The Federal Housing Administration (FHA) is the largest mortgage insurer in the United States, with more than $1.3 trillion in its portfolio. As part of the Office of Housing at the U.S. Department of Housing and Urban Development (HUD), it helps roughly 1.3 million people across the country become homeowners each year. Low down payments and low credit score requirements make FHA loans much more attractive than conventional mortgages.

While this may be good news for some homeowners, real estate investors looking to take advantage of the benefits of an FHA loan may need to look elsewhere. That’s because the conditions of these loans restrict those who qualify. There are, however, ways in which some homeowners may be able to use an FHA loan for a property that also (or eventually) yields income. Read on to find out more about FHA loans, who qualifies, and whether you can use them to finance rental properties.

What Are FHA Loans?

Homeowners had a difficult time buying and maintaining payments on their properties during the Great Depression. They were limited to loans worth 50% of a property’s market value, and mortgage terms were generally very short. Many loans ended with very large balloon payments, something most people couldn’t afford to make. This led to a massive amount of default, pushing up the foreclosure rate. In 1934 the U.S. Congress decided to form the FHA in an effort to promote affordable homeownership. This was how the FHA loan program came to be.

Loans offered by the FHA have lower down payment requirements and more liberal underwriting standards than most conventional mortgages. For example, as of 2021, homeowners only need a credit score of 580 or more to qualify. Approved applicants can finance as much as 96.5%, meaning they only need to put down 3.5%. Those with credit scores between 579 and 500 still qualify, but they need to put down a little more—10%.

FHA loans are, for the most part, restricted to buyers who intend to use the home they purchase as a primary residence. That means an FHA loan cannot be used to finance a second home, a rental home, a vacation home, or an investment property. However, there are a few exceptions and a few ways to get around this general rule.

FHA Occupancy Requirement

Under FHA rules and guidelines, the property being financed must be occupied by the owner. This means rental and seasonal properties do not apply. The FHA uses this rule as a way to prevent investors from benefiting from the program.

The borrower must take possession of the home within 60 days after the mortgage closes, and they must live in the home for the majority of the year. The property must be used as a principal residence for at least one year. If there is more than one borrower listed on the mortgage, the FHA requires at least one to satisfy the occupancy requirement.

Refinancing an Existing FHA Loan

Suppose someone uses an FHA loan to finance the purchase of a primary residence. And then, let’s say the owner moves out of the home down the road, but they continue to own it and rent it out for income. In other words, the house becomes an investment property. Suppose also that interest rates drop, and the owner wants to refinance through the FHA for a better deal.

Even though they no longer live in the house, FHA rules allow them to refinance into another FHA loan. An FHA-to-FHA refinance is also known as an FHA streamline refinance.

There are several requirements to qualify for refinancing:

• A minimum of 210 days must have passed since you closed your original home loan.
• You must have made at least six monthly payments on your FHA-issued mortgage.
• If you have only had your FHA loan for less than a year, you cannot have any payments overdue by more than 30 days. If you held your FHA loan for more than a year, you are allowed a single 30-day late payment within 12 months, but that late payment cannot have been within the last 90 days.
• The refinance must lower your monthly principal and interest payments, which is often described as a “net tangible benefit.” For example, if your previous monthly payment was $1,100, your new monthly payment after the refinance should be $1,050 or lower. Refinancing into a mortgage with a shorter term also qualifies as a net tangible benefit.

If the homeowner meets the criteria above, FHA streamline refinances are quite possibly the easiest loans to close. They require no employment or income verification, no credit score verification, and no home appraisal. The main thing that matters is that the homeowner has made their existing FHA loan payments on time.

Dual Purpose

Another way to use an FHA loan to buy an income property is to purchase a multiunit dwelling. The FHA allows homeowners to buy a property with up to four units, provided one is occupied by the owner. There is no limit to how large the lot size may be. This way the owner is able to live in one unit, making it an owner-occupied property and, therefore, FHA-eligible. The owner can rent out the other unit(s) for income.

A savvy investor in a hot rental market sometimes earns enough income using this method to live in the home for free. As noted above, the FHA lends up to 96.5% of the appraised value, meaning the purchaser can put down as little as 3.5%.

Special Considerations

The FHA has special provisions that may allow you to earn rental income from your home. If your job requires you to relocate and you need a second home—or if your home is too small for your expanding family—you may be able to rent out your first home after you’ve satisfied the one-year occupancy requirement. If you are off work because you’re otherwise incapacitated, you may be able to rent out rooms in your home to boarders to make up for lost wages.

Of course, you can always pay off the mortgage early. The FHA doesn’t charge any prepayment penalties, so if you can eliminate the loan in its entirety, you are free to do whatever you wish with the property.

The Bottom Line

You must use an FHA loan to facilitate the purchase of your primary residential dwelling, and you must live there for at least one year. It cannot be used to finance a second home, a rental home, a vacation home, or an investment property. That said, there are some exceptions. You can use an FHA loan to purchase up to a four-unit dwelling as long as you live in one unit as your primary residence. Then you can rent the other three units out for income. You can also rent out rooms in a single-family home if you are unemployed because you are incapacitated.

If your job requires you to relocate, or if your home becomes to small for your growing family, you may rent out your first home after purchasing a second one if you have met the one-year residency requirement. And you can refinance that initial home mortgage with an FHA streamline refinance. Thus, there are some exceptions to the rule that an FHA loan cannot be used to purchase an investment property.