance (PMI) on conventional loans, it can be difficult or impossible to get rid of FHA mortgage insurance without refinancing.

Is an FHA loan right for you?

There's no such thing as a perfect type of mortgage, and an FHA loan is no exception. If you have a so-so credit score, can only make a low down payment, or want to purchase a multi-unit home without putting a ton of money down, an FHA loan could be an excellent choice for you (if you have a stronger credit history and a large down payment saved, another loan would be a better fit). If an FHA loan is right for you, the next step is to find an FHA lender that best meets your needs, and apply.

Still have questions?

Read more about FHA loans:

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FAQs

  • An FHA Loan is a mortgage that is guaranteed by the Federal Housing Administration, designed to make it easier for homebuyers without great credit scores or large down payments to obtain financing for home purchases.

  • FHA loans are originated by most mortgage lenders and are guaranteed by the Federal Housing Administration through the FHA mortgage insurance program. Buyers pay an upfront and ongoing mortgage insurance premium in exchange for the guarantee.

  • The single biggest difference between conventional and FHA loans is that while conventional loans must meet certain lending standards, they aren't guaranteed by any agency. On the other hand, FHA loans are guaranteed by the Department of Housing and Urban Development (HUD), meaning that if the borrower can't make payments, the lender isn't on the hook for the balance. This is why FHA loans have much easier credit requirements.