FHA Loan: How It Works And How To Qualify

Saving up for a large down payment or getting approved for a mortgage when your credit is less than ideal can be a challenge. However, these circumstances don’t necessarily have to serve as barriers to homeownership.

There are many types of mortgage loans, including FHA loans, designed to make homeownership more accessible to certain types of borrowers. If your personal finances have made it difficult to qualify for a traditional mortgage, keep reading to learn whether an FHA loan could be the right choice for you.

FHA Loan Key Takeaways

• An FHA loan is backed by the Federal Housing Administration and makes homeownership more accessible to first-time and low-credit home buyers.
• To qualify for an FHA loan, you’ll need a credit score of at least 500 and a debt-to-income ratio of no more than 57% (though some exceptions apply).
• FHA loans have low down payment requirements for many borrowers, as well as competitive interest rates.
• Downsides of FHA loans include strict property standards and both upfront and annual mortgage insurance premiums (MIP).

What Is A Federal Housing Administration (FHA) Loan?

An FHA loan is a type of mortgage that’s backed by the Federal Housing Administration, a part of the U.S. Department of Housing and Urban Development (HUD). This means the government will protect the lender’s investment against default, which can make qualifying easier. An FHA loan is one of several such government home loans.

As government-backed loans, FHA loans – also known as 203(b) loans – can afford to be more lenient with some borrowing requirements, including their credit score and down payment requirements. This makes FHA loans popular among first-time home buyers and those with low to moderate incomes.

How Does An FHA Loan Work?

FHA loans operate the same way as a conventional mortgage. Like any other mortgage, borrowers must work with a private lender. Though the FHA backs these loans, mortgage lenders offer and originate them, not the FHA.

As with a conventional home loan, you’ll apply for an FHA loan, and your eligibility, the amount you can borrow and your interest rate will be determined by your credit score, your income, your debt-to-income ratio (DTI), and other factors.

Generally speaking, the higher your credit score and the lower your DTI, the lower your interest rate will be. Your credit score will also determine the down payment size you’ll need.

FHA loans can come with fixed or adjustable interest rates. A fixed interest rate remains the same for your entire loan term, while an adjustable rate can fluctuate throughout the life of the loan. FHA loans can also have terms ranging from 15 to 30 years.

FHA Loan Requirements

FHA loans are easier to qualify for in many cases, but they still have certain requirements that borrowers must meet. The table below outlines the various FHA loan requirements.

Credit Score And Down Payment

FHA loans have a minimum credit score of 500. However, for a credit score that low, you’ll need a down payment of at least 10%. The credit score requirement to qualify for a 3.5% down payment is 580.

Debt-To-Income Ratio (DTI)

In most cases, borrowers must have a debt-to-income ratio (DTI) (meaning the relationship between your income and debt payments) of up to 57%.

The FHA also limits the relationship between your income and your mortgage payment. In most cases, your mortgage payment can only take up 31% of your income. But with certain compensating factors, the ratio can be as high as 37%.

Mortgage Insurance Premiums

FHA loans require two types of mortgage insurance premiums (MIP). First, all FHA loans require an upfront MIP of 175 basis points or 1.75% of the base loan amount. Loans also require an annual MIP, with an amount that depends on your loan amount and down payment. Annual MIP is required for either 11 years or the duration of your mortgage, depending on your loan amount and down payment.

FHA Loan Limits

The FHA loan limits are the maximum amount a person can borrow. The loan limit in most parts of the country is $498,257. In high-cost areas, the limit can be as high as $1,149,825.

Income Requirements

FHA loans don’t necessarily have an income requirement. There is no minimum or maximum income to qualify. However, a borrower must have verifiable and consistent income for 2 years (education can be used to meet this requirement). Additionally, you must meet the FHA’s DTI requirements, meaning a low income could limit the amount you’re able to borrow.

Property Requirements

When you purchase a home with an FHA loan, you’ll need to get an appraisal and inspection. And because of the nature of this type of loan, the property will be subject to stricter requirements than a conventional loan. HUD sets certain standards for the durability, safety and soundness of properties purchased with FHA loans.

FHA Loan Pros And Cons

FHA loans have some major advantages to borrowers, especially first-time home buyers, but there are also some downsides. Consider both the pros and cons of FHA loans before applying.

