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 580 but is still above 500, you may still qualify for an FHA loan with a high down payment amount of 10% or more.
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.
- An FHA loan is a great option for multifamily investors that are open to living in one of the units (potentially rent free)
Some of the cons of choosing an FHA loan to finance an investment property include:
- An FHA loan limits yare lower than conventional loan limits
- 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, but still needs to meet the requirements set forth by government sponsored entities such as Freddie Mac and Fannie Mae in order to be sold on the secondary market.
Conventional loans usually offer the best rates and terms, but come with stricter income and credit qualifications than an FHA loan. However, acquiring an investment property through a conventional loan is more straightforward and does not require you to live in the property for a certain amount of time.
Most conventional lenders require a credit score above 620 to qualify for a conventional mortgage, although some may require a score above 640. Premium mortgage insurance (PMI) is required for conventional borrowers providing less than 20% down payment.
Finally, lenders are looking for a lower DTI ratio for a conventional loan to ensure that a borrower is not overextended and can cover their new monthly mortgage payment.
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.
- Buying an investment property through a conventional loan is more straightforward.
- 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.
- Conventional loans will require a higher down payment for investment property purchases
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:
- Non-QM Loans are commonly used by real estate investors that do not meet the income and credit requirements of a conventional or FHA loan. Non-QM lenders set their own requirements which allows for more flexible underwriting and alternative forms of verifying income. This is a great option for borrowers that are seeking permanent financing but have trouble verifying their income due to being self employed or a foreign national. Additionally, luxury investors that require large loan amounts, known as jumbo loans, can also benefit from a non-QM loan.
- Bridge loans are short-term loans 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 3 years in length and are more flexible than traditional financing options. They are a common option among foreign investors and luxury condo buyers that require quick funding due to their financing fall through at the last minute, contractual obligations and/or to avoid losing their deposits.
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 or purchase a multifamily and live in one of the units. If you are looking for more of an immediate investment, you may want to consider a conventional loan or other types of loans like non-QM loans and bridge loans from reputable lenders like Vaster
- FHA Loan: What to Know - 2021 Guidelines | Nerd Wallet
- What Is a Conventional Loan? | Experian
- Home Equity Loans and Home Equity Lines of Credit (HELOCs) | Investopedia