How the FHA Loan Process Works: A Complete Guide for Borrowers

FHA loans offer a unique and flexible financing strategy for home buyers in the United States. This program has been assisting borrowers since the 1930s and was born from the Great Depression.

FHA loans allow for a down payment as low as 3.5% of the home’s purchase price. This makes them popular with first-time buyers in particular, since they don’t have money from a previous home sale to put toward their next purchase.

In this guide, you’ll learn how the FHA loan process works, starting with the initial application and going all the way through to the final closing.

Hint: It’s Basically One Big Insurance Fund

The Federal Housing Administration (FHA) does not lend money directly to home buyers. Instead, they insure the mortgage loans originated by lenders within the private sector.

The FHA loan program is basically one big insurance fund.

Home buyers who use this program have to pay a mortgage insurance premium, as part of their monthly payments. If the borrower defaults on the loan, the FHA will use this insurance fund to reimburse the lender for losses.

Yes, you read that right: Borrowers pay for the mortgage insurance, while it actually protects the lender. This is how FHA loans work.

But home buyers can also benefit from this insurance. Because of the government’s backing, FHA loans offer low down payments and flexible qualification criteria. This creates an alternative financing path for borrowers who cannot qualify for a stricter conventional mortgage.

So, FHA home loans are similar to other types of mortgages but with one major distinction. They are insured by the government through the Federal Housing Administration, a government agency that falls under HUD.

There Are Different Types of ‘FHA Loans’

The Federal Housing Administration supports several different types of mortgage loans. For instance, the FHA 203(k) program allows home buyers to purchase a property and renovate it, all with a single mortgage product.

They also have a reverse mortgage product for seniors who want to convert some of their home equity into cash, while staying in the home.

The FHA 203(b), on the other hand, is the “regular” FHA loan used by home buyers who only need to finance the purchase of a home. The rest of this guide applies to the 203(b) program specifically, which is the one most commonly used by home buyers.

How The FHA Loan Process Works for Buyers

For the most part, the FHA loan process works the same as a standard conventional loan (that’s not backed by the government). But it also has some specific requirements that are unique to the FHA program, like the mandatory home appraisal.

Let’s start by summarizing the steps that take place when a person uses an FHA loan to buy a house, before taking a deeper dive.

1. Eligibility: Borrowers should understand the minimum requirements for this program. You’ll need a down payment of at least 3.5%, a credit score of at least 500, and enough income to cover your monthly payments and all other recurring debts.
2. Lender: FHA loans are very popular, so most mortgage lenders offer them. You can find a lender by seeking referrals from friends or family, searching the state-by-state database on the HUD website, or inquiring with your local bank or credit union.
3. Pre-approval: Mortgage pre-approval is like a financial pre-screening. During this process, the lender will determine if you’re qualified for the program and the amount you can borrow. You can then shop for houses within that price range.
4. Application: During pre-approval, you’ll also need to complete a standard home loan application. It’s called the Uniform Residential Loan Application (URLA). You might be able to complete this form online, if your lender offers that option.
5. Shopping: Now you’re ready to shop for a home that falls within your budget. But bear in mind: all homes purchased with an FHA loan must meet the FHA’s minimum property requirements. So try to find one that’s in good overall condition.
6. Offer: When you find a home you want to buy, you’ll make an offer to the seller and eventually sign a purchase agreement. You’ll then need to give your lender a copy of the purchase agreement for underwriting purposes.
7. Appraisal: Your lender will order an appraisal of the home you want to buy. They do this to ensure the property is worth the amount you’re borrowing and that it meets HUD’s minimum property standards (mandatory for FHA loans).
8. Underwriting: At this point, your loan application file will move into the underwriting stage. This underwriter will evaluate your financial situation, credit history, employment status, and other factors to determine if you qualify for the loan.
9. Conditions: You might receive some “conditions” from the underwriter at this stage. These are questions or issues that need to be resolved for a final approval. Handling them promptly can help keep the loan process on track.
10. Approval: When the underwriter decides that you meet all of the minimum requirements for the program, your file will be marked as “clear to close.” This means you can proceed to closing and finalize your purchase of the home.
11. Closing: This marks the final step in the FHA loan process, from a borrower’s perspective. You’ll sign all of the finalized documents and disclosures, pay your closing costs and down payment, and get the keys to your new house.
12. Funding: Your lender will complete the transaction by disbursing funds to the seller or their representative. Funding typically occurs during the closing process or shortly thereafter, just as it does with a regular mortgage loan.

Pre-Approval, Appraisal, and Underwriting

Next, we’ll take a closer look at three of the most important stages of the FHA loan process. These include pre-approval, home appraisal, and mortgage underwriting.

As a home buyer, you need to understand how these different stages of the FHA process work because they can determine whether or not your loan gets approved.

The Pre-Approval Process

Pre-approval is one of the first steps in this process that actually involves the mortgage lender. And it can be very helpful to you as a borrower.

You’ll learn two important things during pre-approval:

1. Whether or not you’re qualified for an FHA loan
2. The maximum amount you’re able to borrow

In order to pre-approve you, the lender will review your current financial situation with a special focus on your income, debts, and assets.

They’ll also request a variety of documents including pay stubs, bank statements, and IRS W-2 forms. They need these documents to verify the information you provided on your loan application, in accordance with FHA guidelines.

