FHA loans are definitely one of the best ways to start buying and holding real estate. They are an especially good place to start for “save-and-hold” investors, as they can fund 96.5% of the price of a deal at very low interest rates for a homeowner’s property. What’s even better is that you can finance up to a fourplex. So why not buy fourplex, live in one unit and rent out the other three? That’s a great strategy for first-time home buyers.
Here’s what you need to know, including the pros and cons of FHA loans compared to conventional loans.
Are you ready to invest?
One of the most frequently asked questions on the Pyjama People forums is “How can I start investing in real estate with no money and bad credit?” The answer? You should not. You need to resolve your situation and invest from a financial position.
What is an FHA loan?
FHA loans are a mortgage issued by a lender approved by the Federal Housing Administration (FHA), a United States government agency. These mortgages are insured by the FHA and only require a 3.5% discount. They are usually amortized over 30 years and the interest is also quite low, which is attractive to borrowers.
In addition, if the property is in need of rehabilitation, the FHA has a similar product designed for such properties, a 203K loan. You should be able to inquire about these products from almost any mortgage broker.
The ceiling price for an FHA loan depends on the market you buy, but it usually includes just about any starter home. At the time of writing, in some higher-end coastal markets, FHA loan limits will be raised from $ 765,600 to $ 822,375. (That’s the maximum loan amount you can borrow, not the total price of the house.)
The primary qualifications for an FHA loan are as follows:
- 580-plus FICO score
- 43% debt / income
- Two years of employment
- Own house
However, there are a few other guidelines that lenders should follow … and a little wiggle room in some areas. For example, a FICO score between 500 and 579 can be accepted, but the down payment should be 10% instead of 3.5%.
And while FHA loans are great, you need to decide if they make sense for you and your unique situation. Now let’s look at the difference between FHA loans and conventional loans
FHA Loans vs Conventional Loans
An FHA loan can be easier to qualify than a conventional home loan. Compared to conventional loans, FHA loans do not require high credit scores and allow for a lower down payment. That can make them more accessible to investors.
However, there are drawbacks. The process of getting approved for an FHA loan is quite tedious as compared to the process of getting approved for a conventional loan. They also have a lower cash limit than conventional loans.
First, let’s take a look at the benefits of determining if an FHA loan is right for you.
Pro: Great interest rate
You will almost always find better interest rates for owner-occupied properties than for investment properties. For example, your home may have an interest rate of 3.125%, while your investment property may have an interest rate of between 4% and 4.5%.
And FHA loans usually beat other conventional loans too. While interest rates have risen in recent years, Mortgage News Daily estimates that an FHA loan will be 3.5%, while a conventional 30-year home mortgage will be around 3.125%. With today’s record-low interest rates, mortgage payments for both types of loan will be exceptionally low – and regardless of the prevailing rate, FHA loans will still be affordable.
Advantage: high loan-to-value ratio
Because real estate is so expensive, it is difficult to maintain large cash reserves – at least in the beginning. And given this problem, one of the biggest benefits is the low down payment requirement of an FHA loan. If your FICO score is above 580, you can finance up to 96.5% of the purchase (and rehabilitate with a 203,000 loan).
For those who are just starting out in real estate investing and don’t have a lot of capital to invest, this provides an excellent entry point. That’s especially true if you can get a good deal on the property and refinance in a few years with a conventional loan. (You can only have one FHA loan in your name at a time.) Then, after refinancing, consider buying another real estate with an FHA loan and moving there. Why not?
Pro: You can buy a maximum of a fourplex
FHA loans can be used for homes or anything up to a fourplex as long as the real estate is your primary residence. You could buy the property and live in one unit and rent out the other, also known as a house hack.
That way, you can let the other tenants pay your mortgage while you live for free or nearly free. All the while, principal repayment and real estate valuation work to build you long-term wealth.
Advantage: you don’t need a high credit score
While good credit will always help you qualify, FHA loans usually don’t require high credit scores. Applicants must have a minimum credit score of 580 to be eligible for low deposits of 3.5%. As mentioned before, you can still qualify if you have a credit score lower than 580. You will only need to make a higher (10%) down payment for this.
Pro: Deposits required are low
Unless you are buying a home for the first time or you earn more than 80% of the median income in your area, you will have to pay off 5% for a conventional loan.
For an FHA loan, that amount is much less. Those looking for an FHA loan with a credit score of at least 580 can get a loan with a 3.5% down payment. However, the worse your credit is, the more your down payment can be.
Credit reporting company Experian reports that the average credit score in the United States is 711. If that’s your credit score, you’re in good shape.
As with all good things, there are drawbacks too. The main drawbacks of FHA loans are as follows.
Con: you have to live in the property … and you can buy a maximum of a fourplex
The first drawback may seem counterintuitive as it is also mentioned in the benefits above. You cannot buy a property larger than a fourplex. In addition, you must live in the property for at least a year.
If you are already based in your current home or prefer to live in a single family home, this is a problem and an FHA loan would likely become unattractive. In such cases, you can still take advantage of an FHA loan to get good financing for a home. Unfortunately, you wouldn’t be able to take full advantage of it with a multi-family home.
Con: Slightly tedious approval process
Every time you deal with the government there will be a few hoops to jump through. As such, FHA loans are more difficult than conventional financing and have less flexibility.
For example, a bank can get you approved for a conventional loan with only one year of employment history. However, it takes two years to be approved for an FHA loan. If you plan to use an FHA loan to buy a home, make sure you get approved for it in advance.
Con: Strict inspection process
In order to buy a home as an FHA buyer, there is at least one mandatory FHA inspection that must be completed by the lender before closing the property. There are a number of minimum property standards that can prevent a home from passing an FHA inspection, including water damage to the home and missing roof tiles.
FHA loans differ from the standard home inspection as the inspector must adhere to the FHA’s requirements. And their list of requirements is exhaustive. If the home you are buying doesn’t tick all of their boxes, your loan could be declined unless the seller makes the necessary repairs.
Con: Mortgage insurance
Any loan that is funded for more than 80% of the estimated value of the property requires mortgage insurance, which insures the lender against losses, as such loans with a high loan-to-value ratio are clearly riskier. Fannie Mae and Freddie Mac are companies that can assist with mortgage financing.
Private mortgage insurance, which a borrower may need to have as a condition of a conventional mortgage loan, adds 0.5% –1% of the loan balance to your payment each year. FHA loans in particular now cost 0.85% of the loan for the term of the loan (if the deposit is less than 5%). So for a $ 100,000 loan, private mortgage insurance (PMI) would be $ 850 per year, or monthly payments of $ 70.83.
Since a $ 100,000 loan at an interest rate of 4.5% amortized over 30 years would cost $ 507 a month, this adds nearly 14% to each payment for an effective interest rate of about 5.65%.
FHA loans generally also come with a few extra costs, such as closing costs and mortgage insurance premiums, over conventional loans.
Con: Looks bad in bidding wars
Since FHA loans don’t require high credit scores, some sellers look down on them. They may be thinking of selling to a buyer with an FHA loan as a last resort, or they may choose to sell to the highest bidder with a conventional loan – or none at all.
FHA loans also have strict appraisal and inspection requirements, which can mean financing will fail if a property doesn’t meet their requirements. Buying a home with an FHA loan can seem like a risk rather than a security.
While FHA loans are not without their drawbacks, they still present a great opportunity – especially for new investors. Anyone with a job looking for real estate who doesn’t have a lot of capital to begin with should seriously consider using an FHA loan to get started.