What Is an FHA Loan and How Does It Work?

If you have poor credit or if saving for a down payment on a house feels out of reach, an FHA loan might be the financing solution you need. FHA mortgages are insured by the Federal Housing Administration, allowing approved mortgage lenders to offer more flexible eligibility criteria. FHA loans can make homeownership more accessible for borrowers who may not qualify for conventional financing or who benefit from FHA's more flexible qualification standards.

But FHA loans come with some added costs and limitations. They’re not the right fit for everyone, including people with good credit and high incomes. We’ll walk you through how FHA loans work, who qualifies for an FHA loan, the benefits, drawbacks, and costs, and how to decide if an FHA loan is right for you. 

What is an FHA loan?

An FHA loan is a mortgage loan insured by the Federal Housing Administration and issued by an FHA-approved private lender. The FHA, part of the U.S. Department of Housing and Urban Development (HUD), can reimburse the lender for certain financial losses if the borrower defaults. It allows lenders to offer more flexible qualification criteria for FHA loan programs than conventional mortgages, although certain costs are passed along to the borrower.

FHA loans offer benefits, including:

• Lower minimum credit score requirements than typical conventional loans
• Low minimum down payment requirements and closing costs
• Opportunities to finance rehabilitation costs or buy a multifamily property and earn rental income

How does an FHA loan work?

To get an FHA loan, you need to apply with an FHA-approved lender. An FHA-approved appraiser will need to evaluate the home to ensure it meets certain property standards and falls within loan limits — how much you can borrow — for that area. If an appraisal identifies safety or security issues, you can still negotiate repairs before closing, and if the home’s appraised value doesn’t match the sale price, you can pay the difference in cash. 

You’ll need to meet FHA requirements for the loan program you’re applying for, and the individual lender you’re applying with may have additional requirements as well. The process of applying for an FHA mortgage is similar to applying for a conventional loan, including a credit check and verification of employment.

While the FHA insures FHA mortgages, the borrower is responsible for paying mortgage insurance. You’ll pay an upfront mortgage insurance premium, which you can opt to pay with your closing costs or roll into your loan, along with annual mortgage insurance premiums, which you’ll pay with your monthly mortgage payments. Annual mortgage insurance premiums are typically paid as part of the monthly payment and held in an escrow account, then paid to HUD annually on your behalf. 

Who qualifies for an FHA loan?

“FHA gets people into homes who otherwise could not make a loan program work for them,” says Erik Leland, real estate broker at Realty First in Lake Oswego, Oregon. “There are lower credit score requirements, lower down payment, and more flexibility with debt-to-income ratios. For a buyer with a 600 credit score and limited savings, FHA might be the only path to homeownership.”

To qualify for an FHA loan, you’ll typically need to meet the following qualification requirements:

• Borrowers with credit scores of 580 or higher may qualify with as little as 3.5% down, while borrowers with scores between 500 and 579 may qualify with a 10% down payment. Individual lenders may have stricter requirements. 
• A debt-to-income ratio of 43% or less (or up to 50% for borrowers who have credit scores of 580 or higher and compensating factors such as residual income or documented cash reserves)
• Proof of income and steady employment history
• No currently delinquent federal debts or delinquent FHA mortgages
• Generally, at least one borrower must intend to occupy the property as their primary residence, starting within 60 days of closing and continuing for at least 1 year

In addition, the loan amount you request must fall within FHA loan limits for your county, which the HUD updates annually based on home sales data for the area.

Types of FHA loans

There are several types of FHA loans you can apply for depending on your financing needs and the property you’re purchasing or refinancing. Options include:

• FHA 203(b) Basic Home Mortgage: This is the loan program most homebuyers use to buy or refinance a primary residence. You can also use this type of FHA loan to refinance an FHA or conventional loan. You need to meet standard eligibility criteria and pay mortgage insurance premiums. 
• FHA 203(k) Rehabilitation Mortgage: This program allows you to finance the purchase or refinance of a property plus eligible improvements or rehabilitation with one fixed or adjustable-rate mortgage. You can use 203(k) loans for a wide range of property types and a broad list of improvements, as long as the property is at least a year old and the original foundation remains intact. These loans have similarly flexible requirements to basic FHA loans. 
• FHA Energy Efficient Mortgage: The FHA EEM program allows you to finance the purchase or refinance of a home plus the cost of energy efficiency improvements, such as replacing an HVAC system, with one mortgage. 
• FHA 245(a) Graduated Payment Mortgage: This program is for homebuyers purchasing owner-occupied, single-family residences who expect their incomes to increase over time. It offers a few different plans with monthly payments that increase annually at different rates. 
• FHA Streamline Refinance: This allows you to refinance an existing FHA loan with minimal underwriting, sometimes without requalifying based on your credit. Some lenders offer streamline refinances with no upfront costs, instead building loan costs into the interest rate. The refinance must benefit the borrower. 
• FHA Cash-Out Refinance: This replaces your existing mortgage with a larger one, allowing you to tap your home equity to keep the difference as cash. “Compared to a conventional cash-out refinance, an FHA cash-out offers more liberal credit requirements and debt-to-income ratio tolerances,” says Cody Schuiteboer, president and CEO of Best Interest Financial. “The trade-off here is mortgage insurance premium.” FHA cash-out refinances are generally subject to maximum loan-to-value limits established by HUD.

