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What is an FHA Loan?

by Jesse Campbell on
3/24/2024
in Housing and Homeownership
Parents playing with young daughter who is sitting in open moving box in new home.

FHA mortgage loans are insured by the Federal Housing Administration (FHA), a government program focused on putting homeownership within reach for eligible first-time homebuyers. For many people, owning their own home is the dream, but in many areas, today’s real estate prices place that out of reach. An FHA loan is one option for renters who want to become homeowners. It’s designed to make homeownership more accessible to people with lower incomes or lower credit scores. Here’s what to understand about the FHA first-time homebuyer program.

FHA loans vs conventional mortgage loans

Although FHA mortgage loans are designed for people who may not be able to qualify for a conventional loan, there’s no minimum or maximum income limit for first-time homebuyers. Your ability to make payments with the FHA mortgage rate is the key factor considered. In short, just about anyone can qualify for an FHA loan if they meet the requirements. However, as with a conventional mortgage, FHA loan regulations will pay close attention to your job and income verification, debt-to-income ratio, and repayment history.

One of the primary advantages of an FHA vs. conventional mortgage is that they have a lower down payment requirement than conventional loans. FHA down payment requirements can be as low as 3.5% of the purchase price for qualifying FICO scores. Conventional mortgages often require down payments ranging from 5% to 20% or more.

Other benefits:

  • You may be eligible for down payment assistance.
  • FHA loans have lower credit score requirements vs most conventional mortgages.
  • FHA loans are assumable (unlike conventional loans), which means a qualified buyer can take over an existing FHA loan with its terms. That can be an attractive feature if you sell the home.
  • You don’t need to be a US citizen to qualify.
  • FHA mortgage rates will still be determined by your credit score, though they may be lower than conventional mortgage rates. Compare other costs to balance any rate benefits.

The drawbacks:

  • Borrowing limits: FHA loans have borrowing limits that may impact what you can purchase. These limits are designed to ensure the program targets moderate-income individuals. However, loan limits vary by state and county, and they may not end up being a big factor for you. For example, the 2024 FHA loan limits set the amount at $498,257 in a low-cost area and $1,149,825 in a high-cost area. Check your state and county for specific figures.
  • Property standards: FHA loans may have stricter property standards to qualify. Houses must meet the FHA standards to be eligible for financing (in short, fixer-uppers need not apply). They must be your new primary residence, and you have to stay in a house for at least a year after you purchase.
  • Mortgage insurance: FHA mortgage loans don’t require private mortgage insurance (PMI), like conventional mortgages (if your down payment is under 20%), but they do require an Up-Front Mortgage Insurance Premium (UFMIP) and a mortgage insurance premium (MIP) to be paid instead.

MIP: Understand FHA Mortgage Insurance Premium impact

FHA loans require an Up-Front Mortgage Insurance Premium (UFMIP) at closing, either in cash or you can have it financed into the loan amount (the base loan amount multiplied by 1.75%). You’ll also have an annual MIP (Mortgage Insurance Premium) that is typically paid monthly as part of the mortgage payment. FHA mortgage insurance is required on all FHA loans regardless of the size of your down payment, and it cannot be cancelled if your down payment was less than 10%. In that case, you will pay the MIP for the lifetime of the loan. If you were able to put 10% or more down, you can cancel MIP insurance payments after 11 years, or by refinancing to a conventional loan.

Most conventional mortgages will require private mortgage insurance (PMI) if the borrower's down payment is less than 20%, but the structure and cost of PMI differs from FHA mortgage insurance, especially since you can request removal of PMI when you have 20% equity in your home, and it is automatically removed when you reach 22% equity. You should consider whether the MIP insurance represents a drawback for you when comparing FHA vs conventional mortgage insurance.

It’s important to understand the costs of these fees, particularly the monthly MIP. This fee can add a significant chunk to your actual monthly payment. Use this FHA.com payment calculator to calculate the UFMIP and MIP monthly payment as your research feasible loan amounts for your budget.

FHA requirements for eligibility

Although FHA loans are designed for people who can’t qualify for a conventional loan, they still have eligibility criteria. Here are the requirements to qualify for an FHA loan:

  • The house must serve as your primary residence for at least one year.
  • There are no income limits but you must be able to show proof of employment and steady income, and may need to have records going back two years.
  • Your debt-to-income ratio must not exceed 43%. That means the FHA may allow up to 43% of your monthly income to go toward housing expenses and other long-term debt payments (31% for just housing). But in many cases, they may allow only 36% for all long-term debts, including the FHA loan.
  • FHA loan credit requirements:
    • Your FICO (credit) score must be at least 580 to qualify for a 3.5% down payment.
    • Lower FICO scores between 500-579 require a 10% down payment (you represent more of a risk).
    • If you have a score lower than 500, you will not be eligible.
    • FHA mortgage rates will also be impacted by your credit score.

Additional FHA considerations for first-time homebuyers

If you meet the requirements, FHA loans can be a great option for first-time homebuyers with limited available cash, less-than-superb credit, or both. They aren’t any riskier than conventional loans. But you should still be cautious when taking out a home loan because it represents a significant cost per month. Before you sign on, take these steps to ensure you won’t get in over your head.

  • Set a budget. Understand what you can realistically afford for a mortgage. Try to avoid spending more than 30% of your gross monthly income on housing expenses.  
  • Understand the hidden costs. On top of your mortgage payments and PMI or FHA mortgage insurance, you’ll have property taxes, homeowner’s insurance, utilities, property maintenance, and other fees and expenses to consider. Just because you can afford the initial down payment or mortgage payment doesn’t automatically mean you can afford the house.
  • Shop mortgage options. Maybe an FHA loan is the best choice, but maybe it isn’t. Be sure to review all of your available options to make sure you’re getting a loan that best suits your needs.

Are you thinking about buying a home? MMI offers education and counseling specifically for new homebuyers to help you figure out if it’s right for you. MMI housing counseling can also help meet any education requirements your chosen loan program may have. Get in touch if you’d like to explore your options.

Tagged in Loans, Mortgages and foreclosure

Jesse Campbell photo.

Jesse Campbell is the Content Manager at MMI, with over ten years of experience creating valuable educational materials that help families through everyday and extraordinary financial challenges.

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