FHA Loan Pros

• Low down payment: As long as you meet minimum credit requirements, you’ll only need a down payment of 3.5% on an FHA loan.
• Flexible loan requirements: FHA loans have low credit score requirements and flexible income and DTI requirements.
• Low interest rates: FHA loans have competitive interest rates that are often lower than the rates on conventional loans.

FHA Loan Cons

• MIP required: FHA loans require both upfront mortgage insurance premiums and annual premiums, often for the entire duration of the loan.
• Strict property standards: HUD sets certain property standards for durability, safety and soundness, which don’t apply to homes purchased with conventional loans.
• Low loan limits: The loan limits on FHA loans are lower than those for conventional loans, especially in low-cost areas.

How To Apply For An FHA Loan

Interested in an FHA loan? Here are some steps you can take to prepare for getting one. 

1. Gather documents: It’s smart to have the right documents needed for mortgage preapproval. This includes 2 years of W-2s and tax returns, two of your most recent pay stubs and two of your most recent bank statements from any accounts you have. You should also be prepared to show sourcing for a down payment and reserve funds. 

2. Choose an FHA lender: There are a variety of lenders on the market so be sure to do your research to find one which best suits your needs. Consider reaching out to a Rocket Mortgage^® representative today. 

3. Submit an application: When working with any lender, it’s smart to get preapproved before putting in an offer on a house. Not only will this tell you how much you can afford based on your down payment and DTI, but you’ll also be able to show sellers that you’re serious about your offer and already preparing how you plan to finance the purchase. 

4. Compare rates and terms: You can get preapproved with multiple lenders and use their loan estimates to help see which ones give you the best deal. Know that it doesn’t always come down to money. Be sure to check out the reviews on each lender’s client service and feel free to ask questions. Lenders sometimes charge fees for something as simple as making a payment over the phone or online. 

Types Of FHA Loans

Though we’ve mostly discussed FHA purchase loans, there are actually several types of FHA loans that can help make homeownership more accessible, including the popular 203(b) and 203(k) loans. Each of the loans in the table below is best suited for a specific type of borrower and situation.

FHA Loan FAQs

Before you buy an FHA loan, make sure to read the answers to these frequently asked questions.

Who qualifies for an FHA loan?

You can qualify for an FHA loan if you have a credit score of at least 500 or 580, can provide a sufficient down payment and meet the FHA’s DTI requirements.

Is an FHA loan worth it?

An FHA loan can be worth it for many borrowers, but whether it’s worth it for you depends on your unique financial situation, including your credit score, down payment, income and more. FHA loans are generally a good fit for buyers with below-average credit scores but may not be best suited for borrowers with good credit or high income who can qualify for conventional loans (which typically have lower costs than FHA loans).

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

A major difference between an FHA loan and a conventional loan is the eligibility requirements. A conventional loan requires a credit score of at least 620. Meanwhile, you can qualify for an FHA loan with a credit score of either 500 or 580.

Another major difference between FHA and conventional loans is mortgage insurance. FHA loans require upfront MIP and annual MIP, often for the duration of the loan. Conventional loans may require private mortgage insurance (PMI) when you have a down payment of less than 20%, but there’s no upfront PMI required, and the monthly PMI is only temporary.

How do I remove MIP on an FHA loan?

Whether you’re eligible for FHA mortgage insurance removal depends on when you got your loan, the size of your down payment and how much equity you have in your home. If you think you’re eligible, contact your lender to inquire about cancellation.

How often are FHA loans denied in underwriting?

According to 2020 data from the Consumer Financial Protection Bureau, roughly 14.1% of FHA loan applications were denied. In fact, FHA loans have the highest denial rate of any loan type. Even though an FHA loan is easier to qualify for than other loan types, the property needs to meet stringent HUD standards and borrowers must still meet certain requirements for their credit score, DTI and more.

The Bottom Line

An FHA loan is a popular loan for first-time home buyers thanks to its flexible borrowing requirements. You can qualify with a low credit score and a high debt-to-income ratio. However, these loans do have certain costs and requirements that don’t apply to conventional loans.

If you’re considering buying a home with an FHA loan or any other type of loan, start the application process today to find out if you’ll qualify.