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Reader question: “Can somebody please explain to me how FHA loans work in 2014, and particularly the part where I have to deal with the lender? I’m confused about where the money comes from and how the loan actually gets funded on closing day. How do FHA mortgage loans work, in general? I know this is a very basic question. But I’m clueless about this stuff. Thanks for helping!”

FHA loans are actually one of the most popular mortgage products in the current lending market. So I’m always happy to field questions about this program. Here’s how the FHA mortgage-insurance program works.

How FHA Loans Work

The Federal Housing Administration does not actually lend money to borrowers. They only insure the loans made by private-sector mortgage companies. So the money comes from a lender in the private sector — not from the government.

This program is managed and overseen by the Department of Housing and Urban Development (HUD). It is HUD that establishes the minimum eligibility requirements for borrowers, and the underwriting procedures for lenders. HUD is a department of the federal government — FHA is an agency that falls under this department.

The loan might be originated by a local or regional bank, a credit union, or one of the big national banks like Wells Fargo, Bank of America or Citi. Many lenders offer these loans, because they’ve become very popular among home buyers.

So how do FHA loans work? It works like this: You approach ABC mortgage company to apply for the home loan. ABC mortgage company gives you the money to buy the house, after carefully screening you to ensure you are eligible for the FHA program. The Federal Housing Administration insures ABC against financial losses that may occur if you stop making your payments (i.e., default).

After applying for the loan, the process works much like any other type of mortgage. You get pre-approved by the lender for a certain amount of money. You find a home within that price range and make an offer to buy it. You take the purchase agreement back to your lender, so they can appraise the home and estimate its value. You get a home inspection. You go through the underwriting process, where they closely review your file to make sure you’re qualified. Then you go to closing and get the keys to your new house. Yay!

The application process is similar to a regular loan, but you’ll have to sign a few extra disclosures required by HUD.

Obviously, this is a simplified overview of how FHA loans work. If you want to learn more about this process, check out our 60-page handbook. It goes into much more detail about the application, underwriting and approval process.

The FHA’s insurance backing is key to the whole program. It protects the lender, not the borrower. But it benefits the borrower in the sense that the qualification process is easier (when compared to conventional loans that are not insured by the federal government).

That’s how an FHA loan works, in a nutshell. If you have any other questions about this program, or anything else relating to mortgages and home buying, feel free to post again.