FHA Loan Requirements, Tips, and Advice

Due to lower requirements, FHA loans help break down the barriers to homeownership.

If you do not have the 20% down payment required for most conventional mortgages, you are in luck; an FHA loan requires a down payment of just 3.5%. If you have just suffered a foreclosure or a bankruptcy, you will have to wait less than half the time of a conventional loan to qualify. Lenient gift funds and low closing costs are additional perks.

However, there are downsides, and after weighing the drawbacks, you may decide it is better to shop for a less expensive home or save up for a conventional mortgage.

To give you a better understanding of the ins and outs of an FHA loan—and especially how they differ from conventional loans—here is everything you need to know. For the mortgage professionals who frequent our website, this is a perfect article to send to a client who has a question about this type of loan.

What is the FHA?

FHA stands for the Federal Housing Administration, which is a part of the U.S. Department of Housing and Urban Development. The FHA provides mortgage insurance on loans made by lenders that are FHA-approved. The FHA insures mortgages on single-family homes, multi-family properties, residential care facilities, and hospitals in the U.S. (and U.S. territories).

Mortgage insurance from the FHA protects lenders against losses, such as paying a claim to the lender for unpaid principal balance if a property owner defaults on their mortgage. Since this alleviates risk, lenders can offer more mortgages to homebuyers. Qualifying for FHA mortgage insurance means meeting certain requirements.

The FHA generates its own income by collecting mortgage insurance premiums from borrowers through lenders. The income is then used to operate the FHA’s mortgage insurance programs which benefit renters, homebuyers, and communities.

FHA loans: A brief history

The FHA was created as part of the National Housing Act of 1934 to alleviate foreclosures and to help make owning a home more affordable. In fact, the FHA established 20% down payment on a property as the new normal by insuring mortgages up to 80% of the property’s value. Prior to this, homeowners could only borrow between 50% and 60%. Now, the FHA insures loans for roughly eight million single-family homes in the U.S.

How exactly does an FHA loan work?

A mortgage insured by the Federal Housing Administration, an FHA loan offers a minimum 3.5% down payment for borrowers with a credit score of 580 or more. An FHA loan is especially popular among first-time homebuyers who have little savings or have poor credit.

The FHA insures mortgages that are issued by banks, non-banks, credit unions, and other lenders. The main reason for this insurance is to protect lenders if there is a default on the loan. Because of this setup, FHA lenders can offer more favorable terms to borrowers who would otherwise have more difficulty qualifying for a home loan.

What are 5 reasons for an FHA loan?

One of the main reasons for an FHA loan is to help anyone who might not qualify for a conventional mortgage buy a home. There are also many benefits that come with an FHA loan, from competitive FHA rates to low down payment requirements.

While there are both advantages and disadvantages to FHA loans, let’s look at 5 reasons getting an FHA loan might be a good idea:

1. Easy credit qualifications
2. Short qualifying time after bad credit
3. Low down payment
4. Lenient gift funds
5. Low closing costs

Let’s take a deeper dive into the 5 reasons for an FHA loan:

1. Easy credit qualification

Compared to conventional loans, FHA loan requirements are less strict. In fact, an FHA loan is one of the easier loans you can qualify for—especially if you have poor credit. But while the minimum credit score for an FHA loan is 500, your required loan-to-value (LTV) ratio must be 90%. Keep in mind, though, that lenders can set their own minimum credit score, which are called overlays. For instance, an FHA credit score of 620 is a common lender overlay.

Compensating factors also make qualifying for an FHA loan even easier, meaning that you can provide proof of your creditworthiness and additional factors to bolster your application. Some examples of these compensating factors include:

• Low debt
• Residual income
• Increased earning potential
• Verified cash reserves
• Minimal housing payment increase
• Substantial non-taxable income

2. Short qualifying time after bad credit

While past foreclosures and bankruptcies can make a mortgage more difficult, FHA loans offer the chance to get a mortgage after you have had a negative credit event.

For instance, you can get an FHA loan two years after a Chapter 7 Bankruptcy waiting period, whereas you would have to wait four years for a conventional loan. Following a foreclosure waiting period, you can get an FHA loan in three years versus having to wait seven years for a conventional loan.

In other words, you have a better chance of getting an FHA loan sooner than a conventional loan after a negative credit event.

3. Low down payment

For an FHA loan, you will need less time to save for a down payment on a home than you once thought, because they are designed to help borrowers who do not have 20% to put down. This is especially beneficial in more expensive markets where higher down payments present a barrier to homeownership.

Keep in mind, however, that the down payment for an FHA loan is dependent on credit score. For instance, if you have a credit score under 580, you will have to make a higher down payment, like 10%. If your credit score is 580 or higher, your down payment will likely be 3.5%. In the latter case, this means a down payment of $10,500 on a $300,000 single-family home.

