Looking to finance your first house hack? The good news is there are many options out there for house hacking. Some of the popular loan programs we will talk about for house hacking (owner-occupied rental investing) are FHA Loans, Conventional Loans, VA Loans, Soft Second Loans, and Alternative Loan Products.
One of the biggest hurdles people have to overcome when house hacking is finding the money to buy a multifamily property. Nearly all multifamily investment properties are purchased with some combination of equity and debt. The equity is the amount of money the person puts down as a down payment. The debt is usually a bank loan of some kind.
There are many ways to finance your first house hack. In this article, we take a look at various loan programs available to someone looking to start their house hacking journey – including the pros and cons of different options.
There are many kinds of multifamily properties, ranging from a two-family duplex to a 500-unit apartment complex. Someone who is house hacking is generally buying a two- or three-family home in which they live in one unit and rent out the other(s).
“Residential” vs. “Commercial” Loans
The financing options we talk about here today assume you’ll be buying a multifamily investment property with four units or less. In which case, you’ll be looking for residential financing. Buildings with five or more residential units, although still considered multifamily properties, will only qualify for “commercial” loans. Commercial loans are usually more expensive (and much more complicated!) than residential loans. But it is important to distinguish between these two types of loan products, since people often don’t realize that buildings with 5+ units are considered commercial property and are treated differently by lenders.
How to Get the Best Rate on Multifamily Financing
House hacking is truly the best way to get the best rate on multifamily financing. Owner-occupied 2-4 unit properties are eligible for the same kind of financing you might get if buying a single family home or condo. The bank assumes owner-occupied properties will be well cared for and maintained, and therefore, offer attractive financing alternatives compared to someone buying a multifamily home as strictly an investment. For example, banks typically require investors to put down 20-25% when buying a non-owner-occupied investment property (compared on as little as 0-3% down if owner-occupying – more on that to come).
In other words, to get the best multifamily financing, owner-occupy the property (at least in the short term). The rate and terms of your loan will be much better than if you were purchasing as an investment only.
House Hacking with FHA Loans
One of the biggest barriers to entry for those looking to buy investment property is their ability to come up with the down payment. As we mentioned above, banks require between 20-25% down for non-owner-occupied properties. If you were buying a duplex worth $300,000, that means you have to come up with at least $60,000 just as the down payment.
This is where house hacking with FHA loans comes into play.
If you owner-occupy a 2-4 unit property, most banks will allow you to put down as little as 3.5% using what’s known as an FHA loan. On that same $300,000 property, you’d only have to put down $10,500 up front – a huge savings and much more feasible for the first-time house hacker.
FHA loans come in 15- and 30-year terms with fixed interest rates. They are administered through the Federal Housing Administration. In short, FHA loans are loans backed by the federal government in an effort to promote homeownership. The program came to be during the 1960s when the housing market was flat on its back. The federal government promised banks that it would repay the loans if a borrower defaulted, but in exchange, wanted banks to offer loans with significantly lower down payment requirements.
FHA Loans for Owner-Occupied Duplexes
The FHA loan program remains incredibly popular today. It is the most commonly used loan program for house hackers looking to purchase owner-occupied duplexes. These loans provide an in-road to house hacking for those who otherwise would not have the up-front cash needed to secure a more traditional bank loan. FHA loans also tend to provide at- or below-market interest rates for the most qualified borrowers.
Who is Eligible for FHA Loans?
FHA loans come in all shapes and sizes. At a minimum, you must have a 500 FICO credit score. Those with a FICO score of 500 to 579 must put 10% down. Anyone looking to put down just 3.5% will need a FICO score of 580 or above. Banks will also require verifiable employment history for the last two years to show steady, reliable income. This is how they determine whether you’ll be able to pay the mortgage each month.
Conventional Bank Loan Financing
Conventional bank financing can be used by anyone buying an owner-occupied multifamily investment property. Conventional loans are available through banks, credit unions and other mortgage lenders. Their loans are similar to what you might get when buying a single-family home, condo or townhouse. When you apply, the lender considers your credit score, credit history, income, assets, and other debts.
When determining your maximum loan amount, the bank will usually look not only at your income, but at the income-generating potential of the rental units in your house hack. They’ll typically add 75% of the projected rental income to your total monthly income when calculating how large of a mortgage you’ll be able to get.
The biggest drawback of conventional bank financing is that these loans usually require people to put down at least 10% (plus PMI – see below), but more often, 20% of the purchase price.
Alternative Loan Products
While FHA loans and conventional bank loans are the most common ways to finance house hacking, there are other alternatives to consider. These alternatives are often even more attractive than the FHA loans for house hacking we described above.
