FHA mortgages are home loans that the Federal Housing Administration insures. With the administration's insurance, these home loans make mortgages more accessible to low- and moderate-income homebuyers who have trouble qualifying for a conventional mortgage.
The Federal Housing Administration insures mortgages
As mentioned, FHA mortgages are insured by the Federal Housing Administration. The administration is sometimes mistakenly called the “Federal Housing Authority,” but that’s not actually the agency’s name. Other times, FHA mortgages are referred to as HUD mortgages or HUD home loans, because the Federal Housing Administration is a division of the U.S. Department of Housing and Urban Development.
These mortgages aren’t underwritten by the FHA but are insured by the administration. Should a borrower default on an FHA-insured mortgage, the Federal Housing Administration will reimburse the private lender for a portion or all of its losses.
Only approved private lenders may issue FHA mortgages, but there are many approved lenders.
Borrowers pay for the FHA’s insurance
The insurance that the FHA provides is available to anyone who qualifies, but it doesn’t come free. Just as homebuyers who need it pay for private mortgage insurance, those who take out an FHA loan pay for the FHA’s mortgage insurance. The added cost is distributed over the mortgage’s monthly payments and is commonly referred to as FHA MIP.
Unlike PMI, which may be removed after homeowners reach about 20% equity, FHA MIP is required for the duration of the mortgage. Homeowners who qualify for a conventional loan in a few years might be able to refinance with a traditional loan that doesn’t have FHA MIP later on, however.
Lenders lower requirements for FHA mortgages
While homebuyers who can afford to avoid the added cost of FHA insurance certainly should do so, there are many who need the benefits that this insurance provides. The main benefits of an FHA mortgage are threefold.
First, down payments for an FHA mortgage can be as low as 3.5% of the purchase price. While some conventional mortgages require as little as 3% down, the vast majority have minimum down payment requirements ranging between 5% and 20%.
Second, homebuyers can qualify for an FHA mortgage with a lower credit score, since the federal government backs the loan. Whereas conventional mortgages typically require a credit score of at least 620, FHA mortgages are attainable with a credit score as low as 500. A credit score between 500 and 579 requires a 10% down payment, and a score of 580 or higher requires only 3.5% down.
Third, the debt-to-income ratio limit for an FHA mortgage is 50%. This is the portion of a homebuyer’s income that goes toward debt payments, and the limit for most mortgages is 45% unless a buyer has substantial cash reserves or impeccable credit.
Other FHA mortgage requirements
In addition to the above criteria, FHA mortgages have a couple of additional requirements.
They must be used to purchase, refinance or renovate a primary residence. This residence can be a single-family home, condominium, unit within a small multiunit structure (with up to four units) or select type of manufactured home. It can’t be an investment or vacation property, though.
Homebuyers must also be able to furnish proof of employment, and the employment must be stable.
FHA mortgages appeal to low- and moderate-income homebuyers
While there are no specific income requirements for FHA mortgages, these home loans tend to help low- and moderate-income homebuyers the most. These individuals and families often have limited financial resources and sometimes have a blemished credit history, but the Federal Housing Administration's program provides a way toward homeownership nonetheless.
If you have imperfect credit or are struggling to save up a large down payment, consider whether an FHA-insured mortgage could be right for you.