House Hackers! Six Things you Need to Know About FHA Loans

House Hacking is a great strategy to get started in real estate investing. The benefits are two-fold: you can benefit financially in several different ways AND you have the opportunity to learn what it is like to be a landlord. This experience is crucial because you have the chance to learn so many things about landlording, and it will help you decide if you want to continue down this path or not.

Not only are you offsetting your cost of living by renting out rooms or attached units on the property, but you’re also building equity by having someone else pay down your mortgage balance while simultaneously having market appreciation work in your favor. An added bonus: you can closely monitor your asset because you live there!

Many new investors see these advantages and want to find a way to get started. A common barrier is not having enough money to bring to closing to cover the down payment and all closing costs. New investors are frequently taking advantage of the FHA loan program (Federal Housing Administration). It is known for having low down payment requirements, which provides access to single family residences and 2-4 unit properties for many first time home buyers. Below are some important details that every investor needs to know if they plan on using an FHA lending program.

Down Payment

The most appealing feature of the FHA loan is the 3.5% minimum down payment requirement. What is even better is that the down payment can be 100% gifted. This means a family member or friend can give you money for your down payment, and typically the lender will only require a written letter acknowledging the gift money. Always be nice to your mother!

DTI and Credit Score

FHA loans allow high back-end Debt-to-Income (DTI) ratios typically up to 42%, but it’s possible to be approved up to 50%. If you’re planning on your down payment being 3.5%, then your minimum credit score needs to be 580. You can get a free copy of your credit report once a year from www.annualcreditreport.com.

Self-Sufficiency Test

For 3-4 unit properties, the FHA requires that the rent cashflow is equal to or greater than the mortgage payment. For example: Let’s assume you want to house hack a 3-unit complex. If your mortgage payment is $900, then the three units will need to gross at or over $900. Typically, FHA appraisers don’t use the rent figures that are provided by the seller (if any are provided). They resort to using local market values to determine what each unit would be, and they also factor in a vacancy rate into this calculation. Vacancy rates are pulled from HUD.gov. All of the units are factored into the rent revenue calculation, including the unit the borrower plans to occupy.

Mortgage Insurance Premiums

According to the FHA ruling, an application after June 3rd, 2013 will not be eligible for auto-cancellation of mortgage insurance premiums (MIP). Applicants opting for 3.5% down payment will be required to have MIPs for the life-of-the-loan or until they refinance into a conventional loan program. This is important to consider because the older regulations would allow for auto-cancellation after the mortgage balance reached 78% LTV based on original purchase price with a 5-year minimum requirement. Applicants prior to June 3rd, 2013 can remove their MIP and account for that in their investment decision making process. New applicants will need to factor in MIPs as a fixed cost in the mortgage payment.

Lower Interest Rates and Assumability

Typically, FHA loans provide lower interest rates, which will not only help the borrower during the payback period, but it will help them with resell value. In the event that interest rates rise to 8 or 10 percent, having a lower interest rate of 3 or 4 percent will provide the seller with leverage. FHA loans are “assumable”, which means a buyer can take over the payments with the same terms. If interest rate increase in the future, then having a low interest rate FHA loan will be an added benefit for a seller.

FHA Appraisals/Inspection

FHA Appraisals are more so designed to make sure the building is in good condition. Since the FHA loan is a government back mortgage, they require an approved FHA appraiser to ensure the property is safe and secure. They are looking for issues that are in plain sight or obvious hazards. With that said, be prepared to make cosmetic repairs or pay for them to be completed. If these repairs are not completed, then you will not be able to close.

Conclusion

The FHA loan is a great lending tool, especially for real estate investors that want to break into the game. The aforementioned items are some important details to know and understand when analyzing a potential house hack deal. It’s vital to consider all angles of a deal, and not just focus on one aspect. Cash flow is important, but having profitable exit strategies is arguably more important. That is why it is so important to know your lending products well. Hope this helps!