Pre-approval benefits you, as a home buyer, in two ways. First of all, it will help you limit your home search to the types of properties you can actually afford, based on your borrowing capacity. This will make the entire process more efficient.

A pre-approval letter can also make sellers more inclined to accept your offer. It shows that you’re working with a lender already and will likely be approved for a loan. Most sellers will expect to see a pre-approval letter with all offers backed by mortgage financing.

Important: Pre-approval is not the same as the final approval. Problems can still arise at this stage. So try to keep your financial situation stable until you reach the finish line.

The Home Appraisal

The home appraisal is another important step during the FHA loan process, so let’s look at how it works.

Appraisals are a mandatory step required by HUD. All properties purchased with an FHA-insured mortgage loan must be appraised prior to approval and closing.

The purpose of the property appraisal is twofold:

1. It determines the current market value of the home. This helps the lender avoid a situation where they are lending more money than the property is worth.
2. The appraisal also determines if the home meets the minimum property requirements established by the FHA (and explained here).

When a home buyer makes the minimum 3.5% down payment on an FHA loan, the lender will provide the remaining 96.5%. So they have a huge financial stake in the deal. They’ll use the appraisal to ensure they are making a sound investment.

If the home appraises at or above the purchase price, great! But if the appraisal “comes in low,” the buyer has some decisions to make.

The home buyer could negotiate with the seller to reduce the price, increase their down payment to cover the difference, or use an appraisal contingency to exit the transaction.

The home must also meet the minimum property requirements established by HUD. This is required for all FHA purchase loans. The house must be safe, structurally sound, and habitable.

Minor issues like peeling paint or missing handrails can usually be repaired prior to closing and with minimal expense. But serious problems, like a damaged foundation or holes in the roof, could result in loan denial.

“Fixer-upper” properties typically do not qualify for standard FHA purchase loans. For such properties, you would want to look into the FHA 203(k) renovation program.

The Underwriting Process

If everything goes well with the home appraisal, you’ll move on to the underwriting phase of the FHA loan process. Here’s how that process works.

Definition: Mortgage underwriting is the process of evaluating a borrower’s financial information to determine their eligibility for a mortgage loan. It’s a form of due diligence that’s designed to reduce the mortgage lender’s risk.

When it comes to FHA loans, underwriting guidelines can come from two sources.

• The Federal Housing Administration requires lenders to perform specific underwriting tasks for all borrowers.
• Additionally, the lenders themselves can impose their own requirements for things like credit scores and debt ratios. And they might be stricter than the FHA’s guidelines.

When you enter the underwriting stage of the FHA mortgage process, keep an eye out for additional requests from the underwriter. For example, the underwriter might need a letter of explanation relating to an employment gap or a large bank deposit.

Not all borrowers receive these additional requests. Some home buyers move straight through the underwriting process without any snags. But if you do receive such a request, try to resolve it quickly and completely to prevent unwanted delays.

Takeaway: You’re not fully approved for an FHA loan until you get a green light from the underwriter. So it’s generally wise to avoid major financial changes until after you close.

How You Can Prepare for This Process

Now that you understand how the FHA mortgage process works, let’s talk about some of the things you can do to prepare for it.

If you’re currently in the research stage and won’t be applying for an FHA loan until later, you can use that time to strengthen your qualifications.

Here are some things you can do now that could benefit you later on:

• Start saving money. Even for a median-priced home, the 3.5% down payment for an FHA loan could exceed $10,000. And you’ll probably have closing costs as well, which could add thousands more. So the sooner you start saving, the better.
• Establish a housing budget. What’s the most you can afford to spend each month on your housing costs? You should have a number in mind before you even start talking to lenders. Here’s an excellent budgeting guide to get you started.
• Check your credit. You’ll need a credit score of 500 or higher to be eligible for an FHA loan, and a 580 or above to qualify for the minimum 3.5% down payment. If you check your credit scores now, you’ll know if improvements are needed.
• Avoid major purchases or credit usage. Big purchases will deplete your savings, and any new debt you take on will increase your debt-to-income ratio. Both of those things could raise red flags as you begin the mortgage process.
• Research the pros and cons. All mortgage products have pros and cons, and that applies to FHA loans as well. Understanding the potential upsides and downsides will help you decide if this program is right for you.
• Review the loan limits. FHA loans have limits when it comes to the maximum amount you can borrow. These limits vary by county because they are based on median home values. You can find the limits for your county here.
• Explore assistance programs. If you can’t afford the minimum 3.5% down payment required for an FHA loan, look into down payment assistance programs. They’re usually offered by state and local housing agencies.
• Consider gift money. The FHA loan program allows borrowers to use gift money from an approved third party, such as a parent or other family member. This is worth considering if you’re short on savings up front.
• Gather financial documents. You can expedite the application and pre-approval process by gathering the financial documents mentioned earlier. At the very least, figure out how and where to obtain them so you’ll be ready.

Disclaimer: This guide explains how the FHA loan process works for most borrowers. Every mortgage transaction is unique, due to a number of variables. So portions of this guide might not apply to your particular situation. If you have questions about this program, refer to the FHA’s online resource center or speak to a HUD-approved mortgage lender.