Buying your first property using an FHA loan
A home or property for that matter, is an expensive object. Many people do not have enough cash to buy a home outright which means they will need to finance it. In the world of real estate, there are many different ways to finance a home. Traditional bank mortgage loans, federal government offered loans, HUD loans, private money loans, and seller financing are a few of the many ways to finance a property purchase. Each of them have their benefits and drawbacks but I want to dive into one specific type of loan and explain how it can be used to accelerate an individual’s ability to build wealth in real estate. The FHA loan or Federal Housing Authority’s fed backed loan program is the one we will be taking a look at in this post.
What is an FHA loan?
The first point I’d like to clear up is that the FHA loan is not a first time home buyer loan. The FHA stands for “Federal Housing Authority” and not “First-time Homebuyer Association” or whatever people confuse the abbreviation to be. There are rules and conditions that must be met but the main advantage to the FHA loan that makes it powerful is leverage. Leverage is the ability to put down a small amount of money as a downpayment in order to control an asset worth much more. With a traditional home loan, one would need to put down 20% to make the purchase. Say for example, if a house costs $500k and the down payment is $100k, you would be using 100k to leverage a 500k purchase. The property can be rented to generate income or be improved to increase its value, but you only need 100k to be able to purchase it.
The FHA loan allows a buyer to use maximum leverage since you only need to put down 3.5% to buy that same $500k house. Instead of $100k one could choose to put down $17,500 instead.
Why put down less money?
Now this does mean the monthly mortgage payment will be higher but when executed properly, your ROI can also be much higher. If you purchase the house for 500k, make some improvements for 30k and sell it for 600k, you would profit say $30k. With an FHA loan you only had to put down $17,500 to make $30k vs. putting down 100,000 to make the same $30k.
Another reason the FHA loan is powerful is that, with little money down, someone can buy a home much sooner than it would take to save 20%. Saving 18k vs. 100k is a difference worth many years of saving money aggressively for the average person. In the time it would take to save the 20%, you are most likely missing out on appreciation that takes place over time. If it takes you 3-5 more years to save for a $500k home, the property may be worth $600k by the time you are ready to afford it. Additionally, you miss out on the equity gains from appreciation and loan pay down for those few years on the sidelines.
Types of properties to finance with FHA
Since FHA loans will leave you with little equity at the time of purchase, it’s important to not overpay for a property. If the market has a downturn and you owe more on the property than what it’s worth, it is not an ideal situation to be in. Because of this, I would advise not buying properties that are brand new at retail or not income generating in any way.
Properties that make good candidates for FHA loans are ones where it’s possible to increase the value with “sweat equity” or improvements and updates. Other properties include ones in rapidly appreciating areas or properties that are income generating by renting out other rooms or units.
With an FHA loan, one can purchase a condo, single family home, or a two to four unit multi-family since those are still considered residential properties. Multi-family homes cost more than single family but since a unit or two could be rented, it can offset the cost and thus increase how you leverage the deal.
If you are on the younger side and want to have roommates for a couple years, a single family with three or more bedrooms can be a great choice. Having two rooms rented out even if it’s only for a year can help significantly with your finances. I used this approach and after my experience of having two or three roommates for a couple years I can share some insight on how to do this properly in another post: How to househack a single family home.
FHA loan rules
Okay so you can put down less money with an FHA loan. In doing so, there are certain rules that one must abide by in order to use the loan. You want to follow these rules since you can technically get into trouble for mortgage fraud. This can set you back financially and will make it hard for you to find lenders in the future, so be cautious with the decisions you make doing this.
The FHA loan is an owner occupied product meaning the person using it intends to occupy the property as their primary residence. Because of this, one cannot purchase a vacant home and immediately use it as a rental property. You can immediately rent out other rooms or units however. The occupancy rule is not for the life of the loan but only for the first year of ownership. After year 1, the owner can rent his or her unit and move out of the property.
There are slightly different rules for 3 and 4 family homes which need to pass an analysis test. For a 3 family to be approved for an FHA loan, the income of two units rented must be able to pay the entire mortgage in order to get approved for the loan. Similarly with a four family, three of the four units rented must be able to pay for the entire mortgage otherwise FHA will not approve the loan.
A common misconception is that you can only use an FHA loan one time. The FHA is not a first time home buyer loan product and you can use one again after using both an FHA or conventional. The stipulation is that you can only have one FHA loan open at a time. If you want to finance with FHA for another property, the prior FHA property will have to be refinanced to conventional or paid off and closed out.
PMI is another component to an FHA loan that is overlooked by many. PMI stands for private mortgage insurance and is mandatory when putting down less than 20% for a down payment. The insurance is not for you but rather to protect the bank if you stop making payments on the property. The PMI is typically 1-2% of the sales price of the home each year. The PMI is factored into the monthly mortgage payment but it can eventually be removed if one of two things happen; you attain 20% equity in the property or you refinance out of the FHA loan to a conventional where there is no PMI. Sometimes contacting the bank and having an appraisal will speed up the 20% equity mark to get out of the PMI.
Who can use an FHA loan?
In order to qualify for an FHA loan, an individual must meet specific criteria although it is not too challenging. Most people who are financially stable should be able to use FHA without any issues. The credit score requirement is 580 or better any many should strive to have a credit score above 700. If you want to improve your credit score there are some tips I can share with you regarding this topic here.
With most home loans, you need to show consistent employment history and income earned at your job. Lenders will ask for pay stubs and sometimes contact your workplace to confirm this information. There are no income limits to the loan so earners on the higher end are not pushed away from it.
You can use an FHA loan to purchase your first property but you can also use one to purchase more properties after the first. If you are single or married, you can also use one. If a couple is not married yet, they each have an FHA loan that can be used if both parties are willing to buy their own properties in their individual names.
Closing on a property
When purchasing a property using an FHA loan, the home must be livable and functioning to an acceptable standard. There is an FHA inspection that is performed prior to closing on the property. The inspection is not as thorough as a home inspection but it checks to make sure the heat works, the toilets flush, the roof doesn’t leak, and the home is safe to inhabit.
Since the inspection can slow down the closing process, the buyer must work diligently to make sure all actions are completed in a timely manner. Sellers can sometimes be hesitant to work with an FHA buyer so it is important to instill confidence that you will be able to move quickly once an offer is accepted. Over 30% of homes are purchased with an FHA loan in today’s market so these procedures should be understood by real estate professionals you would be working with.
