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SHOW NOTES FOR EPISODE 138: HOW TO PURCHASE A RENTAL PROPERTY FOR ONLY 3.5% DOWN
We have all heard the old adage “It takes money to make money.” And, for the most part, that’s true. But it doesn’t necessarily mean you need to spend “a lot of money” to get started in real estate investing. In this episode, Bill shares a little secret that can allow you to purchase your rental property for only 3.5% down!
You may have found a property or a market that looks appealing to you but, you you’re thinking I just don’t have the money for a 20% down payment! The property could certainly be sold by the time you save up enough, and the market may have completely changed by then! Luckily, with a little knowledge and creativity, there are options to help you acquire rental property with a small amount of capital!
What do you do, when you have limited funds to start with? The first way we will mention is fairly obvious: borrow money from family, or friends for the down payment, and work out some sort of repayment option with them. Most people would rather borrow money from someone like a close relative, rather than a bank, so that is always a possible starting point. But the reality is, you will need some money to get started. While buying a property with no money down sounds great, that usually requires working with a seller who is agreeable to some kind of seller financing or other concession. If you don’t put something into the purchase, you also may not feel as committed to the property, or care about its success if you have not actually put your own hard earned money into it. I feel that if you want to call yourself an investor, it’s always better to have at least some of your own skin in the game.
Before you start putting money into real estate, there are a few bases you should have covered. If you have not already, you should have several “savings accounts” or funds that you are contributing to. Firstly, the emergency family fund is always a great idea (generally enough to cover 3-6 months worth of rent and regular monthly expenses). You probably already have a 401k, IRA or other longer term retirement account. Beyond that, you will want to have your own real estate investment starter fund. Take a look at your income and expenses, and try to peel off as much as you can afford to put into that real estate fund.
Now, on to the fun stuff. Traditionally, a down payment on a home is 20% — sometimes more based on your credit. If you don’t have enough saved for that chunk of cash, what are your options? Aside from borrowing money from friends, or family in order to get started investing in residential rental property, and special non-profit grant programs, you have the U.S. government on your side. The Federal Housing Authority (FHA) is a program that allows homebuyers to get into property with very little money down. The FHA will insure loans made by FHA approved lenders.
The one hook here, however, is that you must live in the property for at least 9 months to one year. Now, already, you are probably thinking, I’m not just going to just move out of my current home. For many that may not be an option. However, it does depend on your situation. Ways around that may include:
- Moving out of your house temporarily and renting it out your permanent residence while you reside in your rental property for 9-12 months.
- Maybe one of your kids could be on the loan and they could move in the house you’re purchasing.
- Or, you and your wife could just commit to being “house hackers” for a while and let your kids live in your permanent residence while you move into your rental for 9-12 months to fulfill the requirement to qualify for the loan.
Now, one of the great thing’s about this loan is that you can buy up to four units. So, if you buy it, you could move into one of the units and rent out the other four. In other words, from day one you will not only have your tenants pay the mortgage, you will also likely make a profit, after expenses in month one!
Either way, if you are willing to live in the house that you are buying for a while, this program can be a great benefit to for an investor getting started.
Here is a list of FHA general requirements for the loan:
- You must live in the home you are purchasing for at least 9 months to 1 Year
- FICO credit score of 580 or higher to be approved for 3.5% down payment. Otherwise, 10% down required.
- Must pay annual mortgage insurance (PMI) (this insures lenders against losses), as well as upfront premium (generally, 1.75% of purchase price, which can be financed.)
- There are limits to the amount that you can borrow. Each state has their requirements. I will have a link in our show notes so you can check your state limits. But, for example
- For example, I live in California and the maximum loan amount limits are as follows:
- Single family – $636,150
- Duplex – $814,500
- Triplex – $984,525
- Four-plex – $1,223,475
- And 5 units and above are considered commercial and do not qualify
- But, look at that, you could buy a fourplex for $1,223,475 and only have to pay $42,822 down. If you have an equity line of credit on your permanent residence or a HELOC, you could jump right into a cash flowing income property that could quickly pay off your loan
- For example, I live in California and the maximum loan amount limits are as follows:
To check FHA loan limits for your state, click here.
- Other requirements are:
- Mortgage debt-to-income ratio must be 31%, or less. This is the mortgage payment, property taxes, insurance, and HOA dues divided by your total monthly income.
- Total debt-to-income ratio must be 50%, or less. This includes mortgage payment, property taxes, insurance, HOA dues, PLUS any other debt expenses (payments on your car, personal loans, etc.) divided by your total monthly income.
You you still may be thinking “I want an investment property, but not a new place to live!” Well, if you can make it work, living in the house not only locks in a lower rate (currently in the low to mid 3% range for a 30-year loan), but it also allows you to fix the place up, work out any oddities with the property, learn property management up-close and begin to develop relationships with your neighbors.
Now, if you plan to take advantage of this program, and depending on the market in your area and the numbers you are looking at, I would recommend having at least 10-15% of the purchase price of the property (if you can afford it) you are looking at in cash, as opposed to the 3.5% minimum that may be available to you.
Let’s take a look at an example. We’ll use $100,000 property. If your Real Estate Investment Savings account has $15,000 in it or you decide to pull equity out of your current residence, you could either put the full 15% down ($15,000 at a 4% interest rate, making your monthly mortgage payment $406), or, you could put down just 10% ($10,000 @ 4%, monthly mortgage pmt of $430). While you are living in the house and fixing it up (if necessary) for the first year, you have an extra $5,000 for repairs on the property, or safety reserves (basically, just like the emergency account I talked about earlier, but for your property instead of your family). This extra $5,000 only costs you $24/month and can be very helpful to a buyer that has very little capital to begin with.
As a note, if you don’t have the 10%-15% for a down payment, but you’re sure that you’ve found a screaming deal, just be certain that your numbers work out and that your payments are not going to sink you should something go badly when you decide to rent the property out. Keep that monthly mortgage insurance premium on your mind too as you are shopping around.
FHA-insured loans can be a great way to get you into a property when you are low on funds. There are even FHA loans that will include the cost of repairs for a property as well – with the same great terms!
Be sure to meet with an FHA-approved lender who will walk you through the process of getting pre-approved (which is good for 4 months). This will give you leverage as you are shopping for properties to buy. It usually takes 30-40 days to apply and get qualified. Also, remember that you are buying for the purpose of renting the property out. Do not get caught up in the idea that “you could never live there,” because ultimately, YOU won’t be living there, your tenants will!
On that note, it is very important to understand your numbers. Do a careful analysis on every property so that you know exactly what to expect as far as assumptions, expenses, cash flow, and return on investment. Always, factor in any contingencies, including vacancies.
Overall, this is a great way, if you have limited funds, to get started. If you have the flexibility and are up for the “house hacking” adventure, you could literally purchase 5 fourplexes in 5 years (or less) and end up with 20 cash flowing units that will not only generate significant monthly income but, if you buy right, will be increasing in equity each year and thus boost your experience AND net worth, giving you leverage to purchase larger apartments in the future!
If you want to see if you qualify for or to apply for an FHA loan, Quicken Loans is one of the largest processors of FHA loans. Here is a link to their website: QuickenLoans
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