FHA Loans: What You Need to Know

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Qualifying for a mortgage can be challenging enough even when we’re not in the middle of a pandemic and recession.

By some estimates, mortgage credit availability has plummeted 25% as lenders tighten standards on loan approval. Many lenders have raised minimum credit scores to around 700, a score that 40% of Americans did not have as of April 2019, nearly a year before the pandemic hit. Buyers who can’t afford a 20% cash down payment have an even steeper hill to climb.

For certain buyers, a loan through the Federal Housing Administration (FHA) might offer an alternative path to home ownership. Since 1934, these FHA loans have been a way for the federal government to make home ownership accessible to more people. They have looser credit requirements and require lower down payments.

What is an FHA Loan?

FHA loans are mortgages offered by the Federal Housing Administration, a branch of the U.S. Department of Housing and Urban Development (HUD). These loans differ from conventional mortgages in that they are much easier to qualify for; most notably, these loans are much less strict when it comes to credit score and down payment requirements. Homebuyers who have been turned down by other lenders often turn to FHA loans as an alternative route to homeownership.

While homebuyers can purchase a home with less money down through an FHA loan, these low upfront costs come with strings attached. All FHA loans require private mortgage insurance, or PMI. It’s on the buyer to pay for PMI premiums, which add an extra cost to the monthly mortgage bill. “FHA loans are considered a riskier product than conventional loans,” explains Brian Koss, executive vice president of Mortgage Network, a mortgage broker with locations throughout the East Cost. “Mortgage insurance protects the lender from the borrower potentially defaulting on the loan.”

With traditional mortgages, PMI can eventually be canceled once you reach 20% equity in the home. This isn’t always the case with FHA loans. If you put less than 10% down on an FHA loan, PMI premiums must be paid for the life of the mortgage. The only way to stop making PMI payments is if you refinance with a different loan entirely.

Why Use an FHA Loan?

An FHA loan can be an option to consider if you can’t qualify for a traditional mortgage due to poor credit history or not having enough money saved for a larger down payment. Homes can be purchased with as little as 3.5% down, as opposed to the 20% that is recommended for conventional mortgages. 

While it’s a good idea to save up for a 20% down payment before buying a home if you can, the FHA loan does allow a path for first-time homebuyers to buy a home sooner than they’d otherwise be able to. 

Pro Tip

FHA loans have looser credit and down payment requirements, but sometimes the best option is to put off buying a home until you are in a stronger financial position.

There are also a few lesser-known perks to using FHA loans. For one, an FHA loan could help you avoid the years-long process of waiting to purchase a home again if you have defaulted on your mortgage in the past but improved your financial situation since then. “The waiting period after a short sale, bankruptcy or foreclosure is much lower on a government-backed loan than a conventional loan,” says Philip Georgiades, CLS at Federal Home Loan Centers, a national FHA loan broker. “You can purchase a home one day after a short sale using an FHA mortgage as long as your payments were current at the time of sale.”

FHA ProsFHA Cons
Available to buyers with low creditRequires up-front mortgage insurance
Low down paymentMust be issued by an FHA-approved lender
Can be used to buy, build, or renovate a homePurchase price cannot exceed local limit
Faster closing timeDebt-to-income ratio must be below 43%

How to Qualify for an FHA Mortgage Loan

Technically speaking, you only need to meet a few qualifications to get approved for an FHA loan. You should have a credit score of at least 580 with a 3.5% down payment, or a credit score as low as 500 with a minimum down payment of 10%. Your debt-to-income ratio must be below 43% and you’ll need to show proof of steady income through employment.

However, recent economic impacts from coronavirus are likely to affect these prerequisites. Many FHA lenders have raised their minimum credit scores significantly. “Because of the impact the pandemic has had on the economy, some lenders have tightened up their lending requirements for FHA loans,” says Brian Koss. “All lending to higher risk borrowers has been curtailed.”

These changes are a result of mortgage forbearances caused by the ongoing financial crisis, which could theoretically improve before the virus goes away entirely, Georgiades says. “Once the economy fully reopens, these forbearances should stop,” Georgiades says. “Investors will be willing to take on more risk and we should see more favorable terms appear again.” The question remains, of course, when exactly that might be.

Is an FHA Loan Right For Me?  

If you dream of owning your home but don’t have the cash or credit to get a standard mortgage, an FHA loan may be an option. While there are a few extra costs involved, such as PMI premiums, you might determine it’s worth it to own a home sooner than you otherwise would be.

Of course, it’s always an option (and sometimes the better one) to put off buying a home until you can improve your credit or save more for a larger down payment. And whenever you decide is the right time to buy a house, it’s also a good idea to research and take advantage of any first-time homebuyer programs you might qualify for. 

This article was updated on Sept. 4, 2020, to remove comments made by a source whose credentials do not meet NextAdvisor editorial standards.