It’s a big misconception that if you want to invest in real estate, all the money you need has to be your own. Several home hacks are available to all American investors, and an FHA Loan is one of them.
Those who apply for an FHA loan may read the requirements and see that investment properties are ineligible. However, a loophole allows any investor to use the FHA Loan for an investment property with one small catch – the property must be their primary residence for a time.
We show you how an FHA Loan can be used on your home and an investment property simultaneously and why this loan vehicle, backed by the U.S. Government, is such a great deal for investors.
What is an FHA Loan?
In short, FHA stands for Federal Housing Administration, and an FHA Loan is backed by the U.S. Government and issued by a bank or independent lender approved by the FHA.
These loans were designed to help low to middle-income families buy a home, and they come with a lower-than-average down payment requirement and require a lower-than-typical credit score to qualify. In 2022, you can borrow up to 96.5% of the value of a home and only need a 3.5% down payment if you have a credit score of 580 or above.
A credit score between 500 to 579 can also qualify for an FHA loan, but you’ll need to up the down payment to 10%.
Who is Eligible for an FHA Loan?
In addition to the credit scores above, you must have the following:
- A steady income with verifiable proof of employment
- A debt-to-income ratio that doesn’t exceed 43%
- A willingness to pay a mortgage insurance premium along with your monthly mortgage payment
- The home financed by your loan must be your primary residence as the borrower
That last one would bar you from purchasing an income property with an FHA Loan, but not so fast. Sure, the home needs to be your primary residence, but the property is allowed to have up to four livable units, so you can live in one and rent the other three for incredibly cheap compared to the typical cost of real estate.
Plus, you only have to live in the home for up to 12 months after closing. Once that period is over, you are within your rights to move out and rent the other unit where you once lived and could even repeat the process with another property if you want to.
If you rent out those four units with the help of an FHA Loan, or you decide to buy another property using the exact funding source, Baselane’s Expense Management Tool can help you keep it all straight.
That’s the good news.
Of course, like everything, FHA Loans have a few drawbacks, whether you’re using them to purchase an income property or not. One of the big ones is the expense of the mortgage insurance premiums you must attach to your mortgage payments to inoculate the lender against the possibility of default. Over time you can pay down the principal and get rid of mortgage insurance premiums by having 20% equity in the home.
Plus, only some people want to be a landlord and share parts of a property with another person.
How to Apply for a FHA Loan for a Rental Property
Once you choose a lender, either a bank or private lender offering FHA Loans, you can go to the bank in person to get an application or apply online.
Like any other mortgage lender, FHA lenders offer varying rates with varying terms, so comparing at least five is essential before choosing one.
Then, once you have settled on a lender, it’s time to give them some basic information that includes the following:
- Property Address
- Employment history
- Rental Income information
- Social Security Number
- The purchase price for the property
- Down payment amount
- Driver’s License or state-approved I.D.
Providing the above authorizes the lender to do a credit check to verify your debt load and current monthly payments. To be approved, you will also be responsible for several things:
Credit score – 500 to 580 (regular mortgage loans require at least 620).
Down payment – 3.5% to 10% (depending on credit score).
Loan-to-value ratio – 96.5% or lower.
Closing costs – 2% to 5% of the loan amount (on top of the down payment).
Debt-to-income ratio (DTI) – shouldn’t exceed 43% in all but a few cases, and you typically shouldn’t spend more than 31% on a mortgage payment. A lender may allow for a higher DTI if there are mitigating factors, such as an exceptional credit score or a large number of cash reserves.
Mortgage Insurance Premium (MIP) – There are two types of MIP: The upfront MIP, which is 1.75% of the total value of your loan that’s paid at closing, and an annual fee, which is produced in monthly installments along with your mortgage payment and depends on the size of your down payment, the length of your mortgage term and how much money you borrowed. The lender usually calculates your annual payment as a percentage of your base loan value.
FHA Loan Limit – Your loan cannot exceed $420,680 in areas where 115% of the median home prices are less than this “floor” limit. However, any area where the limit exceeds this floor is considered a high-cost area, and in those areas, the “ceiling” limit for FHA loans is $970,800.
FHA Appraisal – The property must pass an FHA appraisal to meet the FHA’s minimum property standards.
An FHA Loan typically takes 30 to 45 days from start to finish to close. During that time, it goes through an underwriting process where the underwriter verifies the financial documents supplied, whether or not you can take on the loan, and whether you and the chosen property meet the requirements of the FHA Loan itself.
FHA Loan Document Checklist
In addition to your application form, here’s a list of documents you will need to submit as part of your Federal Housing Administration (FHA) Loan application:
- Proof of social security number
- Driver’s License or state-approved I.D.
- Two years worth of W-2s, pay stubs, and valid tax returns
- If some income sources are gifted and you don’t need to pay them back, you need signed and dated letters saying so
- Bank statements for all accounts for the past three months
- Recent utility bills to supplement a thin credit score
- Year-to-Date Profit and Loss statements for the past three years if you own your own business
- Account statements for all held investments, including mutual funds, stocks or 401ks
- Green card or work permit (if applicable)
- Proof of home ownership (if applicable)
- Proof of co-signer on any loan or credit vehicle (if applicable)
- Proof of property rental, including landlord’s name and address and 12 canceled rent checks (if applicable)
- Rental agreements for a multi-unit property (if applicable)
- Property tax bill (if applicable)
- Payment coupon for the current mortgage (if applicable)
- Note and deed for any existing loan (if applicable)
- Hazard homeowner’s insurance policy (if applicable)
Where to Find Rental Properties Eligible for FHA?