VA Loans for Active and Retired Military Personnel
Another program run by the federal government is the VA (Veteran’s Administration) loan program. This is a great financing tool for anyone in the military – both active duty and veterans. The VA loan program actually allows people to put down zero percent when purchasing an owner-occupied property, as long as they have a credit score of 620 or higher. You can use the VA loan program multiple times as long as you continue to meet the VA’s eligibility requirements, making this an incredible pathway for people looking to house hack their way to a substantial multifamily investment portfolio.
Soft Second Loan Programs
Just as the FHA and VA offer their own loan programs, many states have their own loan programs designed to encourage homeownership. These programs are often referred to as “soft second” loan programs. While each program might be a little different, they generally function like this:
The state partners with traditional lenders to provide two loans to a borrower: the first is a traditional loan for 80% of the purchase price. The second loan is a “soft second” loan for up to 17% of the purchase price and is guaranteed by the state. In total, these two loans cover up to 97% of the purchase price, meaning the borrower only needs to put down 3% as a down payment. The breakdown might look something like this:
Purchase Price: $300,000
First Loan (80% loan-to-value): $240,000
Second Loan (17% loan-to-value): $51,000
Down Payment (3% of the purchase price): $9,000
Soft second loan programs are usually targeted to lower- to middle-income earners. As such, the programs often provide other benefits, such as below-market interest rates and are often structured with no PMI. Combined, these benefits can save house hackers hundreds of dollars each month.
High vs. Low Down Payments for House Hacking
Although there are ways to house hack with small down payments, it’s important to understand the implications of doing so. Most loans, regardless of whether it’s an FHA loan or conventional bank loan, will require you to pay for private mortgage insurance (PMI) if you put down less than 20% of the purchase price. PMI is a premium that banks charge in exchange for accepting a lower down payment. Depending on the size of your loan, PMI can cost hundreds of dollars each month. PMI only “burns off” after achieving the 80% loan-to-value (LTV) ratio that most banks require – something that can take years.
In an ideal scenario, a property’s value will appreciate as years go by. As the property value increases, the borrower can then refinance the property to get to 80% LTV sooner than if they were just making their standard principal and interest payments under the original loan agreement.
PMI on FHA Loans
In addition to the PMI that banks charge, FHA loans also have their own, separate PMI. FHA loans charge an upfront PMI premium equal to 1.75% of the loan amount, which is paid at the time of getting the loan. The premium can be rolled into the financed loan amount. The FHA also charged an annual PMI fee, equal to between 0.45% to 1.05% of the loan amount, depending on the loan term and initial LTV ratio. This annual PMI premium is charged on a monthly basis.
That said, the additional PMI charged to FHA loans can be “burned off” after 11 years for most borrowers if they have financed 90% or less of the property’s value and have stayed current with payments during that time. Loans with more than 90% LTV will carry that PMI premium for the duration of the loan, unless otherwise refinanced.
The Pros/Cons of High Down Payments
The most obvious benefit of putting down a high down payment (20% or more) is that you’ll get to bypass ever paying PMI, which will save you thousands of dollars over the lifetime of your loan. Another benefit to having a high down payment is that you’ll qualify for a broader range of financing alternatives, from FHA loans to conventional bank loans. A higher down payment also lowers your mortgage payments, which results in more cash flow from your house hack each month.
Of course, the downside of having a high down payment is that it can make house hacking cost prohibitive. The first-time investor may not have tens of thousands of dollars to put into their down payment, which makes low down payment options more attractive for those looking to get their foot in the door.
The Pros/Cons of Low Down Payments
The biggest benefit of house hacking with a low down payment is it makes house hacking more approachable to the masses. It lowers the barrier to entry and allows people to buy their first investment property when they might otherwise be locked out of multifamily properties.
But let’s say you DO have the money to put down a high down payment, does that mean you should? Not necessarily. Another benefit of low down payments is it means you can keep the rest of your cash in the bank for when renovations or repairs are needed. It also provides a safety net in the event you have trouble renting the other units in your live-in property, or if one of your tenants fails to pay the rent on time. Having a cushion of cash reserves is a good thing.
That cushion comes at a cost. The biggest con to having a low down payment is you’ll pay hundreds, even thousands, of dollars in PMI over the years. It will also take you a long time to build equity in your home, since mortgage payments tend to be structured as interest-heavy at the beginning and more principal-heavy during the second half of your loan term.
In Conclusion: Which Owner Occupied Investment Loan Program is Best for You?
Which loan product you decide to use really depends on your personal finances, including how much money you have for a down payment. Even if you have a lot of money to put down, you might decide not to. You might have other ideas for how you’d like to use that money, like paying off student loans or investing more heavily in your retirement account.
Which loan program is best for you depends on other factors, such as your credit score and the interest rate you can lock in with any given program. Always, always be sure to shop around for loans. Marginal differences in loan terms can equate to thousands of dollars over the lifetime of your loan.
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