What is an FHA Loan?

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If you qualify, a FHA loan is a great path to home ownership

The term “FHA loan” is actually somewhat of a misnomer. That’s because the FHA, or Federal Housing Administration, doesn’t actually lend money to would-be homeowners. Rather, it insures the loans made by private lenders. So, while we’ll use the term “FHA loan” for simplicity, an “FHA-backed loan” is more accurate.

An FHA loan aims to put homeownership within reach for many Americans who wouldn’t otherwise qualify for a conventional, non-FHA-backed mortgage. You may be able to get an FHA loan with a lower credit score, lower down payment, and a higher debt-to-income ratio than you could have for a conventional mortgage.

Why are FHA lenders willing to relax their requirements? Simple: If the homeowner can no longer pay his or her loan, Uncle Sam is on the hook instead of the lender. That means the lender can offer loans to home buyers they would otherwise deem too risky.

Am I eligible to apply for an FHA loan?

If you’re a legal resident of the U.S., chances are you can apply for an FHA loan.

Perhaps you’ve heard that FHA loans are for first-time or low-income homebuyers. While helping first-time and lower-income buyers are certainly two aims of the program, you don’t have to be buying your first home or making under a certain amount of money to get an FHA loan.

You do, however, have to be seeking a loan for your primary residence — the rule here is that you have to live there for at least half the year. In most cases, that excludes investment properties, with one important loophole: You can buy up to a four-unit dwelling with an FHA loan as long as one of the units will be your primary residence.

You may even have more than one FHA loan — common qualifying circumstances include relocating to an area outside reasonable commuting distance from the first FHA-backed property, or a family simply outgrowing the first property.

Advantages of an FHA loan

Most of the benefits of an FHA loan relate to more lenient approval standards. Here are some specific advantages:

You can make a lower down payment: This is the biggie. With an FHA loan, your down payment may be as low as 3.5% of the home’s purchase price. While you may be able to get a conventional mortgage with as little as 3% to 5% down, the closer you get to 20%, the more likely you are to be approved.

Your credit doesn’t need to be perfect: FHA loans also offer a bit more wiggle room if your credit score isn’t top-notch. You can have a credit score as low as 580 and still nab an FHA loan with a low down payment. Some lenders even allow scores as low as 500 if you can make a larger down payment of at least 10%. Contrast that with a conventional loan, when approval becomes much less likely once your credit score drops below 700.

You can have more debt: As with credit scores, you may be able to nab an FHA loan with a less-than-ideal (i.e. higher) debt-to-income ratio, or DTI. If the ratio of your monthly debt payments to gross income is higher than 45%, you may have a hard time getting a conventional loan. However, you may still be able to get an FHA loan at 50% or higher if the rest of your application is solid.

Someone can gift you all the money for closing costs: Unless you put at least 20% down, you’ll need to use at least some, if not all, of your own money for the down payment on a conventional loan. In most cases, with an FHA loan, all of your down payment can come from a gift, though you will have to document the source.

You can have a recent bankruptcy, foreclosure, or other serious financial hardship: These black marks make it all but impossible to get a conventional loan for several years after the fact, but the FHA has recently relaxed its own rules, which were already a bit more lenient. Its “Back to Work” program waives what was a three-year waiting period after foreclosure and two-year waiting period after bankruptcy. To qualify, you’ll have to meet several standards, including the ability to demonstrate full financial recovery, complete housing counseling, and document at least a 20% reduction in household income related to the financial hardship.

Your FHA loan is assumable: Unlike most conventional loans, FHA loans are assumable. That means that when you sell your house, the buyer can take over your loan at its current terms instead of getting a new one. This can be a big selling point if interest rates have zoomed up since you received the loan.

Disadvantages of an FHA loan

The FHA loan program is enormously popular, but there are some downsides. Here’s what you need to know before you decide an FHA loan is your best bet:

There’s an upfront mortgage insurance premium: When you get an FHA loan, you’ll have to cough up 1.75% of the loan amount, which will then be rolled into your payments. This isn’t the case with conventional mortgages.

You’ll always have to pay monthly mortgage insurance: With conventional loans, you won’t be required to pay private mortgage insurance, or PMI, if you have a traditional 20% down payment. Even if you don’t put 20% down, you may be able to get your PMI cancelled once you’ve paid enough of your loan and built up some equity. With FHA loans, an annual mortgage insurance premium is required every month — and this is in addition to the upfront premium — for a minimum of 11 years, though most borrowers will pay it for the entire mortgage term.

There is a cap on how much you can borrow: You won’t be able to finance a palace with an FHA loan. That’s because loans are capped at a set limit that varies depending on where you live.  On the other hand, you can get a jumbo loan conventionally, assuming you can qualify for the amount you need.

Inspection standards can be strict: All homes financed with an FHA loan must meet extensive FHA minimum property standards, which evaluate the safety, security, and structural integrity of a home. Your loan won’t be approved until any issues that run afoul of these standards are remedied.

What are the Interest Rates on FHA Loans?

There isn’t much difference between average interest rates on FHA loans and conventional mortgages. The rates may even be slightly lower, which many may find surprising given that they tend to go to less credit-worthy individuals and come with more forgiving terms.

Even if rates are slightly lower, though, remember to factor in the cost of mortgage insurance — typically pricier with FHA loans — to determine whether the FHA loan is truly cheaper. Your lender should be able to provide a detailed comparison to help you make a decision.

Alternatives to FHA Loans

If you’re considering an FHA loan, be sure to investigate your alternatives before pulling the trigger. There’s always a chance one of the options below will be a better fit for your situation.