It seems like everyone is trying to get into real estate investing these days. With such a hot real estate market, it’s not hard to see why. However, getting into the real estate game without any knowledge can be quite challenging. For instance, what type of loan is best for your investment property? Odds are that you have heard about both FHA loans and conventional loans so let’s discuss each one to determine which one is better for financing an investment property.
What Is an FHA Loan?
An FHA loan is a mortgage loan that is backed by the federal government through the Federal Housing Administration (FHA). FHA loans are issued by FHA-approved lenders. While you’re not getting your mortgage loan directly from the government, they guarantee it thereby making it less risky for the lender. In the event that you default on your loan, the FHA pays a claim to the lender.
FHA loans are designed for low-to-moderate-income borrowers. This type of loan is especially ideal for first-time homebuyers as it allows you to borrow up to 96.5% of the value of the home. You will need to make up the rest of the 3.5% through a down payment that can come from savings, a gift from a family member, or a down payment assistance grant.
Additionally, your credit score needs to be above 580 in order to qualify for a 3.5% down payment. If your credit score is less than 58 but is still above 500, you may still qualify for an FHA loan with a high down payment amount of 10%.
In exchange for guaranteeing your loan, you are required to pay an additional amount each month for a mortgage insurance premium (MIP). The annual amount for your MIP depends on your original loan amount and original down payment percentage. For instance, if your original loan amount was less than $625,000 and you paid more than 5% for your original down payment then your annual MIP percentage will be 0.80%.
Finally, you are required to pay a separate MIP of 1.75% of the loan amount when you close on your loan. Although you don’t have to pay MIP throughout the entire lifetime of your loan, it’s not automatically canceled. Instead, you have to refinance out of paying MIP once you have reached 20% equity in your home based on its current value.
What Are the Pros and Cons of an FHA Loan for an Investment?
Like any loan type, there are both pros and cons of going with an FHA loan for an investment.
Some of the pros of choosing an FHA loan to finance an investment property include:
- An FHA loan is a more accessible option for buyers with lower income, lower credit scores, and lower cash reserves for a down payment.
- An FHA loan is a better option for buyers with a debt-to-income (DTI) ratio above 40%.
- An FHA loan is a good option if you have filed for bankruptcy within the past four years.
Some of the cons of choosing an FHA loan to finance an investment property include:
- An FHA loan limits you to homes priced less than $314,827 in most parts of the United States.
- An FHA loan requires you to pay both upfront and annual mortgage insurance that can substantially increase your mortgage payments and associated closing costs.
- An FHA loan has strict requirements wherein the home must meet strict safety and livability guidelines in order to qualify.
- An FHA loan requires you to live in the purchased home for at least one year after closing and cannot be used for second homes or rental homes.
What Is a Conventional Loan?
A conventional loan is a mortgage loan that is issued by a lender and is not backed by the federal government. Since lenders are taking on all the risk themselves, they often come with stricter requirements that are harder to meet. That being said, many conventional loans end up being purchased by the federal entities Fannie Mae and Freddie Mac to boost lenders’ liquidity and help stabilize the mortgage market.
FHA loans are designed for more established buyers. A down payment of 20% of the home’s value is recommended if you wish to avoid paying private mortgage insurance (PMI). PMI usually costs between 0.5% and 1% of the mortgage annually and is included as part of your monthly mortgage payment. In many cases, PMI automatically drops off once you reach 22% equity in the home.
Most lenders require a credit score above 620 to qualify for a conventional mortgage, although some may require a score above 640. In order for your loan to conform to federal standards, the maximum loan amount for a single-family home in lower-cost areas is $484,350. For higher-cost areas, the maximum loan amount for a single-family home is $726,525.
Finally, lenders are looking for a lower DTI ratio for a conventional loan to ensure that you’re not spending all of your money paying off debts. Generally speaking, you should pay no more than 36% of your gross monthly income on debts (including car loans, student loans, credit cards, etc.) and no more than 28% of those debts should be housing-related.
What Are the Pros and Cons of a Conventional Loan for an Investment?
Some of the pros of choosing a conventional loan to finance an investment property include:
- If you have a down payment above 20%, you aren’t required to pay extra PMI with a conventional loan.
- Conventional loans are considered more competitive in a crazy housing market.
- Conventional loans often offer lower interest rates than FHA loans.
- Conventional loans often offer higher loan limits than FHA loans.
- Conventional loans offer more flexibility in terms of your property. For instance, you do not have to make it your primary residence.
Some of the cons of choosing a conventional loan to finance an investment property include:
- Conventional loans may still involve extra costs through PMI if you are not able to make a down payment above 20%.
- Conventional loans are harder to qualify for in terms of income, credit score, and debt-to-income ratio.
- Conventional loans require more paperwork and documentation since the lender is taking on all the risk.
3 Other Types of Loans to Consider for an Investment
Now that we have discussed FHA loans and conventional loans, it’s time to talk about three other types of mortgage loans you may want to consider for an investment:
- Bridge loans are used to get you to the closing table as quickly as possible while you secure long-term financing. They typically have terms of less than one year in length although they may be extended beyond that time. Bridge loans are more flexible than traditional financing options and are a great fit for foreign investors who may not have documented tax returns or income statements. Bridge loans typically offer interest rates between 7.5% and 10%.
- Hard money loans are a quick loan option for an investment but you will pay for speed with high interest rates that may range from 7.5% all the way up to 15%. Hard money loans are ideal for short-term fix-and-flip projects that only span a few months since you’ll want to pay back your loan as soon as possible to avoid paying thousands more in interest. Hard money loans are pretty easy to qualify for since lenders will be able to get their money back whether you can pay or not since you sign over the property in question as collateral.
- Home equity loans allow you to take out a loan based on the equity that you have built up in your home. Most lenders will allow you to borrow up to 80% to 85% of your home’s equity so long as you have a minimum of 15% to 20% equity in your home. These loans typically offer lower interest rates but may be slower and have more restrictions than other types of loans.
FHA Loan vs. Conventional Loan: Wrap Up
As you can see, an FHA loan isn’t really ideal for an investment property as this type of loan is meant for financing primary residences rather than investment properties. That being said, you can still rent out the property and turn it into an investment property after living in it for one year. If you are looking for more of an immediate investment, you may want to consider a conventional loan or other types of loans like bridge loans, hard money loans, or home equity loans from reputable lenders like Vaster Capital.
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