Investors should determine a preferred investment market and focus their search there. Start with the FHA maximum loan amounts suitable for small multifamily properties in your region. If you’re making the minimum down payment, FHA loan limits will be a good indicator of where you can find suitable rental properties.
Drive your market regularly and create a database of multifamily properties with no more than four units. You can find owner information in online county tax records. Start following up with the owners consistently, and let them know you want to purchase properties like theirs.
Online marketplaces designed primarily for investors like HouseCashin are the best resource. In addition to helping you find investment properties in your area, they have tools to reach other goals, such as securing financing at the best rates and estimating the property’s profit potential.
You can find demographic data, investment evaluation tools, special investment zones in your location, and features showing data for a particular market area you select.
Another online source — the hud.gov website- lists HUD/FHA homes in foreclosure. View the section “Homes for Sale.” You can find foreclosures listed by HUD/FHA, VA, FDIC, USDA, Fannie Mae, Freddie Mac, IRS, U.S. Customs, the U.S. Marshals Service, and the General Services Administration.
There are other tools on the website to determine whether a targeted property is FHA approved.
Primary online residential property listing services such as Zillow are also good places to search for FHA-qualified rental properties. These websites have a search filter option for multifamily properties that will speed up the process. Some also indicate whether the selected property has been approved for an FHA loan.
Pros and Cons of an FHA Loan for a Rental Property
Considering an FHA loan for an investment property? As with any financial decision, weighing the pros and cons is important. FHA loans have certain benefits that make them attractive, but they may also have downsides depending on your situation.
Here’s what you need to know about securing an FHA loan investment property.
Pros of Using an FHA Loan for an Investment Property
- Low Down Payments: One of the most significant advantages of an FHA loan investment property is the low down payment requirement. Borrowers can put down as little as 3.5% of the purchase price. This can make the investment more attainable, especially for first-time investors.
- Flexible Credit Requirements: FHA loans are known for having more lenient credit requirements compared to conventional loans. If your credit score could be better, an FHA investment property loan can be feasible.
- Higher Debt-to-Income Ratios Allowed: FHA loans allow higher debt-to-income ratios compared to traditional loans. This can enable potential investors to qualify for a loan, even with other significant debts.
- Refinancing Opportunities: With an FHA loan for an investment property, you can refinance the property more easily down the line, potentially lowering your monthly payments or shortening your loan term.
- Potential for House Hacking: An FHA loan lets you buy a multi-unit property (up to four units) if you live in one of the units. This tactic, often called house hacking, allows you to rent out the remaining units, offsetting your mortgage and potentially earning income.
Assumable Loans: If interest rates rise, an FHA loan can be an attractive feature for a future buyer because it’s assumable. It means a buyer can take over the seller’s loan instead of getting a new mortgage.
Cons of Using an FHA Loan for an Investment Property
- Owner Occupancy Requirement: The biggest downside of using an FHA loan for an investment property is that the FHA requires the borrower to live in the property for at least one year. This makes it challenging if you’re looking to buy a purely rental property.
- Limits on Number of Properties: With an FHA loan, you can typically only have one outstanding loan at a time. This may restrict investors who are looking to expand their real estate portfolio.
- Higher Mortgage Insurance Premiums: FHA mortgage insurance come with both an upfront and annual Mortgage Insurance Premium (MIP), which can make the overall cost of the loan more expensive than other loan types.
- Property Condition Standards: FHA loans require that the property meet specific health and safety standards. If the investment property needs significant repairs or upgrades, it may not qualify.
- Loan Limits: FHA loans have set limits for the loan amount, which varies by location and the number of units in the property. In higher-cost areas and for larger properties, you might exceed these limits.
An FHA loan for an investment property can be an attractive option for first-time investors or those with limited funds for a down payment. However, there are restrictions and additional costs to consider. Weighing the pros and cons can help you make the best decision for your property investment journey.
Your FHA Loan might get rejected for any number of reasons. These can include, but are not limited to, the following:
- Your credit score isn’t high enough
- You have no consistent income
- The property you selected doesn’t meet FHA standards
- Your debt-to-income ratio is too high
- Your documents prove you can’t afford the mortgage payments or down payment
- You don’t plan on making the property your primary residence
- The loan you would need on the chosen property exceeds the FHA Loan limit
You shouldn’t apply for an FHA Loan if you don’t want to have to pay mortgage insurance premiums, you don’t want the higher cost upfront, you want more flexibility in the loan structure or you don’t plan on living in the home you want the loan for.
This depends entirely on your situation, but if you want to pay less of a down payment, you don’t have the credit score to qualify for a conventional loan and you plan on living in the property as your primary residence, then an FHA loan is easier to qualify for and cheaper to pay, even with mortgage insurance premiums on top of everything.
However, if you can afford a more conventional loan, you want more flexibility in the terms and rates on the deal and you want to be able to do more with the property you’re getting the loan for, like turn it into a vacation home or flip it, then a conventional loan is better for you.