What Is an FHA Loan?

Buying a home can feel out of reach, especially if your credit isn’t perfect or you don’t have a large down payment saved. 

Fortunately, FHA loans represent a popular alternative to conventional mortgages. These home loans are backed by the Federal Housing Administration and can make ownership more accessible for first-time buyers and those with less-than-ideal credit histories.

What is an FHA loan? More importantly, how does it work, and is it right for you? If you’ve been asking these questions, you certainly aren’t alone. Consumers who are exploring the road to homeownership should consider FHA loans due to the favorable down-payment requirements and flexible credit score thresholds. 

This guide unpacks everything you need to know so you can evaluate your options more effectively.  

What is an FHA loan?

An FHA loan is a type of mortgage insured by the Federal Housing Administration. Since the federal government backs the loans, lenders are able to offer more flexible qualification requirements compared to traditional (conventional) mortgages. 

FHA loans are designed to help borrowers who may not qualify for standard home loans due to one or more of the following limitations:

• A lower credit score
• Limited savings
• Short credit histories
• Not enough money down

For example, conventional loans typically require borrowers to have a credit score of at least 620. Traditionally, lenders also required 20% down. Today, conventional loans are available with variable amounts down, ranging from 3% to 20%. However, the credit score and history requirements are relatively strict. 

For comparison, lenders require a credit score of 580 or higher to qualify for an FHA loan with 3.5% down. You may even be able to qualify for an FHA loan with a credit score of 500 or better, but you will be required to put 10% down. 

In addition to being more lenient with credit score requirements, lenders also allow higher debt-to-income ratios. Lenders receive protection from the federal government, so even if someone defaults, lenders aren’t stuck footing the bill. 

How does an FHA loan work?

FHA loans are still issued by private lenders, such as credit unions, banks, or mortgage companies. However, the Federal Housing Authority provides insurance to reduce the lender’s risk, allowing them to approve borrowers that might otherwise get turned away.

In exchange for this flexibility, you will be required to pay mortgage insurance premiums (MIP), which protect the lender if you default. The MIP, homeowner’s insurance, and property taxes are all paid out of an escrow account, which is set up using money you pay at closing.

With conventional loans, the private mortgage insurance automatically falls off when you reach a loan-to-value of 80%, meaning you have at least 20% equity in the home. 

FHA loans are different. To get rid of MIP, you have two options. You can refinance your home once you hit the 80% loan-to-value threshold, or if you put 10% down on your FHA loan, the MIP can be removed after 11 years of mortgage payments. 

Here’s how getting an FHA loan works:

• You apply with an FHA-approved lender
• The lender evaluates your file, including your credit, income, and financial history
• If you’re approved, the FHA insures the loan
• You make monthly payments, including mortgage insurance

FHA loans are made to be accessible. You can use it as a stepping stone toward homeownership and still access favorable rates, provided you meet the credit score requirements. 

FHA loan requirements

While FHA loans are more flexible than conventional mortgages, you still have to meet the basic credit score requirements. You’ll need a 580 or better to qualify for a 3.5% down payment FHA mortgage. The higher your score, the better your odds of qualifying for a better interest rate. 

If you have a score between 500 and 579, you may still qualify. However, you’ll have to come up with at least 10% down. Typically, you’ll also need a debt-to-income ratio below 43%, although some lenders offer exceptions if your application is otherwise strong. 

Your lender will also review your employment history and require you to provide proof of income. 

The FHA requires applicants to use the home as their primary residence. You can’t use FHA loans to buy investment properties. 

If your credit score is on the lower end, improving your credit before applying can make a big difference in your approval odds. Tools like Kikoff put you in the driver’s seat. You can report on-time rent payments and build stronger credit habits that make you a more appealing applicant. 

FHA loan limits

FHA loan limits vary for high-cost and low-cost areas. Most properties fall into low-cost areas, with recent FHA limits in the mid-$500,000 range. The FHA reevaluates loan limits annually to account for average home prices, inflation, and other economic factors. 

Talk to your lender about FHA loan limits in your area, especially if you are looking at homes over the $500,000 threshold. That way, you can choose the right mortgage option for your price point and home-buying goals. 

FHA loan pros and cons

The key advantages of FHA loans include:

• Lower credit requirements
• Smaller down payments
• Flexible qualification criteria
• Easier approval for first-time buyers

Potential downsides include:

• Mortgage insurance premiums that don’t fall off your loan
• Strict borrowing limits
• Property requirements set by the FHA
• Only available for primary residences

Overall, FHA mortgages represent a flexible option for first-time homebuyers and those with scores that fall below the requirement for conventional loans. 

FHA loan vs. conventional loan

An FHA mortgage requires a credit score of at least 580 for the 3.5% down payment. Additionally, the mortgage insurance won’t fall off. 

Conventional loans require a score of 620 or higher and may also require a larger down payment, but the mortgage insurance premium will fall off when you hit the 80% loan-to-value threshold. 

Conclusion

Are you ready to start the home-buying process? Before you do, work on building a stronger credit score with tools like Kikoff.

Kikoff allows you to report verified rent payments and utility payments to the credit bureaus. Over time, your on-time payments will boost your score and improve your credit history. 

Start building a positive credit history with Kikoff.