What’s Great (& Not So Great) About FHA Loans
FHA loans are, in my opinion, one of the absolute best ways to get started in buy and hold real estate.
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As I’ve noted before, they’re a particularly great place to begin for “save and hold” investors, as they can finance 96.5 percent of the price of a deal at very low interest rates for a homeowner’s property.
What’s even better, you can finance up to a fourplex. So, why not buy a fourplex, live in one unit, and rent out the other three?
Here’s what you need to know about FHAs, including the advantages and disadvantages compared to conventional loans.
What Is an FHA Loan?
FHA loans are a mortgage issued by a lender that’s approved by the Federal Housing Administration (FHA), which is a U.S. government agency. These mortgages are insured by the FHA, and as mentioned above, require only 3.5 percent down. They are usually amortized over 30 years, and the interest rate is also quite low.
In addition, if the property needs rehab, the Federal Housing Administration has a similar product designed for such properties called a 203K loan. You should be able to inquire about these products with pretty much any mortgage broker.
The ceiling price for an FHA loan depends on the market you're buying in but will usually encompass just about any starter home. As of this writing, in some higher-priced coastal markets that can be as high as $726,525. (How they come up with such odd limits is a mystery to me.)
The primary qualifications for an FHA loan are as follows:
- 580+ FICO score
- 43 percent debt-to-income ratio
- Two years’ employment
- Owner occupied property
However, there are a few other smaller qualifications and a little bit of wiggle room in some areas. For example, a FICO score between 500 and 579 may be accepted, but the down payment would need to be 10 percent instead of 3.5 percent.
And while I think FHA loans are great, whether they make sense for you and your unique situation is another story.
Now let’s go over some of the major advantages and disadvantages to FHA loans.
Advantages of FHA Loans
1. Great Interest Rate
You are almost always going to find better interest rates for owner occupied properties than investment properties. My own house, for example, has an interest rate of 4.125 percent while most of my company’s and my investment properties have interest rates between 5 and 5.5 percent.
And FHA loans usually beat other conventional loans, as well. While interest rates have risen over the past few years, even now Bankrate.com estimates an FHA loan will come in at 4.5 percent while a conventional 30-year mortgage for an owner occupied home will be around 4.85 percent.
2. High Loan-to-Value Ratio
I’ve grown fond of saying, “You’re not a real estate investor unless you’re cash poor.”
Of course, this is not a mindset you want to have forever. But because real estate is so expensive, it's hard to keep large cash reservesâat least in the beginning. And given this problem, an FHA loan's low down payment requirement is one of its biggest advantages. If your FICO score is above 580, you can finance up to 96.5 percent of the purchase (and rehab with a 203K loan).
For those who are just getting started 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 out in a few years with a conventional loan. (You can only have one FHA loan in your name at a time.)
Then, after the refinance, you can consider buying another property with an FHA loan and moving there. Why not?
3. You Can Buy up to a Fourplex
FHA loans can be used on houses or anything up to a fourplex. So, as I said above, why not go the latter route and rent out the other three units?
By doing so, you can pretty much have the other tenants pay your mortgage while you live for free or close to free. All the while, principal paydown and property appreciation are working in your favor to build long-term wealth.
Disadvantages of FHA Loans
As with all good things though, there are downsides. The biggest disadvantages to FHA loans are as follows.
1. You Must Live in the Property and Can Only Buy up to a Fourplex
The first downside might seem counterintuitive since it’s also mentioned above in the advantages: you can’t buy any property larger than a fourplex. Plus, you must live in the property for at least a year.
If you are already settled in your current home, this is a pretty big problem and would likely make an FHA loan unappealing.
Or perhaps your spouse isn’t too keen on the idea. Or perhaps you have a family and living in a duplex or fourplex just doesn’t make a lot of sense to you.
In such cases, you could still take advantage of an FHA loan to get good financing on a house. Unfortunately, you wouldn't be able to take full advantage of it with a multifamily property.
2. Somewhat Tedious Approval Process
Whenever you deal with the government, there are going to be some hoops to jump through. As such, FHA loans are more arduous than conventional financing and don’t have as much flexibility.
For example, a bank might be able to get you approved for a conventional loan with only one year of employment history. However, two years are required to be approved for an FHA loan.
So, if you do plan on using an FHA loan to buy a property, you should make sure to get approved for it in advance.
3. Mortgage Insurance
In my opinion, the worst part about FHA loans is the mortgage insurance. Any loan that is financed over 80 percent of the property's appraised value will require mortgage insurance, which simply insures the lender for losses because such high LTV loans are obviously riskier.
Mortgage insurance in general usually adds 0.5 to 1 percent of the loan's balance to your payment each year. FHA loans specifically now cost 0.85 percent of the loan for the life of the loan (if the down payment is under 5 percent). So, for a $100,000 loan, the PMI would amount to $850 per year, or $70.83 per month.
Since a $100,000 loan at 4.5 percent interest amortized over 30 years would cost $507 per month, this adds almost 14 percent to each payment for an effective interest rate of about 5.65 percent.
FHA loans also generally come with a few extra fees over conventional loans.
While FHA loans are not without their downsides, they still present a great opportunity, particularly for new investors. Anyone with a job who is looking to get into real estate and doesn't have a lot of capital to begin with should seriously consider using an FHA loan to get started.
What else can I tell you about FHA loans? Do you think they’re a good option for first-time home buyers? Why or why not?
Let me know in a comment below.