For many real estate investors, the primary hurdle to entering the market is assembling the necessary down payment for a rental property. The prospect of gathering substantial sums like $30,000, $50,000, or even $100,000 can be daunting, as these funds aren’t always readily available.
Conventional rental property loans generally demand a significant 20% down payment in cash. Beyond this initial hurdle, the interest rates associated with these loans are typically higher than those for owner-occupied mortgages.
However, there’s a clever solution that investors with adult children can utilize: FHA’s “kiddie condo” program, which provides an avenue for securing FHA, owner-occupied financing for a rental property.
Exploring the “Kiddie Condo” Loan Strategy
Let’s clarify upfront that there is no official FHA loan program dubbed “Kiddie Condo.” This term has been coined by mortgage brokers as a catchy label to describe this concept, and it has certainly caught on.
The underlying concept is straightforward: parents can cosign their children’s mortgages as joint owners. This joint ownership structure allows parents to collaborate with their adult children on real estate ventures. FHA financing can be employed to fund a property provided the children reside in the property for at least a year.
For instance, consider the case of my friend Tracy, who was attending medical school. Her parents purchased a townhouse for her to reside in during her studies. Tracy paid rent to her parents. Years later, when she completed her medical training and relocated, her parents found themselves with a well-maintained rental property boasting substantial equity.
In Tracy’s situation, her parents financed the property through a rental property loan, but they could have opted for an FHA mortgage had Tracy been included on the deed.
Leveraging Your Children for “House Hacking”
This setup essentially allows parents to engage in a form of “house hacking” through their children. Some parents acquire a property with their child, where the child occupies one bedroom while the remaining rooms or units are rented out to others.
This arrangement offers the child reduced or even free rent while the rental income from housemates covers the property’s expenses. Additionally, the child takes on property management responsibilities, including finding tenants, signing leases, collecting rent, and managing repairs. This provides the child with invaluable experience in real estate investing and property management.
Conversely, parents secure an investment property while benefiting from affordable owner-occupied financing. Furthermore, they sidestep the need for a property manager.
Advantages of the FHA “Kiddie Condo” House Hacking Strategy
Although we’ve touched upon some advantages already, let’s delve a bit deeper before addressing potential risks.
3.5% Down Payment
Borrowers with a credit score exceeding 580 are eligible for an FHA loan with a mere 3.5% down payment. Even by homeowner loan standards, this is remarkably low. When considering a rental property, this down payment requirement is truly remarkable.
Borrowers with credit scores in the 500-579 range can also qualify for an FHA loan, albeit with a 10% down payment. It’s important to note that most borrowers with such low credit scores would struggle to secure any other type of mortgage, including portfolio rental property loans.
For a rental property valued at $200,000, an FHA loan entails a $7,000 down payment—significantly less than the (minimum!) $40,000 down payment for alternative rental property loans.
Low-Interest Rates & Fees
Presently, borrowers with solid credit can expect interest rates between 4% and 4.5% for an FHA loan. Those with excellent credit can avoid paying points, one-time lender fees equal to 1% of the loan amount, at settlement. To explore today’s interest rates and compare terms from different lenders, check out Credible.
In contrast, portfolio rental property loans typically incur interest rates ranging from 5% to 8%, accompanied by 2-3 points.
Consider a 30-year loan of $200,000 at 4% interest. The lifetime interest sum is $143,738.80. In contrast, the same loan at 7% interest accumulates $279,016.00 in interest over its lifetime—nearly twice the amount.
Up to 4 Units
FHA loans extend to properties containing up to four units. Therefore, you and your adult child could jointly invest in a duplex, triplex, or fourplex. Your child occupies one unit, while the other(s) generate rental cash flow.
The theoretical income from these additional units may even contribute to your loan qualification.
No Residency Requirement
Unlike multifamily property house hacking, which necessitates personal residence for at least a year, the “kiddie condo” strategy doesn’t impose such constraints. Your child’s residency meets the owner-occupancy requirement on your behalf. Even then, they are only obligated to live on the premises for a year.
The Drawbacks of FHA Loans
While FHA loans come with several notable advantages, it’s essential to acknowledge the downsides before embarking on a “kiddie condo” investment with your child.
Permanent Mortgage Insurance Premium (MIP)
Unlike many mortgages, which allow mortgage insurance to be canceled once the loan balance dips below 80% of the property’s value, FHA loans feature permanent mortgage insurance. This means that you’ll continue paying mortgage insurance for the entire life of the loan, which can add hundreds to your monthly payment.
Credit Reporting Impact
While cosigning allows your child to establish a robust credit history, it can temporarily impact your own credit, particularly if you carry higher debt balances. Moreover, this arrangement could restrict your eligibility for conventional mortgages on other rental properties.
Limited Scalability
The number of mortgages that can appear on your credit report is limited before conventional and FHA lenders cease lending to you. Additionally, the success of this strategy hinges on your child’s participation, which might not be feasible in the long run.
Responsibility of Kiddos
Not only must your child cooperate, but they must also responsibly manage the property. This includes timely payment, rent collection, property maintenance, and enforcing lease agreements. Some young adults may not be up to these demands.
Complex Personal & Financial Dynamics
In collaborative real estate ventures involving friends or family, challenges can arise if a party defaults on the agreement, particularly when names are on the property deed. Establishing an exit strategy becomes essential, and differing preferences can complicate matters. Planning for potential scenarios is crucial.
Conclusion
Utilizing FHA’s “kiddie condo” program can be an effective means of investing in rental properties while benefiting from favorable financing terms. However, it’s vital to understand both the advantages and potential drawbacks before entering such an arrangement. By weighing these factors and planning accordingly, you can make informed decisions that align with your long-term financial goals.