What are the different types of FHA loans and how do they work?

There are many different home loan choices if you want to purchase a residence. One of the best options for first-time and lower-income buyers is an FHA loan. It requires as little as 3.5% down.

Take a closer look at how FHA loans work, their pros and cons, the different types of FHA loans available, and how to apply.

In this article (Skip to...)

• What is an FHA loan?
• Why use an FHA loan?
• FHA loan requirements
• FHA loan limits
• FHA loan types
• Which loan is right for you?
• Applying for an FHA loan
• FHA loan FAQ

What is an FHA loan?

An FHA loan is a government-backed mortgage loan insured by the Federal Housing Administration. These loans are offered and underwritten by third-party mortgage lenders the FHA approves, including traditional banks and other private lenders.

FHA loans are different from conventional loans. The latter are not guaranteed or insured by a government agency. Conventional loans are provided and underwritten by private-sector lenders, including banks, credit unions, and other lenders.

Why use an FHA loan?

An FHA home loan can be a worthy option for first-time buyers and borrowers who don’t have a lot of savings. They are also great for individuals with lower credit scores. That’s because they are geared to be more affordable and accessible to current or former renters and lower-income purchasers.

“FHA loans are a great option for these types of buyers because they are less credit-restrictive, have lower down payment requirements, and, in many cases, are all around cheaper for the consumer,” says Sam Royer, national director for Heroes First Home Loans, a division of Churchill Mortgage.

FHA loan pros and cons

A big reason why FHA loans are popular is that they require a minimum of 3.5% down if your credit score is 580 or higher. You’ll need to make a 10% down payment if you have a credit score between 500 and 579. Consider that most conventional loans require at least 20% down and a credit score of 620 or higher.

“It’s fairly easy to qualify for FHA loans. The financial requirements are lower than those for traditional mortgages, and the programs are fairly easy to learn about and apply for online,” says Martin Orefice, CEO of Rent To Own Labs.

Attorney Min Hwan Ahn notes that “FHA loans also have lower closing costs and more flexible underwriting standards than conventional loans.”

What’s more, your down payment can come from savings, a financial gift, or via the help of a down payment assistance program, according to Erin N. Slade, mortgage loan officer for Silverton Mortgage.

On the downside, fixed interest rates for FHA loans are usually slightly higher than those for conventional mortgage loans. Furthermore, you’ll need to pay an upfront mortgage insurance premium of 1.75% of your loan amount and an annual mortgage insurance premium of 0.5% to 1.05% of your loan amount for the entire life of your loan – unless you refinance to a conventional loan. Slade notes that if you put down 5% or more, your mortgage insurance can be reduced and dropped after 11 years.

Additionally, an FHA loan has lower loan limits than a conventional loan, which vary by county and property type.

FHA loan requirements

You’ll need to meet eligibility requirements to be approved for an FHA loan. To qualify, prepare to have:

• A 3.5% down payment if your credit score is 580 or higher
• A 10% down payment if your credit score is between 500-579
• A debt-to-income ratio (DTI) of 50% or less
• Documented, steady income and employment history
• The home be the primary residence you live in
• No record of foreclosure in the last three years

FHA loan limits

When it comes to how much you can borrow with an FHA loan, this loan program is relatively generous. FHA mortgage limits are set by county or MSA (Metropolitan Statistical Area) and vary from $472,030 to $1,089,300 for single-family residences and many areas of the country. The limits are higher for duplexes, triplexes, and fourplexes and in Alaska, Hawaii, the U.S. Virgin Islands, and Guam.

Note that if the FHA’s loan limit in your desired area is too low for the home you are purchasing, you’ll probably need a conventional or jumbo loan.

What are the different types of FHA loans?

There are several different types of FHA loans available if you qualify. Consider the pluses, minuses, and requirements for each.

FHA purchase loan

This loan is the most common type of FHA loan available – it’s the one we’ve described previously. It requires as little as 3.5% down. An FHA 203(b) loan is another name for this mortgage.

FHA refinance loan

This type of FHA loan enables borrowers to refinance their existing mortgage either to lower their interest rate, change their loan term, or switch from an adjustable-rate mortgage to a fixed-rate mortgage or vice versa.

“The pros of this loan are that it can help borrowers save money on interest, reduce their monthly payments, or access equity in their home,” Ahn explains. “The cons are that it may require upfront and ongoing mortgage insurance premiums and a new appraisal.”

To qualify, prepare to have a credit score of at least 500, a DTI ratio of up to 43% (50% in some cases), and a loan-to-value ratio of 97.5% or less for a rate-and-term refinance, or 80% or less for a cash-out refinance.

FHA streamline refinance loan

This simplified version of the FHA refinance loan permits borrowers to refinance their existing FHA loan to a new FHA mortgage with a lower interest rate. It doesn’t require a new appraisal, income verification, or credit check.

Plus, this loan is often processed quickly, charges lower closing costs, and requires no minimum credit score. But you will need to pay an upfront and ongoing mortgage insurance premium and pass a net tangible benefit test.

“That means the new loan must result in at least a 5% reduction in your principal and interest plus the mortgage insurance payment, or reflect a change from an adjustable-rate mortgage to a fixed-rate mortgage,” Ahn adds.

FHA cash-out refinance loan

To qualify for an FHA cash-out refi, you must have earned more than 20% equity in your home and retain at least 20% after the refi is complete.

“This type of refinance is only available for the primary residences of individuals who have lived there for 12 months or longer and have made on-time payments for those 12 months,” Orefice says. “A minimum credit score of 500 is also required.”

