One of the biggest challenges in securing an FHA mortgage for a multifamily property is the sustainability test, a crucial factor that most banks and lenders don’t discuss upfront. Here’s what you need to know if you’re planning to buy a multifamily property with FHA financing.

FHA Loans for First-Time and Move-Up Homebuyers

As a first-time homebuyer or even a move-up homebuyer, you might be considering an FHA loan. FHA loans are popular because they allow you to purchase a home with a very low down payment—typically just 3.5%—and you can often qualify with a credit score as low as 580, sometimes even lower depending on the lender.

FHA loans are designed by the Federal Housing Administration to help borrowers purchase primary residences, not rental properties. However, this doesn’t mean you can’t rent out part of the property. The program is intended primarily for homes where the borrower will live.

Using Rental Income to Qualify

If you’re buying a single-family residence with an accessory dwelling unit (like a granny unit), you can use the income from that unit to help you qualify for the loan. This applies even if you don’t have a history of homeownership or rental property management. The same rules apply if you’re purchasing a multifamily property such as a duplex or a property with two units or buildings on the same parcel.

The Sustainability Test for Multifamily Properties

Things get more complicated when you look at three- or four-unit properties. For these larger multifamily homes, the FHA requires the property to pass a sustainability test. This means that the property must be able to generate enough rental income to cover the mortgage payments in the event of a foreclosure.

Here’s the rationale: when you buy a primary home, the bank can sell it relatively easily if they need to foreclose. The same is generally true for a duplex, where only one additional unit is involved. However, with a three- or four-unit property, the bank faces increased risk and potential costs associated with managing multiple rental units.

Understanding the Ratios

Let’s break this down with an example. Suppose you buy a duplex, live in one unit, and rent out the other. This creates a simple 50/50 occupancy ratio—50% occupied by you, 50% rented out.

Now, consider a three-unit property. If you live in one unit and rent out the other two, the occupancy ratio shifts significantly, with only one-third of the property owner-occupied. Similarly, for a four-unit property, living in one unit and renting out the other three means only 25% is owner-occupied.

Because of these ratios, the FHA requires that the property can sustain itself financially. For instance, if your mortgage payment is $7,000 per month, including principal, interest, taxes, and insurance (PITI), and the total rent from the property is $6,000 per month, you need to calculate 75% of the rental income to account for vacancies and maintenance costs. In this case, 75% of $6,000 is $4,500. Since $4,500 is significantly less than the $7,000 mortgage payment, the property would not pass the sustainability test, as it doesn’t generate enough income to cover the mortgage.

Legal Considerations for Additional Units

If you’re looking at a property with a granny unit or an additional unit that is not legally permitted, this unit cannot be counted towards your income for qualification purposes. For example, if you’re considering a three-unit property but one unit is not legally recognized, it will be ignored in the ratio calculations, further complicating the qualification process.

When to Consider Conventional Loans

Given these complexities, if you’re in the market for a three- or four-unit property, an FHA loan might not be the best fit. Instead, you may want to consider a conventional loan. Conventional loans typically require a higher down payment—often 20% or even 25%—but they can offer more flexibility in terms of property types and qualifying criteria.

Conclusion: Be Smart and Informed

Navigating the process of buying a multifamily property with an FHA loan requires careful consideration of the FHA’s guidelines and sustainability test. Don’t be misled by lenders or mortgage companies who suggest that you can easily buy a multifamily property with more than two units using an FHA loan. Given current housing prices, rents, and interest rates, passing the FHA sustainability test can be challenging.

If you are looking to get a mortgage? Get a no cost FHA quote today!