FHA Loans to Buy or Refinance a Home

FHA home loans are mortgage loans backed by the Federal Housing Administration. The FHA doesn't make loans directly; instead, it insures home loans granted by participating lenders. 

The FHA loan program has been around since 1934 and is overseen by the Department of Housing and Urban Development. These loans tend to be a popular choice for first-time homebuyers, though you don't need to be buying a home for the first time to get one. 

So what's good about FHA loans? The main benefits of FHA loans include:

• Low down payment requirements
• Lower closing costs
• Easier credit requirements to qualify

In a nutshell, FHA loans are designed to make the path to homeownership easier to navigate. 

How Do FHA Loans Work?

FHA loans work like other mortgage loans--they provide borrowers with the money they need to buy a home. 

Again, the FHA doesn't grant loans. Instead, the Federal Housing Administration works with lenders to insure loans through the FHA program. This insurance protects the lender, not you.

If you default on an FHA loan, meaning you stop paying it, the FHA steps in and pays money to the lender. That helps minimize financial losses for lenders when borrowers cannot meet the obligations to the loan. 

If you already have an FHA loan, you can get an FHA refinance loan. Refinancing means taking out a new loan to pay off your existing loan. You might refinance your FHA loan if doing so means getting a better interest rate or repayment terms. 

FHA Loan Requirements

Like other types of loans, FHA home loans have specific requirements that borrowers are expected to meet. These requirements are covered in the FHA Single Family Housing Policy Handbook.

Here are some of the essential FHA loan requirements to know:

• You must have the home appraised by an FHA-approved appraiser
• You can only use the loan to purchase a primary residence
• You have to move into the home within 60 days of closing
• Homes must meet FHA-inspection standards and an inspection is required
• The price of the home must be within FHA loan limits

These guidelines apply to the home itself. The FHA also has down payments, credit scores, and mortgage insurance requirements. 

FHA down payment requirements

The down payment is an advance payment you make against the purchase of a home. The larger your down payment, the less you have to borrow. 

One of the most attractive features of the FHA loan program is the down payment requirement. If you have a credit score of at least 580, you can get approved with a down payment of 3.5%. Your credit score is a three-digit number that tells lenders how responsibly you use credit. Credit scores are calculated using the information in your credit reports.

If your credit score is below 580, you'll need to put up a slightly larger down payment of 10% to get an FHA loan. So if you're buying a $300,000 home, you'll need $30,000 down versus the $10,500 you'd need if your score were higher. That's a great incentive to consider improving your credit before applying for an FHA loan.

FHA loan credit score requirements

As mentioned, it's possible to get approved for FHA loans with a credit score as low as 580. The FHA will even consider borrowers with a score of 500 if you're able to put 10% down on the home. 

Your lender will check your credit when you apply. Aside from looking at your score, lenders also consider things like:

• Payment history
• How many open credit accounts you have
• Your credit utilization (which means how much of your available credit you're using)
• Types of credit used
• Overall credit age
• Recent applications for new credit

FHA lenders are interested in how responsibly you use credit and how much of your income goes to debt each month. They use your debt-to-income (DTI) ratio to gauge your creditworthiness for a home loan. 

Your DTI ratio is the percentage of income you spend on debt repayment monthly. The lower this number is, the better your approval odds. The FHA Housing Handbook mentioned earlier sets two optimal DTI ratios for borrowers:

• 31% of your monthly gross income for mortgage payments
• 43% of your monthly gross income for total debt repayment

The second number includes your mortgage and anything you might pay toward credit cards, personal loans, student loans or other debts. The FHA may permit lenders to offer loans to borrowers with a higher DTI when they have higher credit scores. 

So why do FHA loan requirements specify how much debt you can have? 

The simple answer is the FHA wants to make sure borrowers can afford their homes. If you've got too much debt, it could be harder to keep up with your mortgage payments. You might be more likely to default, so the FHA will have to reimburse the lender.

Mortgage insurance for FHA loans

One lesser-known feature of FHA loans is mortgage insurance. Mortgage insurance is an amount you pay to have an FHA loan. The FHA collects two mortgage insurance premiums (MIPs) from borrowers:

• Upfront premiums 
• Annual premiums

The upfront payment is assessed when you close on your FHA loan. This premium is 1.75% of the loan amount. 

Annual mortgage insurance premiums range from 0.45% to 1.05%. The amount you pay depends on how much you borrowed. These premiums are divided by 12 and paid monthly as part of your regular mortgage payment. 

Generally, you're stuck paying the annual MIP for life with an FHA loan. There are only two exceptions. 

First, you can get rid of this payment after 11 years by putting 10% down on the mortgage. The second option is to refinance your FHA loan into a conventional loan once you accumulate 20% equity in the home. Keep in mind that refinancing into a new loan to get rid of MIPs doesn't guarantee you'll be able to get a lower rate. You'll also have to pay closing costs to refinance. 

FHA loan limits

The FHA limits the maximum amount you can borrow to buy a home. The limit that applies to you depends on where you live. 

The FHA updates loan limits regularly to account for inflation. For 2022, the nationwide "floor" for FHA loans is $420,680. The "ceiling" or upper limit for high-cost areas is $970,800.

The Department of Housing and Urban Development offers an online tool that you can use to search limits for FHA loans. You can search loan limits by county, state and metropolitical statistical area (MSA) to see how much you might be able to borrow. 

FHA Loans vs. Conventional Loans

A conventional loan is any mortgage loan that the federal government doesn't back. Other examples of government-backed loans include USDA loans and VA loans. 

So what's better, an FHA loan or a conventional loan? The answer depends mainly on your borrowing needs and financial situation. 

Here's an overview of how FHA loans compare to conventional loans. 

Whether it makes more sense to get an FHA loan, conventional loan or another type of mortgage can depend on how much you need to borrow, your credit scores and how much you can put down. Regardless of which type of loan you choose, it's essential to shop around and compare rates to find the best deal on a mortgage.