How much does an FHA loan cost?

With an FHA loan, there are a few different costs you need to be aware of.

Down payment

While you can qualify for an FHA loan with as little as 3.5% down, making a larger down payment has certain benefits. Putting at least 10% down allows for more lenient credit qualification requirements, lowers your monthly payment and total interest, and allows you to pay annual mortgage insurance premiums for 11 years rather than for the duration of the loan. 

FHA loan interest rates

FHA loan rates may be more competitive than conventional loan rates for borrowers with lower credit scores because FHA loans are federally insured. If you have a 720+ FICO score and a high income, you’ll likely find a better rate on a conventional loan. 

Mortgage insurance premiums

For single-family homes, most FHA loans require you to pay an upfront mortgage insurance premium of 1.75% of the base loan amount, which you can pay at closing or finance with your loan payments. 

You'll also pay an annual mortgage insurance premium ranging from 0.15% to 0.75% of the loan amount, depending on factors such as the loan amount, loan term, and loan-to-value ratio. You’ll pay a portion of the annual mortgage insurance premium with each monthly payment. 

While refinancing is an option to get rid of MIP, “Do not forget that refinancing costs money, too,” says Leland. “So the true cost of FHA is not just the premiums you pay, it is also the cost of eventually getting out of it.”

Closing costs

You’ll also pay certain FHA closing costs associated with completing the home purchase transaction. These may vary depending on your state and other factors. Fees may include:

• Home appraisal fee
• Home inspection fee
• Origination fee
• Document preparation fees
• Title survey and insurance fees
• Property survey fees
• Real estate attorney fees
• Credit report fees
• Taxes and recording fees

Pros and cons of FHA loans

Details on the pros

• Low minimum credit score: It’s possible to qualify for an FHA loan with a credit score as low as 500 if you’re able to make a down payment equal to 10% of the purchase price. Conventional lenders generally set their own credit score requirements, which are often higher than FHA minimums.
• Flexible qualification criteria: “FHA loans make it easier for those who have recently undergone financial hardships,” says Schuiteboer. For example, it’s possible to qualify with a past bankruptcy or foreclosure, after a 2- to 3-year waiting period, if you meet certain conditions, such as improving your credit in the interim. Lenders may also allow a higher debt-to-income ratio if you compensate with factors like a larger down payment or show the ability to save or use credit wisely. 
• Low down payment requirements: You may be able to get an FHA loan with as little as 3.5% down if you have a 580 credit score or higher. 
• Easier entry into house hacking: A 203(b) FHA loan allows you to buy a multifamily property with as little as 3.5% down if you plan to live in one of the units. You can rent out the remaining units to cover your housing expenses, a strategy known as house hacking. 
• Affordable rehabilitation financing: An FHA 203(k) loan can make rehabilitation financing more accessible and affordable compared to construction loans, which typically come with higher interest rates and stricter qualification requirements. “This loan has helped clients buy homes that would have been off the table with conventional loans,” says Schuiteboer.

Details on the cons

• Established loan limits: If you want to buy a home with a purchase price that exceeds FHA mortgage limits for the area, you need to make up the difference with your own funds.
• Mortgage insurance premiums: In addition to an upfront mortgage insurance premium, you’ll pay annual mortgage insurance premiums for the life of the loan or 11 years if you put at least 10% down. These premiums increase the cost of the loan. 
• Primary residences only: You can’t use an FHA loan to buy a second home, vacation property, or investment property, with the exception of an owner-occupied rental property. 
• Longer closing timeline: Homes must meet stricter appraisal standards for FHA loans. “FHA also requires extra documentation from the borrower. Employment verification is more detailed,” Leland says. For these reasons, “the timeline from application to close usually runs a week or two longer than conventional.”
• Disadvantage in competitive markets: Due to the issues mentioned above, an FHA loan can put you at a disadvantage when there are multiple offers and the seller wants a quick sale. “Sellers in competitive markets usually prefer conventional offers because they know the appraisal process will be faster,” Leland explains.

Is an FHA loan right for you?

An FHA loan may be a good option if you can’t qualify for a conventional mortgage because your credit score is too low, your debt-to-income ratio is too high, or you have a history of financial hardship. But due to the added cost of mortgage insurance, an FHA loan may not be the most cost-effective option if you have good credit. You may also find more options and fewer restrictions with conventional mortgages. 

“If a buyer has a 720 credit score and 10% to put down, conventional is generally the better fit. The interest rates are lower and mortgage insurance is shorter-lived. The conventional loan limits are higher for most markets,” Leland says. 

If your credit score is fair or good and you can only put 5% down, the decision may not be clear-cut. An FHA loan may offer more competitive rates, and you’ll pay private mortgage insurance on a conventional loan. In this situation, it’s important to compare options from both FHA-approved and conventional mortgage lenders. You should also consider your local real estate market and whether to use conventional financing to strengthen your offer. 

One option is to apply for an FHA loan and refinance to a conventional loan later on to eliminate mortgage insurance.