Understanding FHA Loans

Among your many loan options are FHA loans. They are a common choice for borrowers that don’t qualify for conventional (traditional) financing.

FHA loans have a bad reputation, but they are one of the most flexible and easy to use programs for first-time homebuyers and subsequent homebuyers. Although this loan program is not meant for the purchase of a rental property… as you will see, it is possible.

What are FHA Loans?

FHA loans are a government-backed program. The Federal Housing Authority oversees the loan program, allowing lenders to offer flexible guidelines for loans, making it easier to qualify for a home loan.

FHA loans are for borrowers who don’t qualify for conventional financing because they don’t have a great credit score, or their debt ratio is too high. The FHA guarantees the loans by paying the lender back if you default.

The FHA sets guidelines for the loan program that lenders must follow, but some lenders also add more requirements to it to further decrease the risk of default.

Who Offers FHA Loans?

FHA loans are offered by FHA-approved lenders. You don’t have to go to the FHA, and you never even deal with them when you apply for an FHA loan.

Most large lenders and banks offer FHA loans, as do some smaller banks. If you think you need an FHA loan because of your qualifying factors, ask the lenders you apply with if they offer FHA financing.

It’s a good idea to shop around with at least 3 lenders even when you find an FHA lender too. Each lender has different qualifying requirements and charges different interest rates and fees. Getting quotes from three lenders will give you the option to comparison shop and choose the most affordable option.

Who is Eligible for an FHA Loan?

You don’t have to belong to a specific group or even be a first-time homebuyer to get an FHA loan. Anyone that meets the qualifying requirements (more in the next section) can get FHA financing.

That being said, the program is great for people with less than perfect credit, coming off a bankruptcy or foreclosure, or with a higher-than-average debt-to-income ratio.

It’s also great for first-time homebuyers, which is why it’s often called the first-time homebuyer’s loan. Its flexible guidelines and low down payment requirements make it a great option for those who haven’t owned a home before. 

How to Qualify for an FHA Loan

It’s easy to qualify for an FHA loan. Here’s what you need:

• Minimum 580 credit score
• Maximum 43% – 50% debt-to-income ratio
• Stable income for the last 2 years
• No recent bankruptcies or foreclosures
• At least 3.5% to put down on the home

These are the basic qualifying requirements for an FHA loan. Like we said earlier, some lenders have different requirements. 

There is also the opportunity to secure financing with a credit score as low as 500. Not all lenders will allow this, but if they do, you must make a 10% down payment instead of a 3.5% down payment.

Down Payment Funds for an FHA Loan

FHA loans require a down payment of 3.5% – 10%, depending on your qualifying factors. Typically, the down payment and closing cost funds must come from you, but there are exceptions.

If you have a 620+ credit score, you may be able to use gift funds for the entire down payment. Gift funds are money you receive as a gift, not a loan, from a close family or an employer. The funds you receive should not require repayment and they must be tracked.

Receiving Gift Funds

If you receive gift funds, your lender must track where they came from to ensure they aren’t a loan or repayment is expected.

It’s best to work with your loan officer to know the lender’s requirements for tracing gift funds, but in general, here’s what they expect.

• The donor must prove the origination of the funds. If they take the funds from their checking account, for example, they must provide their last 2 months of bank statements. This proves that the money is from their account and not borrowed.
• You must prove receipt of the funds. When the donor gives you the funds, make sure it’s in a traceable form, such as a check that you deposit at the bank. Keep a copy of the check and the deposit slip when you deposit the funds.
• Provide the lender with a copy of your bank statement showing the deposit as well. 
• The donor must provide a gift letter. The letter must state that the funds are a gift, and no repayment is expected or required. The letter should also include your name, the address of the property, and the amount of the gift to the penny. The donor should sign and date the letter.

What about Mortgage Insurance?

The one reason FHA loans have a bad reputation is the mortgage insurance charged. The mortgage insurance protects the lender should you default on the loan and is the reason the FHA allows such flexible guidelines.

The downside of mortgage insurance is you pay it for the life of the loan. The annual mortgage insurance is equal to 0.85% of your outstanding loan balance. As you pay your principal balance down, the amount you pay to insurance drops, but you’ll continue to pay it until you no longer owe money on your mortgage.

