FHA loans are one of the absolute best ways to get started in buy-and-hold real estate. They’re a particularly great place to begin for “save-and-hold” investors, as they can finance 96.5% of the price of a deal at very low interest rates for a homeowner’s property. What’s even better is you can finance up to a fourplex. So, why not buy a fourplex, live in one unit, and rent out the other three? That’s a great strategy for first-time homebuyers.
Here’s what you need to know, including FHA loans pros and cons compared to conventional loans.
Are you ready to invest?
One of the most frequently asked questions in the BiggerPockets forums is “How can I start investing in real estate with no money and bad credit?” The answer? You shouldn’t. You need to fix your situation and invest from a position of financial strength.
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 US government agency. These mortgages are insured by the FHA, and require only 3.5% down. They are usually amortized over 30 years, and the interest rate is also quite low, which is appealing to borrowers.
In addition, if the property needs a rehab, the FHA 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, the FHA loan limits will increase to $822,375 from $765,600. (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-to-income ratio
- Two years’ employment
- Owner-occupied property
However, there are a few other guidelines lenders must follow… 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% instead of 3.5%.
And while FHA loans are great, you have to decide if they make sense for you and your unique situation. Now let’s go over the difference between FHA loans and conventional loans
FHA loans vs. conventional loans
An FHA loan can be easier to qualify for than a conventional home loan. Compared to conventional loans, FHA loans don’t require high credit scores and allow for a lower down payment. That can make them more approachable for investors.
However, there are downsides. The process of getting approved for an FHA loan is quite tedious compared to the process of getting approved for a conventional loan. They also have a lower monetary limit than conventional loans.
In order to determine if a FHA loan is right for you, let’s first look at the pros.
Pro: Great interest rate
You are almost always going to find better interest rates for owner-occupied properties than investment properties. Your house, for example, may have an interest rate of 3.125% while your investment properties may have interest rates between 4% and 4.5%.
And FHA loans usually beat out other conventional loans as well. While interest rates have risen over the past few years, Mortgage News Daily estimates an FHA loan will come in at 3.5% while a conventional 30-year mortgage for an owner-occupied home will be around 3.125%. With today’s record-low rates, mortgage payments for both loan types will be exceptionally low—and regardless of the prevailing rate, FHA loans will still be affordable.
Pro: High loan-to-value ratio
Because real estate is so expensive, it’s hard to keep large cash reserves—at 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% 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 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?
Pro: You can buy up to a fourplex
FHA loans can be used on houses or anything up to a fourplex, as long as the property is your primary residence. You could buy the property and live in one unit and rent out the others, aka house hack.
That way, you can 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 to build you long-term wealth.
Pro: You don’t need a high credit score
While good credit always helps you qualify, FHA loans usually don’t require high credit scores. Applicants are required to have a minimum credit score of 580 to qualify for low down payments of 3.5%. As stated before, if you have a lower credit score than 580, you can still qualify. You will just have to put down a higher (10%) down payment to do so.
Pro: Required down payments are low
Unless you’re a first-time home buyer or you make more than 80% of the median income in your area, you will have to pay 5% down for a conventional loan.
For an FHA loan, that amount is much less. Those seeking an FHA loan with a credit score of at least 580 can secure 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 also downsides. The biggest disadvantages to FHA loans are as follows.
Con: 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 or prefer living in a single-family home, this is a problem and would likely make an FHA loan unappealing. 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.
Con: 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 have less 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. If you do plan on using an FHA loan to buy a property, you should make sure to get approved for it in advance.
Con: Strict inspection process
To purchase a home as an FHA buyer, there is at least one mandatory FHA inspection that must be completed by the lender before closing on the property. There are a number of minimum property standards that can cause a property to fail an FHA inspection, including water damage to the home and missing tiles on the roof.
FHA loans are different from the standard home inspection as the inspector is required to go by the FHA’s requirements. And their list of requirements is exhaustive. If the home you’re buying doesn’t check all of their boxes, your loan could be denied unless the seller makes the necessary repairs.
Con: Mortgage insurance
Any loan that is financed over 80% of the property’s appraised value will require mortgage insurance, which insures the lender for losses because such high loan-to-value ratio loans are obviously riskier. Fannie Mae and Freddie Mac are companies that can help with mortgage financing.
Private mortgage insurance, which a borrower may be required to have as a condition of a conventional mortgage loan, adds 0.5%–1% of the loan’s balance to your payment each year. FHA loans specifically now cost 0.85% of the loan for the life of the loan (if the down payment is under 5%). So, for a $100,000 loan, the private mortgage insurance (PMI) would amount to $850 per year, or monthly payments of $70.83.
Since a $100,000 loan at 4.5% interest amortized over 30 years would cost $507 per month, this adds almost 14% to each payment for an effective interest rate of about 5.65%.
FHA loans also generally come with a few extra fees, like closing costs and mortgage insurance premiums, over conventional loans.
Con: Looks bad in bidding wars
Because FHA loans don’t require high credit scores, some sellers look down upon them. They may think 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 requirements for appraisals and inspections, which could mean that financing falls through if a property doesn’t meet their requirements. Buying a home with an FHA loan can look like a risk instead of a sure thing.
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.