It’s a big misconception that if you want to invest in real estate, all the money you need has to be your own. There are several home hacks 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, there is a loophole that 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 both your home and an investment property at the same time and why this loan vehicle, backed by the U.S. Government, is such a great deal for investors
1. 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 that’s 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%.
2. 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 mortgage payment every month
- The home financed by your loan must be your primary residence as the borrower
You’d think 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 do rent out those four units with the help of an FHA Loan, or you decide to buy another property using the same source of fundinding, Baselane’s Expense Management Tool can help you keep it all straight.
That’s the good news.
Of course, like everything, there are a few drawbacks to FHA Loans 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’re required to 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, not everyone wants to be a landlord and share parts of a property with another person.
3. 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 you can apply online.
Just like any other mortgage lender, FHA lenders offer varying rates with varying terms, so it’s important to compare at least five 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
- Income information
- Social Security Number
- Purchase price for the property
- Down payment amount
- Driver’s License or state-approved ID
Providing the above authorizes the lender to do a credit check to verify your debt load and current monthly payments. In order 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 amount 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 paid 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 in order 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 you and the chosen property meet the requirements of the FHA Loan itself.
4. 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 FHA Loan application:
- Proof of social security number
- Driver’s license or state-approved ID
- 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 current mortgage (if applicable)
- Note and deed for any current loan (if applicable)
- Hazard homeowner’s insurance policy (if applicable)
5. 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 4 units. You can find owner information in online county tax records. Start following up with the owners consistently. Let them know that you are interested in purchasing properties like theirs.
Online marketplaces designed specially for investors, such as HouseCashin, are probably 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 that show data for a very specific market area selected by you.
Another online source — the hud.gov website provides a list of 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, US Customs, the US Marshals Service, and the General Services Administration.
There are other tools on the website to determine whether a targeted property is FHA approved.
Major 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.
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.