FHA 203(k) renovation loan

An FHA 203(k) loan, also referred to as a “rehab loan,” allows you to buy or refinance a fixer-upper and finance the necessary repairs — all with only one loan and one monthly mortgage payment.

To be approved, the home must meet certain safety and livability standards, as demonstrated by an FHA home appraisal. You need a credit score of at least 580, a DTI under 43%, and must make at least a 3.5% down payment.

Buying a home with this program could take some time. Try to get all your documents prepared in advance and be ready to move as quickly as possible so that you are not further delaying the transaction.

The 203(k) comes in two choices: standard and limited, which work the same way but with a few differences. The limited version is capped at $35,000 in repairs and requires less paperwork as part of the approval. The standard version is not capped at $35,000 and paperwork requirements are a little more intense.

Additionally, the limit requires that the home be “habitable” throughout the period of renovation. If the home will be uninhabitable for any reason at any time, use of the standard 203(k) is required. However, borrowers using the standard 203k can add up to six months of mortgage payments to their construction loan for the period during which the home is uninhabitable.

Also, with a limited 203(k), the first payment to a contractor can be made at the start of the project (i.e. 50% down to start the work); and, the second payment can be made at the project’s conclusion (i.e. remaining 50% on the work); payments are made differently for a standard 203(k).

Home equity conversion mortgage (HECM) loan

According to Benefits.gov, the Home Equity Conversion Mortgage (HECM) is the FHA’s reverse mortgage program that permits borrowers to withdraw some of the equity in their homes.

With this loan, you can choose how to withdraw your funds, whether in a fixed monthly amount, a line of credit, or a combination of both. You can also use a HECM to purchase a primary residence if you can use cash on hand to pay the difference between the HECM proceeds and the sales price plus closing costs for the property you are buying.

To qualify, you must be 62 or older, own the property outright or have a small mortgage balance, and occupy it as your primary residence. You cannot be delinquent on federal debt and must attend a consumer information session given by an approved HECM counselor.

While a reverse mortgage can be a prudent financial move, the downsides and risks should always be considered. After all, unlike with a regular mortgage, with a HECM, you are drawing down your home equity.

FHA energy-efficient mortgage loan

Per the US Department of Housing and Urban Development, the FHA’s Energy Efficient Mortgage program (EEM) can help you save money on your utility bills by enabling you to finance energy-efficient improvements with your FHA-insured mortgage. The EEM program recognizes that an energy-efficient home will have lower operating costs, making it more affordable for homeowners.

The maximum amount of the energy package that can be added to your regular FHA loan amount is the lesser of cost-effective improvements to be made (energy package) based on the home energy assessment; or the lesser of 5% of the adjusted value, 115% of the median area price of a single-family dwelling, or 150% of the national conforming mortgage limit.

Types of FHA loans: Which one is right for you?

The right type of FHA financing vehicle for you will depend on which loan program you qualify for and your needs. You need to carefully weigh the advantages and disadvantages of the different types of FHA loans. Those include any mortgage insurance premiums and the total cost of the loan versus what you might pay for a conventional loan or other financing option.

How to apply for an FHA loan

You can apply for an FHA loan through any lender that is specifically authorized to originate FHA loans. These are called “FHA-approved lenders.”

“It’s best to work with an experienced mortgage professional who can help you determine the best FHA loan program to fit your needs based on a careful evaluation of your unique financial situation. This person can guide you through the process of how and when to apply for an FHA loan,” Slade recommends.

Frequently asked questions

Is an FHA loan the best option for a first-time home buyer?

Because an FHA purchase loan requires only 3.5% down and can have looser lending requirements than a conventional loan. It is often a more viable option for first-time purchasers, especially those with lower credit scores.

What is the difference between an FHA loan and a conventional loan?

An FHA loan is backed by the government and insured by the Federal Housing Administration. However, it is issued and underwritten by private lenders who participate in this loan program. Conventional loans are provided and underwritten by private-sector lenders, including banks, credit unions, and other lenders.

What are the two types of FHA 203(k) loans?

The 203(k) is available as either standard or limited. The limited version is capped at $35,000 in repairs and requires less paperwork for approval. The standard version is not capped at $35,000 and requirements can be more intense. The limited requires that the home be “habitable” throughout the period of renovation. If the home will be uninhabitable for any reason at any time, use of the standard 203(k) is required. However, borrowers using the standard 203k can add up to six months of mortgage payments to their construction loan for the period during which the home is uninhabitable. Also, with a limited 203(k), the first payment to a contractor can be made at the start of the project (i.e. 50% down to start the work); and, the second payment can be made at the project’s conclusion (i.e. remaining 50% on the work); payments are made differently for a standard 203(k).

What is the minimum credit score for an FHA loan?

The minimum credit score typically required for an FHA purchase loan is 500 to 579, which requires putting down 10%. You’ll need a FICA score of 580 or higher if you want to put down as little as 3.5%.

How hard is it to qualify for an FHA loan?

According to Erin N. Slade with Silverton Mortgage, the FHA’s more flexible eligibility requirements make it relatively easy to qualify. This is especially true for first-time buyers or those with fewer savings for a down payment. Additionally, qualifying is not solely based on credit score alone, which is helpful to purchasers who may have less-than-perfect credit.

How do I get started if I want an FHA loan?

FHA loans are offered from FHA-approved lenders. Shop around with different banks, online lenders, credit unions, and other financing sources that provide FHA loans. You can also work directly with a mortgage broker who can steer you toward the right FHA program.