4. More lenient gift funds

You can get help to pay your down payment if you do not have the money. For an FHA loan, you can get a gift fund from your family, close friends, employer, union, or government down payment assistance program. For conventional loans, on the other hand, rules surrounding gift funds are stricter. (Typically, conventional loans allow gift funds from relatives only.)

But to be clear, a gift fund is just that—a gift. There cannot be any expectation of repayment. After you receive the gift fund from someone or from an organization, you will have to document it in a gift letter. If you are unsure what this looks like, you can ask your loan officer to provide an example. you can also read the guidelines from the official FHA loan documentation.

5. Low closing costs

Sellers can pay up to 6% of the sales price toward some of the homebuyer’s closing costs. Closing costs for FHA loans can average between 3% and 5% of the loan amount. If you negotiate with the seller to pay for some of these, it can help you move while paying less.

Here are some common closing costs:

• Homeowners insurance
• Lender fees
• Property taxes
• Title insurance
• Escrow fees

Another way to pay less up front is to roll some closing costs into your loan. Another option is to pay slightly more in your interest rate. In that case, your lender will give you credit to help pay your closing costs.

What is the difference between an FHA loan and a regular loan?

While both FHA loans and regular loans let you finance property purchases, they are different in several important ways. Here is a quick look at areas in which both FHA loans and regular loans differ:

1. Credit scores
2. Minimum down payments
3. Debt-to-income ratios
4. Mortgage insurance
5. Loan limits

Here is a breakdown of each:

1. Credit scores

FHA loan. To qualify for an FHA loan, your credit score can be as low as 500. A minimum credit score of 580 is, however, more common—and preferable. If your credit score is on the lower end, you will likely have to compensate with a higher down payment, better debt-to-income (DTI) ratio, and housing expense ratio.

Regular loan. For a regular loan, you usually need to have a minimum credit score of 620.

2. Minimum down payments

FHA loan. If your credit score is 580 or more, you will need to make a 3.5% down payment. If your credit score is less than 580 (500 to 579), you will have to make a 10% down payment.

Regular loan. You can make a down payment as low as 3% on some regular loans, but if you want to avoid private mortgage insurance, you will have to make a down payment of 20%.

3. Debt-to-income ratios

FHA loan. For an FHA loan, your debt-to-income ratio (DTI) has to be lower than 45%, if your credit score is under 580.

Regular loan. For more conventional loans, on the other hand, your DTI ratio should be 50% or less.

4. Mortgage insurance

FHA loan. Regardless of the down payment, you have to pay mandatory insurance premiums (MIPs) for an FHA loan. This means an up-front payment and monthly premiums, though you can roll the upfront payment into the loan. If you put down 10% or more, you will have to pay MIPs for 11 years. If you put down less, you have to pay the premiums throughout the life of the loan.

Regular loan. In this case, you have to pay private mortgage insurance (PMI) if you make a down payment of less than 20%. However, when you reach 80% equity in your home, you can ask your lender to cancel PMI.

Find out how much does private mortgage insurance typically cost in this article.

5. Loan limits

FHA loan. In 2022, the FHA loan limit was roughly $421,000 in low-cost areas and $971,000 in higher-priced markets.

Regular loan. In most of the U.S., regular loan limits were $647,200 in 2022. These limits were set by the Federal Housing Finance Agency (FHFA).

What is one advantage of getting an FHA loan?

One advantage of getting an FHA loan is the flexibility it offers, because they are less restrictive and more forgiving than other types of home loans. This is especially true when it comes to the down payment.

For most buyers these days, the traditional 20% down payment required for most loans represents a major obstacle to homeownership. But if you get an FHA loan—and have a credit score of at least 580—you can make a down payment for as low as 3.5%.

What is the downside to an FHA loan?

While there are many advantages to getting an FHA loan, there are also downsides. One of the main drawbacks is that having only enough for a small down payment could be a good indication that you are not yet ready to take on a mortgage.

If you are only able to make the 3.5% down payment, it could mean purchasing a property is too risky for you. If this is the case, you may want to search for a less expensive property or hold off until you can save up enough for a larger down payment. Just keep in mind that the more money you borrow, the more interest you will have to pay—and, ultimately, the more expensive your home will be.

Other downsides to FHA loans include:

• The home must meet strict health and safety standards
• The home loan amount must meet the conforming limit for the area, i.e., no jumbo loans
• FHA mortgage insurance lasts the entire loan term with a down payment of under 10%

Due to the flexibility and especially the lower down payment, an FHA loan is a great option for first-time homebuyers. But as we have seen, there are also downsides, not least of which is the implication that if you are only able to afford a 3.5% down payment, you may not be ready yet to take on a mortgage or you may need to search for a more affordable home. In either case, you will have to know the options available and their benefits in both the short and long term.

Do you have experience with an FHA loan? Was it a good idea for you? Let us know in the comment section below.