U.S. Markets closed

How to Invest in Real Estate Using an FHA Loan

Miranda Marquit

One way to make money over the long haul is to invest in real estate. However, investing in real estate can be tricky because you often need a great deal of capital to buy real estate -- especially for investment.

You can get around the capital requirement, though, with a little creativity. If you're hoping create cash flow from renting, and you want a solid investment for the future, one way to do it is to use an FHA loan.

An FHA loan is a home loan guaranteed by the federal government. Traditional lenders make these loans to those who meet the requirements and the government guarantees them.

[See: How to Invest in Real Estate Without Buying Property.]

When you use an FHA loan, you only need a 3.5% down payment. On a $300,000 property, that's $10,500. That's much more affordable for many real estate investors than coming up with a 20% down payment -- or meeting a $1 million minimum for an investment club.

Using an FHA loan is the foundation for rental income for people like Brandon Turner of BiggerPockets.com. He's used the FHA loan to start investing in real estate to great effect.

Buying a rental property with an FHA loan. When you buy a rental property using an FHA loan, it's important to note that you must live in that home for at least a year. So, if you buy a single-family home, you'll have to make it your primary residence for 12 months before you can start renting it out.

The way around this, if you want to start building your rental empire immediately, is to purchase a duplex or a four-plex. You can use an FHA loan to buy a property with up to four units, so this gives you the chance to live in one of the units, making it your primary residence, while renting out other units.

After a year, you can move out of your unit and make way for another renter. In some cases, it makes sense to hire a property management company to take care of the renters after you move out. As an on-site landlord, you have to be available at all hours, and you might be tired of that after doing it for a year.

No matter which route you take, it's important to have a plan of attack ahead of time. Make sure you know your end goal. Have a clear vision for the property and what you plan to do with it. A plan can help you decide what kind of property to buy and be ready to move out when it's time to turn it into an income stream.

Pros and cons of using an FHA loan. The biggest advantage to using an FHA loan to invest in real estate is the small down payment. However, it also helps that some of the credit score requirements are a little more lenient. Lenders that might not qualify you for a conventional loan with such a low down payment might be willing to do so with an FHA loan.

[See: 9 Places to Invest $500 or Less.]

Before you decide that an FHA loan is the way to go, however, it's important to understand that you'll pay mortgage insurance. This isn't mortgage insurance that just falls off like you see with conventional loans, though. Instead, if you get your FHA loan today, and have a down payment of less than 10%, there's a good chance you'll be required to pay the insurance for the life of your loan. That mortgage insurance payment will eat into your overall profits.

In order to avoid paying mortgage insurance for the long haul, you'll need to put down more than 10% when you buy. In that case, the insurance will drop off after 11 years.

Another way to get rid of your FHA mortgage insurance is to refinance. If you refinance your property with a different lender, you no longer have the insurance. Of course, depending on your loan-to-value ratio, you might still be paying mortgage insurance to your new lender. But at least you know that will drop off in time, as you pay down the mortgage.

When you get an FHA loan, have a plan for getting rid of the mortgage insurance eventually. As your property increases in value and as your rental income increases, this should be possible.

Buy your next property. Once you've been bitten by the real estate investing bug, you might be tempted to get another property. That's normal. Now that you have income from your rentals, you might be able to save up for another down payment.

You will likely have to buy your second property with a conventional mortgage, but at least the FHA loan got you started.

In some cases, if you have successfully refinanced your first property and are no longer paying FHA mortgage insurance, you might be able to use an FHA loan to buy a different property -- as long as you plan to live in it as a primary residence for at least a year.

There are exceptions to buying a second property with an FHA loan when you're paying FHA mortgage insurance but meeting the qualifications might not be practical for you.

[See: 6 Great Tips to Build an Income-Producing Portfolio.]

Using an FHA loan to start real estate investing can be a smart move. As long as you have a plan and you know the rules, the small down payment can be the foundation of your rental property empire.



More From US News & World Report