If you haven’t already, subscribe to our newsletter here to get our articles directly to your inbox and follow us on Twitter, Instagram, and YouTube! In our Educational Series we will be taking a deep dive into different ways to invest your money in hopes that one or multiple of these methods strikes you as interesting and encourages you to invest your money to grow your wealth.
So what is an FHA loan?
If you’ve listened to podcasts or read books around real estate, you may have heard of a Federal Housing Administration (FHA) loan. As its name implies, an FHA loan is a loan backed by the Federal Housing Administration that allows first time home buyers to put as low as 3.5% down on a property! This is a popular loan amongst first time home buyers because it significantly reduces the barrier to entry into real estate. Compared to normal loans, which can require as much as 20% down, 3.5% is a massive advantage for young homebuyers who haven’t had the time and income to save for a property (e.g., recent college graduates just entering the workforce). An FHA loan is amortized over 30 years and the interest rate is generally quite low because it requires the purchaser to live in the property (a.k.a. “owner-occupied”).
There is also an arm of the FHA loan called a 203K loan. The 203K allows you to add the cost of renovation/rehabilitation into the mortgage. The 203K is outside the scope of this article, but if you’re interested in this loan, be sure to talk with your mortgage broker!
The primary qualifications for an FHA loan are the following: 580+ FICO credit score, 43% debt-to-income ratio, two years employment (in my experience this is not always the case if you have a great credit score and money for a down payment), and the property must be owner-occupied for at least 1 year - that is, you must live in the property for at least 1 year. There is generally a ceiling on FHA loans. This ceiling depends on the market you’re buying in, but overall the limit is $822,375. Note that this is the loan limit, not the overall price of the house.
One of the major benefits of an FHA loan is that it can be used to purchase a single family home or a multi-family home up to four units. This is extremely beneficial for someone looking to house-hack. House-hacking is living in a property and renting out either the other bedrooms (if you live in a single family home) or the other units (if you live in a multi-family property) to attempt to cover all or lower expenses for the property. There are pros and cons to the FHA compared to a conventional loan and we’ll get into those below.
Pros of an FHA Loan
Low Interest Rate
FHA loans tend to have lower interest rates compared to a normal investment property. Generally, an owner-occupied property now has the potential to get an interest rate of less than 3%, whereas a conventional interest rate could be anywhere from 3.5% to nearly 6%, according to NerdWallet. Lower interest rates through an FHA loan will lower your monthly payments.
High loan-to-value ratio
As mentioned previously, you can use an FHA to purchase a property for only 3.5% of the sale price of the property (3.5% down payment). This means you can benefit from the 100% of the appreciation of the property which has 96.5% of it funded by a bank.
Purchase up to Four Units
FHA loans can be used to purchase single family homes or multi-family properties up to four units, also known as a quadplex. This feature of the loan provides young real estate investors a great opportunity to “house-hack.” With this loan, you now have a cheap option to either purchase a home or multi-family property and rent out other units/bedrooms. If you balance rent and expenses appropriately, you could live for free and potentially even cash flow from rent. Also you can have a multifamily property as an investment after living in it for only a year, when you would normally need 20% to 25% to purchase a property.
Lower Credit Score Requirements
Having a good credit score will always benefit the purchaser. It typically reduces the down payment which, as noted above, is one of the biggest barriers to entry in real estate investing, particularly for young buyers. FHA loan applicants are required to have only a 580 credit score to qualify for the low down payment of 3.5% of the home value. Even if you have a lower credit score, there is leeway to allow you to put 10% down (this still beats the traditional 20%). According to Experian, the average FICO credit score in the US is 710, and a “good” credit score is considered 600 to 750. This shows that to get the lowest amount for a down payment, other than the VA loan which you can get for 0% down, you do not even need a credit score that is considered “good” by a major credit reporting company.
Low Down Payment
The lowest amount you can get for a conventional loan is 5% down, which is only available if you’re not a first-time home buyer or you make more than 80% of the median income in your area. I referenced this point multiple times previously, but the 3.5% down payment greatly reduces the barrier to entry into real estate.
Cons of FHA Loan
Live in Property for 1 Year Minimum
This could be a positive for some who are looking to house-hack and need a place to live, but living in a single family home with roommates or in a multi-family with limited space could not be feasible or desirable for everyone. If you have a family, it could be difficult to convince a spouse or if you have children you may need more rooms. There are also options to get a side-by-side duplex or get a larger multi-family complex, but it still might take some convincing.
Tedious Approval Process
Although there are many benefits to the FHA loan, the approval process can be a bit more tedious than the conventional loan. Some of the stricter guidelines for an FHA loan include 2 years of employment history (as opposed to the 1 year for a conventional loan) and there are other restrictions that are more tedious due to the governmental backing of this loan.
Stricter Inspection Process
As mentioned in the previous point, government programs generally have stricter guidelines. The inspection needs to be deemed an FHA inspection which has more requirements than a conventional inspection and is mandatory. There are minimum property standards and the property needs to be deemed livable by passing the four point inspection. The list of requirements for an inspection is extensive compared to a property purchased using normal loan, but this may be seen as a benefit to rookie investors who are undergoing their first or one of their first home purchases. The stricter inspection can help determine what needs to be fixed and what can be put off.
Mortgage Insurance
Because you are not putting down at least 20% for the value of the home, you are required to get private mortgage insurance (PMI). Unfortunately with an FHA loan, PMI never disappears for the life of loan so in order to get rid of PMI you would need to refinance into a conventional loan after 20% of the principal is paid down. PMI for a FHA loan now costs 0.85% of the loan. For a $100k loan, PMI would be $850 per year or it is $70.83 additional to the mortgage.
Sellers Don’t Like FHA
Due to the higher regulations behind FHA with the approval process and the inspection, sellers are more hesitant when it comes to accepting FHA loans. This might mean if you get in a bidding war with other buyers, you would need to offer higher, but like they always say “if there’s a will there’s a way.” You will definitely be able to find someone to accept an FHA loan, but it may take submitting multiple offers.
These are some of the in’s and out’s with the FHA loan. I have used an FHA loan and I believe it is a great tool to help grow your wealth!
Have a great rest of your week!
Brandon & Dan
If you liked this article, please subscribe to our newsletter and be sure to follow us on Twitter, Instagram and YouTube!
Disclosure: The article was written by Daniel Kuhman and Brandon Keys, and it expresses the author's own opinions. The information presented in this article is for informational purposes only and in no way should be construed as financial advice or recommendation to buy or sell any stock, asset, or cryptocurrency. Brandon and Daniel are not financial advisors. We encourage all readers to do further research and do your own due diligence before making any investments.