Leveraging FHA Loans for Starting a Business: Understanding the Legal and Financial Implications
Sufficient capital is fundamental for business success, whether managing a large corporation or running a startup. The initial stages of business ownership can be particularly demanding. Around 20 percent of new businesses don’t survive their first two years.
The reasons for startup failures vary. However, according to CB Insights, 38 percent of new businesses fail because they exhausted cash reserves or couldn’t secure new capital.
Without an established track record, startups may find it more difficult to obtain traditional loans. In 2021, the percentage of small businesses seeking traditional financing declined to 34 percent, and those that applied were less likely to receive the funding they pursued.
Alternatively, FHA loans present an alternative path to secure financing for a business venture, but you must consider several legal and financial implications. This article will equip new business owners with the knowledge to use FHA loans as a strategic financial tool for starting a business.
Understanding FHA Loans
Before attempting to obtain an FHA loan for business purposes, familiarize yourself with how it works and what it requires to get approved.
What is an FHA loan?
A Federal Housing Administration (FHA) loan is a type of government-backed mortgage. The FHA operates under the US Department of Housing and Urban Development (HUD). The agency insures mortgages for single-family homes, apartments, manufactured homes, and hospitals.
Such loans are available through FHA-approved lenders across the US and its territories. Since the government guarantees them, private lenders like SoFi typically offer FHA home loans for a lower interest rate. These loans come in various forms, such as the following:
- A basic home mortgage loan or 203(b) loan
- FHA energy-efficient mortgage
- FHA 203(k) improvement loan
- Home equity conversion mortgage (HECM)
- Graduated payment mortgage or 245(a) loan
- Disaster victims mortgage or 203(h) loan
Eligibility criteria for FHA loans
These loans are often helpful to those with low to moderate incomes, as they require a low down payment. They also have lenient credit scores and debt-to-income ratio (DTI) requirements.
Like any other mortgage applicant, your lender will assess your qualifications for an FHA loan. Here’s a list of criteria you must meet to be eligible:
- A credit score between 500 and 579
- A minimum 10 percent down payment if your score is as low as 500 or at least a 3.5 percent down payment for credit scores of 580 or above
- A DTI ratio of 43 percent or as much as 50 percent in some cases
- A steady employment history
The government sets these minimum guidelines for FHA loans, but lenders can establish additional requirements.
Using FHA Loans for Business Purposes
FHA loans are commonly linked with first-time homebuyers. While they make homeownership more accessible, these loans also hold great potential for business investment opportunities. They can be viable for small business owners whose income fluctuations and business activities impact their credit.
Under certain circumstances, you can utilize FHA loans to purchase investment properties and make money for your new business. Below are different ways to harness the potential of these government-backed loans for business ventures.
Rent out your primary home
After meeting the occupancy requirement, you can convert a home purchased with an FHA mortgage into a rental property. However, you cannot use FHA loans to buy a house you will not occupy as the borrower.
You must still live on the property as your primary residence for at least one year. This may be more sensible if you relocate for your job and need to purchase a second home.
Purchase a multi-unit property
FHA loans let you finance properties with up to four units. This is an excellent way to earn money by renting out the extra units. You’ll also enjoy the advantages of FHA’s low down payment and favorable loan terms.
You may generate rental income from the additional units, but the loan cannot solely rely on this rental income as justification. Likewise, you must live in one of the units as your primary residence.
Invest in mixed-use properties
FHA loans typically cannot be used for properties where the commercial space makes up a substantial part of the total square footage. If you want to invest in mixed-use properties with FHA loans, ensure the commercial space is minimal and doesn’t disrupt its residential nature.
5 Essential Steps To Secure an FHA Loan
Understanding an FHA loan’s specific requirements and limitations is imperative whether you’re considering it for homeownership or business investments. The following are essential steps to secure an FHA loan:
1. Assess eligibility
The property’s primary use must be residential, with more than 51 percent of the space dedicated to living areas rather than businesses or other purposes.
2. Evaluate financial viability
Suppose there’s a store or other commercial space on the property. The rent should cover all the mortgage costs, such as the loan amount you repay, interest, property taxes, and insurance.
3. Acquire an appraisal
You’ll need an appraisal conducted by a qualified appraiser who can assess both the residential and commercial space according to government (HUD) guidelines. This appraisal ensures the property complies with the value requirements for the FHA loan.
4. Provide necessary documentation
Once you’ve found a suitable property, you must apply for the FHA loan through a lender approved by the government.
They’ll request that you provide some documents to check your finances and the property, such as proof of your income, your credit history, and details about the condition of the house and the commercial space.
5. Occupy the residential part of the property
FHA loans are for owner-occupants, so you must live in the property you purchase. If the property includes mixed-use with a store or business space, you must reside in the residential part. This rule is fundamental to FHA loans.
Additional Legal and Financial Considerations
FHA loan programs prioritize financing residential properties. While it’s possible to use it for business investments, eligibility and regulatory requirements can be intricate.
Legal considerations
Properties financed with FHA loans must adhere to minimum property standards (MPS) established by the Department of Housing and Urban Development (HUD). These standards cover a thorough check of the property, including its durability, roof, electricity, plumbing, ease of use, and comfort.
These standards protect the lenders and ensure future occupants’ health, safety, and well-being. FHA loans are typically not intended for properties in predominantly commercial areas or areas with significant noise or other conditions that may adversely affect residential comfort.
That’s why the appraiser’s property assessment is significant for FHA loan approval. HUD requires a professional appraiser to examine the property closely and fill out a special FHA form. Likewise, they must consider how local zoning laws affect the property’s value.
Seeking legal advice helps you better understand the implications of using a residential property for business purposes, ensure compliance with regulations, and protect your investment.
Financial considerations
FHA loans provide many opportunities for homeownership and business investments, but knowing the financial implications is crucial before committing to them.
Although a small down payment may seem appealing, consider the long-term impact. Putting down more than the minimum down payment decreases the amount you’ll need to borrow. That means you’ll pay less each month and save thousands in interest throughout the loan’s duration.
Additionally, FHA loans involve mortgage insurance premiums (MIP), which constitute a substantial ongoing cost. You must pay an initial MIP when you get the loan, along with the annual MIP. The upfront MIP for most FHA loans is 1.75 percent of the loan amount.
Suppose your down payment is less than 10 percent. You may be required to pay mortgage insurance premiums for the duration of your loan or until you refinance to a different loan product. Meanwhile, if you put down 10 percent or more, you’ll only have to pay the yearly MIP for 11 years.
Strategically Use FHA Loans To Support Your Ventures
Whether you’re an entrepreneur or an investor, FHA loans offer unique possibilities to support your ventures.
You can benefit from competitive interest rates, smaller down payments, and opportunities to generate rental income. However, understanding regulations and developing a strategic approach to property investment is critical for navigating the complexities of FHA loans.
From getting the property appraised to considering renovations, every step requires careful planning to comply with FHA standards. Ensure you obtain the appropriate legal and financial guidance to maximize the potential of your business and investment.
