What is an FHA loan and how does it work?

A mortgage backed by the Federal Housing Administration (FHA) can be a great option for first-time homebuyers.

FHA loans are less risky for lenders because they’re insured by the government, which means you can often qualify with a lower credit score and a smaller down payment. But there are tradeoffs. FHA loans can be more expensive and there are additional restrictions you won’t find on other types of mortgages.

To help you decide if an FHA loan is a good fit for your homebuying plans, CNBC Select breaks down how these mortgages work and the advantages and disadvantages of FHA loans.

An FHA loan is a type of mortgage that is backed by the Federal Housing Administration. Since these mortgage loans are insured by the federal government (and are less of a risk for lenders), they can be easier to qualify for if you’re rebuilding your credit or if you need to make a smaller down payment.

FHA loans come in several different varieties. You can get an FHA loan with a fixed rate or a variable rate, for example, and you also can choose different repayment periods of up to 30 years.

Beyond financing the home’s purchasing, there are specialty loans such as the FHA 203(k), which also help pay for home renovations. If you choose to refinance the home you purchased with an FHA home, you can also take advantage of streamlined refinancing, which may save you from a credit check or home appraisal.

Although FHA loans differ from conventional loans, the basics of shopping for a mortgage still apply. Compare various types of loans from a handful of mortgage lenders to see what’s the best fit for you. Pay special attention to the mortgage rate and fees, which vary by lender and loan type. FHA loans aren’t offered by every lender, so you may have to do a bit more shopping around.

If you’re looking for a lender that offers a wide range of loan types, PNC Bank is ranked as CNBC Select’s best mortgage lender for first-time buyers for loan variety. Rocket Mortgage also offers FHA loans and can be a good option if you have a lower credit score.

In some ways, FHA loans are easier to get than other types of mortgages. FHA loans typically allow the borrower to have a lower credit score and a potentially higher debt-to-income ratio (DTI). And you can get an FHA loan with as little as 3.5% down for a one- to four-unit property. There are conventional loan programs with down payment requirements of 3% to 5%, but they can come with income limits and you might need a higher down payment for multi-unit properties.

To be eligible for an FHA loan, a property must be the borrower’s primary residence. However, FHA loans can be used to purchase a residential property of up to four units, assuming the buyer plans to live there. FHA loans also require a special FHA appraisal, which must be completed by an FHA-approved home appraiser.

The mortgage insurance you’re required to pay on an FHA loan works differently than with other types of mortgages. You’ll pay an upfront mortgage insurance premium of 1.75% of the loan balance and an annual mortgage insurance premium of 0.15% to 0.75%. You’ll typically pay the monthly premium for the life of the loan. But if you have a down payment of 10% or more, the mortgage insurance requirement is dropped after 11 years.

Other basic FHA loan requirements include:

• Credit score: 580+ with a 3.5% down payment or more; 500+ with a 10% down payment or more
• Income limits: None
• Maximum loan size: From $472,030 to $1,089,300 for a single-family home depending on where the property is located (with some exceptions)
• Maximum DTI: Typically up to 43%, but can be higher in certain circumstances

However, the minimum requirements set by the FHA are only the baseline lenders must follow. Lenders are allowed to set additional approval guidelines above the FHA minimums. This means you may need a credit score of 620 or higher to qualify for an FHA loan, even though the FHA technically accepts a lower credit score.

For a first-time homebuyer or anyone with bad credit or fair credit, an FHA loan may be easier to get than a conventional loan. And the annual mortgage insurance premium may cost less than the private mortgage insurance you pay with a conventional loan because it’s not based on the borrower’s credit score.

At the same time, the fees for an FHA loan can be higher because of the upfront mortgage insurance premium. And in a hot housing market, sellers may balk at needing to deal with the FHA appraisal, which requires more work than the typical appraisals needed for conventional loans.

Pros

• Small down payment, even for four-unit properties
• No income limits
• Lower credit score requirements
• Mortgage insurance isn’t based on your credit score

Cons

• Upfront mortgage insurance premium of 1.75%
• Monthly mortgage insurance payments are more difficult to waive
• Lower loan limits in low-cost areas compared to conventional loans
• Cannot be used for vacation homes or non-owner occupied rental properties
• Requires a more strict FHA appraisal

How can I get rid of FHA mortgage insurance?

FHA mortgage insurance is more difficult to waive than the private mortgage insurance (PMI) you may pay on a conventional loan. PMI is typically waived after your loan-to-value ratio (LTV) hits 80%, so you can avoid it altogether with a 20% down payment or get rid of it later as you pay down your loan balance.

The monthly mortgage insurance you pay on an FHA loan isn’t waived once your LTV hits a certain level. Although, when your LTV drops to 80% or lower, you may be able to refinance into a conventional loan to get rid of the mortgage insurance premium. However, that option may not make sense if the current mortgage rates are significantly higher than your existing rate.

If you have the cash saved, you can guarantee an eventual end to your mortgage insurance by making a down payment of 10% or more when you take out the loan. With a down payment of that size, your insurance requirement drops after 11 years. Just don’t forget that you’re still required to pay the upfront mortgage insurance premium of 1.75%, no matter how large a down payment you put down.

What is the maximum amount I can borrow with an FHA loan?

The amount you can borrow with an FHA loan is based heavily on two factors: FHA loan limits and your debt-to-income ratio (DTI).

Most FHA lenders allow a DTI of up to 43%, although it can be higher depending on your credit history, cash reserves and down payment. In other words, your total debt payments (including the new mortgage payment you’re trying to take on) cannot be higher than 43% of your gross monthly income.

FHA loans are also subject to loan balance limits based on the average home values of the area where the property is located. These limits are adjusted each year, and for 2023 the FHA loan limit for a single-family property is $472,030 for low-cost areas and goes up to $1,089,300 in high-cost areas. The loan cap increases for multi-unit properties and is higher in a handful of special areas where it’s more expensive to build housing.

Mortgages backed by the Federal Housing Administration (FHA loans) can be useful for first-time homebuyers. This type of mortgage is typically easier to qualify for and requires a smaller down payment than many other types of home loans.

However, there are tradeoffs with FHA loans. The mortgage insurance you pay on an FHA loan is an additional cost (upfront and annually) and isn’t easy to get rid of. FHA loans also require an FHA appraisal, which is more strict than a standard home appraisal and can be a turnoff to sellers.

Catch up on CNBC Select’s in-depth coverage of credit cards, banking and money, and follow us on TikTok, Facebook, Instagram and Twitter to stay up to date.