Investing in real estate
Investing in real estate is an attractive investment as it is less volatile and less risky compared with the stock market. But unlike the stock market units of investment, that is house prices, are very large compared to the cash most of us have handy. Naturally most people use mortgages to buy real estate. This makes investment in real estate even more attractive as you can pay for the house by a mortgage and pay the mortgage using rental income from the house itself. But there is a small complication.
Taking out a loan to buy your primary residence is quite easy as the government wants people to be home owners; thus it has created non-conventional mortgage programs including Federal Housing Administration (FHA ) guaranteed loans, Department of Veteran Affairs (VA) guaranteed loans, and US Department of Agriculture (USDA) guaranteed loans. In addition if you have a history of honoring your debt and have a reasonable saving for your down payment conventional mortgages are suitable options.
When it comes to buying an investment property government backed loans are of no use as they are limited to buying primary residences. Government wants people to be homeowners and not necessarily landlords. When it comes to conventional loans, private lenders know that in difficult times people prioritize keeping their main residence over keeping their investment property. That is to say they know the risk of default is higher when it comes to investment properties compared with primary residences. So in lending for an investment property a lender would require both a higher credit score and a higher down payment. A down payment of greater than 30% which is typically required for investment properties is difficult to come up with for most of us. To make this even more difficult, without having documented experience as a landlord, you cannot count on your rental income for paying your mortgage.
Buying a multi-unit property with an FHA insured mortgage
The way out of this conundrum is a multi-unit property. That is a duplex or a triplex or even a four-plex. Note that a building with more than 4 units is considered a commercial property and has different mortgage rules. As long as the owner resides in one of the units of this multi-unit property, FHA considers the property as owner occupied and its purchase can be qualified for the FHA mortgage program. To make the situation even better, according to FHA rules and requirements, you are able to use 75% of the appraised value of rent you will receive from the other unit in a duplex as income in calculating your debt to income (DTI) ratio. 25% of the potential rental income is assumed to be lost to vacancy or used by necessary repairs.
The qualification rule for buying a 3-4 unit property is different from 1-2 unit properties. For a 3 or 4 unit property to qualify for an FHA mortgage it must pass a “self-sufficiency test”. Self-sufficiency is achieved if 75% of the appraised rent of all units can cover mortgage payment for this property. This mortgage payment includes payment for principal and interest together with taxes and insurance.
Thus instead of taking out a conventional mortgage and buying a single family home, you can accept the slightly higher insurance premium charged on an FHA loan to buy a multiplex. The price for a duplex would be higher than a comparable single family unit but the duplex price would not be even close to twice of a comparable single family unit price. Similarly a triplex costs more than a comparable single unit home but far less than 3 times its price. So generally by buying a multi-unit property you get more value for your money.
The amount you can borrow with an FHA loan will depend on the county where the property is located and also on the property type. In most counties in the US the maximum FHA loan you can take is determined by the FHA floor given in the third row of the table below. The maximum you can borrow in the high cost areas of the US is given by the FHA ceiling in the fourth row of the table below.
| FHA loan limits | ||||
| Single | Duplex | Tri-plex | Four-plex | |
| Low cost areas | $420,680 | $538,650 | $651,050 | $809,150 |
| High cost areas | $970,800 | $1,243,050 | $1,502,475 | $1,867,275 |
These values are for 2022 and they are updated each year. Note that the maximum FHA loan for your county might be a value between the above mentioned floor and ceiling values. It depends on the median house prices in your county. You can find out the maximum FHA loan value for your county here. Other conditions which should be mentioned in relation to FHA loans are as follows:
- If you have a credit score of 580 or higher you can make a down payment as low as 3.5%. You can qualify for a mortgage as long as your credit score is higher than 500, but with a credit score below 580 you would need to come up with at least 10% down payment.
- You should be able to repay your loan. To establish your ability to repay the loan your lender would require you to document the stability of your income and employment.
- To further establish your ability to repay the loan, your lender would need to check that your debt to income ratio (DTI) is below 45% after buying this property.
Once again note that, you are buying this house as your principal residence. So you must move in after closing of the sale. You should live in this house for at least one year. After a year you can move out if you have a compelling reason to move. Like if your place of employment has changed to a location which is reasonably beyond commuting distance or if your family is growing and this growth necessitates having more living space.
