How Does FHA Work?

Few things in life are more exciting than buying a new home. However, as you search for just the right residence with just the right amenities and in just the right school district, don’t forget to search for the right type of mortgage, too. If you are a first-time home buyer or have less than stellar credit, your best option may be an FHA loan.

What Is an FHA Loan?

An FHA loan is a home mortgage you obtain from an FHA-approved lender, such as a bank, credit union or private lender, that the Federal Housing Administration insures. Since your mortgage is backed by the federal government, lenders are more likely to grant you this type of mortgage if you are a new buyer or have had credit problems in the past.

The federal government established the FHA and its loans in 1934. The Great Depression was raging at that time, and only about 10% of America’s residents could afford to own rather than rent a home. Thanks to FHA loans, that percentage rose to 65.4% in 2022, despite the effects of the pandemic.

Types of FHA Loans

FHA loans come in the following five types:

  1. Traditional mortgage: finances your primary residence

  2. 203(k) mortgage: includes extra funds to make home improvements, repairs and renovations

  3. Energy-efficient mortgage: includes extra funds to make home improvements specifically geared toward energy efficiency

  4. Graduated payment mortgage: also called a 245(a) mortgage, has an initial low monthly payment that increases over the life of the mortgage

  5. Home equity conversion mortgage: a reverse mortgage for homeowners age 62 or older who want to exchange their home equity for cash

Credit Score

Your credit score must be at least 500 to qualify for an FHA mortgage. If it falls within the 500-579 range, you will need to make a 10% down payment. If it’s 580 or above, your required down payment decreases to 3.5%.

By comparison, other types of mortgages, including conventional loans, usually require that you have a credit score of 620 or above. Due to the pandemic and recession, even some FHA lenders now require a minimum 620 credit score to make an FHA loan.

Down Payment

Whether you make a 3.5% or 10% down payment, this money doesn’t have to come from your own personal assets. Some, or even all, of it can be a gift from someone else. In addition, if you are a first-time buyer, you may be eligible for one of the down payment assistance programs that many state and local governments offer.

Additional Qualifications

In addition to verifying your qualifying credit score and down payment amount, an FHA lender will look at your work history for at least the past two years. This means that you need to have had steady employment during that time, as proved by your tax returns and other official documents.

If you have been self-employed during the past year, the lender likely will want to see evidence that you had a history of solid work and income in a similar occupation for at least two years prior to becoming self-employed.

Mortgage Insurance

All FHA loans require you to purchase FHA mortgage insurance.

You can expect to pay an upfront mortgage insurance premium, called an MIP, of 1.75% of your loan amount. The good news is that you can roll this premium into your overall loan.

You will also pay an annual mortgage insurance premium that can range from 0.45% to 1.05% of your loan value. You don’t pay this premium all at once, however. It gets divided by 12, and that amount is added to your monthly mortgage payment.

MIP Elimination

You can eliminate your MIP once you pay off at least 20% of your mortgage or have been paying it down for at least 11 years. This will, however, require you to refinance your FHA loan. In all likelihood, your mortgage lender will also require you to have remained up to date with your mortgage payments for at least five years.

Even if you fail to qualify for MIP elimination under an FHA loan, you may still be able to accomplish it by refinancing your FHA loan into a conventional mortgage or, if you’re a veteran, a VA loan.

Borrowing Limit

There’s a limit to how much you can borrow with an FHA loan that varies from state to state, and often from county to county. Basically, the FHA itself divides the country into low-cost areas and high-cost areas based on those areas’ respective median home prices and costs of living.

In 2020, the maximum you could borrow for a single-family home in a low-cost area was $331,760. In contrast, the maximum in a high-cost area was $765,600. If your new home was located in Alaska, Guam, Hawaii or the Virgin Islands, however, the maximum amount for a single-family home was $1,148,400 due to the high cost of living in these areas.

Keep in mind that, although the above example uses a single-family home, you can also use an FHA loan to buy or refinance the following types of homes:

  • Duplexes

  • Triplexes

  • Quadplexes

  • Condominiums

  • Manufactured homes

Interest Rate

Your interest rate for an FHA loan will depend on whether you obtain a fixed interest rate or an adjustable interest rate mortgage. With a fixed interest rate loan, as its name implies, your interest rate remains the same throughout the life of your mortgage. Conversely, with an adjustable-rate mortgage, your rate will adjust periodically and increase or decrease depending on an interest rate index, such as the one provided by Libor, the London Interbank Offered Rate.

Finding an FHA Lender

Your wisest course of action when searching for an FHA loan is to find a company that specializes in these types of loans. At FHA Insider, this is exactly who we are and what we do. Our team of FHA experts can answer all your questions and guide you through the entire FHA application and qualification process. Contact us today. We are ready, willing and able to be your FHA loan resource of choice.