You can get a Federal Housing Administration (FHA) loan for rental property. However, the government does not want investors to use these loans.
- You can get an FHA loan for some small rental properties, but there are strict requirements you must follow.
- There are serious consequences for renting a property fraudulently if you have an FHA loan.
- A limited liability corporation (LLC) can get an FHA loan, but there are strict guidelines you must follow.
The main thing to remember is that the FHA wants you to live on the property. If you plan to make a home there for at least a year, then you should have no problems.
Can You Use an FHA Loan for Rental Property?
An investor can use an FHA loan for come rental properties. However, the government places conditions on the loan that dissuade investors from wanting the loan. They require you to live there, and they restrict the number of units on the property. Carefully weigh the benefits against the drawbacks of using this type of mortgage.1
FHA Loan Pros and Cons for an Investor
Because the government never intended these loans for investment properties, why would an investor want such a loan? There are good reasons, but the restrictions make it practical only for certain circumstances.
Basic Requirements for FHA Loans
The financial requirements to get an FHA loan are lower than conventional loans. That is why both residential home buyers and investors want them.
- Your credit score must be at least a 500, and you need to put 10% down.
- With a credit score above 580, you only must put down 3.5%.
- The lender requires mortgage insurance for the life of the loan.
- Your debt-to-income ratio must be below 43%.
- It must be your primary residence for one year.
- You must have proof of employment with a steady income.
In addition, the property can have no more than four units. Since you must live in one, you can rent the other(s). While these conditions are favorable for investors, they also present significant challenges.2
Benefits of Using an FHA Loan for Rental Property
The benefits of using an FHA loan for a rental property are financial. For investors with low liquidity, these mortgages offer an opportunity to make a deal they may not be able to otherwise. Compared to conventional loans, the benefits are:
- Lower credit score requirements
- Lower down payment requirements
FHA loans lower the two biggest hurdles for small or inexperienced investors. Since the threshold credit score for conventional investment loans is high, many would-be investors either fail to qualify or cannot afford the high interest rates charged. As for the second hurdler, most new and/or small investors simply cannot afford to put down 20% on a rental property. 20% on a $400,000 property is $80,000. However, with reasonably good credit an investor only needs to put down 3.5%, or $14,000, with an FHA loan.
Drawbacks of Using an FHA Loan for Rental Property
While the financial benefits of using an FHA Loan for a rental property are significant, most investors cannot or do not want to use these loans because they have significant restrictions.
- It must be your primary residence for at least one year.
- The property can have no more than four units.
- You must pay mortgage insurance premiums for the life of the loan.
These conditions impact your profitability. Mortgage insurance premiums may not seem like a big deal, but they are. They add enough to your monthly bills that you may not be able to earn profits. In addition, with a conventional loan this drops off after you reach 20% equity, but that is not the case with FHA loans. In order to get rid of the mortgage insurance, you must refinance or pay off the loan.
The primary residence condition also greatly reduces your income stream for the investment. A single-family house will not generate any income for at least one year. A fourplex can only generate ¾ of its potential income, a triplex only 2/3, and a duplex only half.
Therefore, these conditions necessitate that the income potential must be very high. Such high-income potential often gets the attention of other investors who can use conventional loans.
Can I Get an FHA Loan for an Apartment Building?
You can get an FHA loan for an apartment building with four units or fewer. Therefore, a large apartment building is out of the question. However, a fourplex may be a great investment for a new real estate investor to get started.
Can I Buy a Fourplex with an FHA Loan?
You can buy a fourplex with an FHA loan, but you must live in one of the units for at least one year. Fourplexes are great niches for small real estate investors who want to use FHA loans. They are big enough that there is still income potential while meeting the primary residence requirement. At the same time, they are small enough that big investors may overlook or not want them.
What Happens if You Rent Your FHA Home?
What happens if you rent your FHA home without using it as your primary residence for at least one year? In this case, you commit mortgage fraud. This type of fraud carries serious penalties because banks set their rates based on risk, and investment property mortgages are much riskier than residential loans.
Penalty for Renting FHA Home
There are serious penalties for renting an FHA home if you lied on your mortgage application. If you never intended to live in the home, it is mortgage fraud, and this crime has serious consequences, which include:
- The bank declares breach of contract and demands that the borrower pays the loan in full.
- Penalties and fines
- Jail time
It is easy for you to establish that the property is your primary residence, and banks do check.3
Does FHA Check Owner Occupancy?
It is more likely that your bank checks owner occupancy, but don’t rule out the government auditing you either. Your insurance company may also check to see if you occupy the property as your primary residence. As we stated before, this is a common and serious crime. Therefore, organizations that have a stake in the loan are likely to audit you and make sure that you really are living at the house for at least a year.4
Can an LLC Get an FHA Loan for Rental Property?
An LLC can get an FHA loan. However, you must follow the same requirements listed earlier together with some other rules. You must:
- Be a sole proprietor, partnership, LLC, or S-corporation.
- Own 25% or more of the business.
- Have two years experience as a business owner or prove industry experience in other ways.
- Provide two years of tax returns and/or a profit-loss statement.
The bank will probably also pull your credit report. Remember, even though the LLC owns the property, it does not mean that the bank will not check owner occupancy. Since you own the LLC, you must live there as your primary residence. That requirement does not go away.
Final Thoughts on FHA Loan for Rental Property
An FHA loan for rental property may be good for a new investor without much cash. If you are just starting out investing in real estate and you do not have much cash it may be your only option. If you do this then make sure you run the numbers and double-check them to make sure you can live in a unit and still have positive cash flow. The other type of investor who should think about FHA loans are people who want to live in a unit permanently and use the property for supplemental cash rather than a business.
On the other hand, if you have liquid assets, want to invest in larger properties, and/or want to maximize returns then FHA loans are not for you. The government specifically made the requirements to discourage investors from using these loans.