For most people interested in rental property investing, the biggest obstacle is the amount of capital it takes to acquire a property. Here's why it can be so difficult to come up with the money to buy your first investment property -- and how I was able to buy my first with just a few thousand dollars down.
With virtually all means of traditional financing, investment properties require down payments of 20% to 25% of the purchase price. This is on top of the typical requirement of at least six months' worth of reserves and whatever origination fees and other closing expenses you have to pay. For a $150,000 investment property, it's common to need $50,000 or more in available cash to close. And that's not to mention the fact that investment property loans tend to have significantly higher interest rates than the same borrower could get for a primary residence mortgage. In many cases, the difference can be two full percentage points or more.
The bottom line is that while rental properties can be great ways to create wealth and build passive income streams over time, the capital requirements create quite a barrier to entry for many would-be investors. Here's how I got around that -- and how you can, too.
House-hacking with an FHA loan
An FHA loan is a popular choice among first-time homebuyers, and it's easy to see why. With as little as a 580 FICO credit score, you can buy a home with as little as 3.5% down. There's just one little problem for investors. FHA loans are exclusively for owner-occupied properties. In other words, you have to live in the home.
However, there's one big loophole. FHA loans can be made on a property with up to four living units. As long as you plan to live in one of the units after the purchase closes, you can potentially use an FHA loan to buy the property. For example, you could buy a triplex, live in one unit, and rent out the other two -- and with just 3.5% down.
Plus, the FHA rules only require you to live in the property for 12 months after closing. After that time period passes, you can move out of the property, rent out all of the units, and repeat the process with a new property if you choose to do so.
My first investment property was a house hack purchased with an FHA loan. At the time, my then-fiance and I were living in Key West, Florida -- a very expensive real estate market, especially for a teacher and a nurse in their mid-20s.
At the advice of my excellent real estate agent, we started looking for a multi-unit property in order to generate some income to offset the high cost of being a homeowner. We found an excellent duplex with a two-bedroom main unit that we could comfortably live in and a one-bedroom unit that we could rent out just a few blocks from the school I was teaching at, and we closed on the purchase with an FHA loan just a few months later. We quickly found a tenant for the smaller unit and ended up living in the home for less than we would pay in rent on the typical one-bedroom apartment in the area.
Drawbacks to house-hacking with FHA loans
To be fair, house hacking isn't for everyone. Not everyone wants to be a landlord, and those who do might not feel comfortable with their tenants being right next door. And I can tell you firsthand that this can create some uncomfortable situations. There is value in having your own yard and the general privacy that comes with a single-unit property.
In addition, there's no such thing as a perfect loan product, and the FHA mortgage is certainly no exception. While the down payment and credit requirements are low, FHA loans have expensive mortgage insurance premiums (both upfront and ongoing) that can make these loans far more costly than their interest rate implies.
A great way to get started
In full disclosure, I've since moved on from that first property. When my wife and I decided to start having kids, our side of the duplex was simply not enough space to accommodate a growing family. Plus, the Key West real estate market had appreciated enough during our ownership period that we were able to sell at enough of a profit to put 20% down on our next home a little further north and still have some money left over.
Even though we no longer own the property, using the FHA loan house-hacking method set me on the right path. It allowed me to buy a property that I couldn't have otherwise comfortably afforded and made my monthly expenses significantly less than I would have paid for rent on a comparable apartment in the area. And because I built equity in the property, I was able to sell it after a few years with enough capital to pursue other investment properties.
Carefully weigh the pros and cons of the FHA loan house-hacking method. If it works with your lifestyle, it could be a great way for you to save big on your first investment property, too.
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