FHA Loan Basics

FHA loans are the most common type of government-backed home loan. The Federal Housing Administration was created in 1934. Somewhat similar to the VA, the FHA insures mortgages against borrower default. While the VA provides a partial guaranty, the FHA fully insures each loan. That guaranty allows FHA lenders to provide financing to borrowers with lower credit scores and minimal down payments. FHA loans tend to have more lenient credit and underwriting requirements.

Here's a closer look at FHA Loans:

Down Payment

The minimum down payment for an FHA loan is 3.5 percent. This is lower than the 5 percent minimum for conventional loans, but it still can't beat the VA's no-money down option. Borrowers with sub-580 credit scores would need to put down at least 10 percent to be eligible for financing.

On a typical $200,000 home purchase, FHA borrowers would need a $7,000 down payment.

FHA buyers can use gift funds to cover their down payment and closing costs. This money truly needs to be a gift from an acceptable source, with no expectation of repayment. Acceptable sources include but are not limited to relatives, friends and down payment assistance programs. Gift funds cannot come from anyone involved in the real estate transaction.

Lenders will need a verifiable paper trail for gift funds, usually with a cashier's or certified check. Both the donor and the borrower will need to sign a gift letter spelling out the dollar amount of the gift, the nature of their relationship and that no repayment is required.

Mortgage Insurance Premiums (MIP)

FHA loans come with their own form of mortgage insurance, known as mortgage insurance premiums (MIP). Borrowers face both an upfront and a yearly mortgage insurance premium.

FHA homebuyers are currently charged an upfront MIP fee of 1.75 percent of the loan amount. This isn't a sum you pay in cash at closing. Instead, the upfront fee is added to the total amount you're borrowing - that is, the balance of your loan after subtracting your down payment.

For example, on a $250,000 purchase, an FHA borrower would need to put down $8,750. The upfront fee would then be applied to the remaining loan balance, which in this example is $241,250 ($250,000 -8,750). Multiply the 1.75 percent times that balance, and you get an upfront MIP fee of $4,222. Tack that fee onto your loan, and that means you're borrowing $245,472 ($241,250 +4,222) for this example.

In addition, FHA borrowers face an annual mortgage insurance premium. This cost is spread over the course of the calendar year and paid as part of your monthly mortgage payment. How much you pay depends in part on the length of your loan term and your loan-to-value ratio.

Most FHA borrowers put down the minimum 3.5 percent, meaning their loan-to-value ratio is 96.5 percent.