In addition to the annual mortgage insurance, all FHA borrowers pay upfront FHA mortgage insurance. This is equal to 1.75% of the loan amount.

For example, if you borrow $100,000, you’d pay $1,750 in upfront mortgage insurance. This is a one-time fee that you pay unless you refinance into another FHA loan, then you’d pay it again. 

Pros and Cons FHA Loans

Like all mortgage loans, there are pros and cons to FHA loans you should know.

Pros:

• Flexible underwriting requirements

FHA loans are great for borrowers with less than perfect credit. You don’t need a high credit score or even a low debt-to-income ratio. You can qualify for a loan as long as you can prove you can afford the loan and have the money to put down. 

• There aren’t any income limits.

Some government programs have income limits, meaning if you make too much money, you don’t qualify. This isn’t an issue with FHA loans. You can make as much money as you want and still qualify.

• FHA loans have competitive interest rates

FHA loans and conventional loans have similar interest rates. Even though you pay mortgage insurance to have the loan, the interest you pay will be along the lines of what you would have gotten for a traditional loan.

Cons:

• You pay mortgage insurance for the life of the loan

Unlike conventional loans, you can’t cancel your mortgage insurance once you owe less than 80% of the home’s value. The mortgage insurance amount decreases each year as you pay the balance down, but you’ll always pay it.

• FHA loan limits are low

The FHA loan limits vary by county and are low in certain areas. The limits are based on the current conforming limit ($647,200) and the average cost of a home in the area. Some areas can see much lower limits than $647,200, which can make it hard to buy the home you want.

• FHA loans have strict property standards

The property must pass certain standards, which are slightly tougher than traditional loans. The home must be safe, sound, and sanitary which isn’t unreasonable, especially for first-time homebuyers, but it can make it a little more difficult to find a property.

FHA Owner Occupancy Requirement

FHA requires that the property being financed must be owner occupied. So, that generally excludes single family rental properties from being purchased. The purpose of this requirement is to prevent investors from benefiting from the program. However, as you’ll see, there are specific cases where a rental property can be purchased, especially in the case of multi-family units.

According to FHA guidelines, the borrower must take possession of the home within 60 days after the mortgage closes and must use it as their prinicipal residence for at least one year. The FHA loan is makde through FHA-approved lenders, such as banks or other financial institutions… which can impose some additional requirements in order to fund the loan.

Financing an Owner Occupied, Multi-Family Investment Property / Apartment Building with an FHA Loan

It is possible to buy a multi-family income producing property with an FHA loan, as long as one of the units is owner occupied. The FHA allows the purchase of up to a four unit multi-family property with the stipulation that one is occupied by the owner. The remaining units make the building an income producing rental property.

So, if you’re willing to purchase a multi-family investment property (two, three or four units) and live in one unit while renting out the others, an FHA loan may work. FHA can lend up to 96.5% of the appraised value, which means the purchaser can put down as little as 3.5%. That’s a very low downpayment, usually unheard of in the traditional rental property investment financing world.

Some Exceptions that allow for FHA Loans to Continue on a Property that Becomes a Rental

There are some situations that may allow you to turn your owner occupied property into a rental investment property. As long as you’ve satisfied the one year occupancy requirement, then special situations, like job relocation or a family that has outgrown the size of their FHA financed home, may potentially allow you to turn your the home into a rental property.

Even if the property is turned into a rental and no longer owner occupied, you may still have the ability to re-finance into a new FHA loan if interest rates drop, through the FHA streamline refinance program. There are a number of criteria and requirements that need to be satisfied, so check with the program and lenders… the the point is that it can be done in certain cases.

Key Takeaway

FHA loans can be a great way to buy a property when you don’t qualify for traditional financing. There are limited situaitons where an income producing rental property can be purchased, or a property with an existing FHA loan can be converted into a rental property. For the flexible, creative thinking investor who also needs a primary residence, attractive competitive interest rates, low downpayments and relatively simple qualifying guidelines may help you get an owner occupied investment property with attractive financiang terms.