Buying a short-sale home with an FHA loan

Imagine shopping for a new house and coming across a short-sale home listed at a low price. What are your financing options?

One might be an FHA (Federal Housing Administration) loan. These are government-backed loans that you may qualify for with a down payment as low as 3.5% and a credit score as low as 580. That said, you and the property must meet additional loan requirements to be eligible.

If you’re interested in financing a short-sale home with an FHA loan, read on. We’ll cover the requirements, process, pros and cons, and more to help you decide if this is the right choice.

How do short-sale homes affect financing options?

A short sale is when a homeowner in financial distress sells their home for less than they owe on their mortgage.

Though not ideal, a short sale is often better than resorting to foreclosure because it does less damage to the borrower’s credit and can minimize the lender’s losses. However, the lender must approve the short sale since they hold the mortgage note.

As a buyer, getting a loan to finance a short-sale home can be challenging. For one, the lender and any other lienholders negotiate offers on behalf of the owner. The more stakeholders are involved, the longer it can take to agree on a deal.

Plus, most short sales require you to buy the home “as is,” meaning the property may have serious defects and damage. And since FHA loans have strict standards regarding the home’s condition and livability, this can hurt your prospects of qualifying for FHA financing.

FHA loan requirements for buying short-sale homes

Let’s take a deeper look at both the property and borrower requirements for FHA loans.

Property requirements for FHA loans

• Occupancy: The property must be your primary residence. In other words, you can’t rent it out or use it as a vacation home.
• Property type: The property must be a single-family dwelling, manufactured home, townhouse, condo, or other residential property with up to four units.
• Safety standards: The property must be safe, secure, and structurally sound per HUD standards. For example, it can’t have a broken roof or foundation.
• Appraisal: An FHA-approved appraiser must verify the property’s condition and value.

Borrower requirements for FHA loans

• Credit score: You must have a credit score of at least 500 if you put down 10%, though Rocket Mortgage® requires a minimum score of 580.
• Down payment: You must put down at least 3.5% (or 10% to qualify with a credit score under 580). To estimate your required down payment, enter your loan details into our down payment calculator.
• Debt-to-income ratio (DTI): Your DTI should be no more than 43%, though some lenders, including Rocket Mortgage®, allow DTIs of up to 57%.
• Mortgage insurance premium (MIP): This is a fee to protect the FHA against the borrower defaulting on the loan. It includes an up-front premium of 1.75% of the loan amount and an annual premium of 0.15% to 0.75%.
• Closing costs: FHA loan closing costs vary by lender and market, but they’re usually anywhere from 2% to 6% of the home’s purchase price.

Pros and cons of buying a short sale with an FHA loan

Now that you understand what it takes to qualify for an FHA loan, here are some pros and cons to consider before getting one to finance a short-sale home.

Pros

• Lower home purchase price: Homeowners and lenders who resort to a short sale are often highly motivated to sell. As a result, you may secure a home at a discount, which can lower the barrier to homeownership if you’re a first-time buyer.
• More lenient credit score requirements: Conventional mortgages generally require a minimum credit score of 620. However, you can qualify for an FHA loan with a score as low as 580 (or even 500 in some cases).
• Low down payment minimums: You can secure an FHA loan with a down payment as low as 3.5%. On a $300,000 house, that’s just $10,500.
• Equity potential: Because short-sale homes are often priced below market value to encourage a quick sale, you may have the opportunity to build equity quickly if the home’s market value increases after the purchase.
• Potentially less competition: Since short sales represent a small percentage of total home sales and are relatively complex, you’re likely to face less buyer competition.

Cons

• Potential property issues: Since most short-sale homes are sold as is, they’re at a higher risk of requiring costly repairs and renovations.
• Strict HUD property standards: Properties financed by FHA loans must meet strict HUD property standards, which could prevent you from buying a short-sale home.
• Longer timeline for purchase: Short sales often take longer than traditional sales because the lender and any other lienholders must approve the sale.
• Increased buyer risk: When you pursue a short-sale home, there’s a higher risk that the deal falls through. For example, the seller’s lender might not approve the sale, or the property might not meet FHA loan requirements.
• Emotional stress and uncertainty: Buying a home is a major life decision. It can be hard to be emotionally invested in a deal that may fall apart, especially if it’s your first time.

Should I use an FHA loan for a short-sale home?

Using an FHA loan to buy a short-sale home may be a smart move if you’re a first-time buyer with limited savings or you’re not in a rush. However, if you need to move quickly or don’t want to take on any repairs, you may want to explore other options.

Before buying a short-sale home with an FHA loan, carefully weigh the benefits and risks.

How to buy and finance a short-sale home

Here’s how to buy and finance a short-sale home with an FHA loan:

1. Get preapproved through an FHA lender. A preapproval letter tells you how much you can borrow and shows sellers you’re serious.
2. Find an experienced real estate agent. They can help you find short-sale properties by asking their professional network for referrals.
3. Make and negotiate an offer. Your offer should be high enough to be competitive but low enough to compensate for the extra risk.
4. Have the short-sale home inspected. The home inspection is an important step that lenders require. It reveals the property’s condition and potential red flags.
5. Wait for lender approval. The sale must be approved by both your lender and the seller’s lender.
6. Close on the property. Once all parties have agreed to the purchase agreement, finalize the deal by signing the closing documents.

FAQ

Here are answers to frequently asked questions regarding buying a short-sale home with an FHA loan.

Is it a good idea to buy a short-sale home?

Buying a short-sale home can be a cost-efficient option for buyers who are aware of the risks, do their research to understand the property’s condition, and are patient enough to deal with a longer timeline and more complex transaction.

What can I do if the short-sale home doesn’t meet FHA requirements?

Typically, you won’t be required to make repairs that help the short-sale property meet FHA standards. Instead, you can explore other loan options, such as FHA 203(k) loans (not available through Rocket Mortgage®), conventional mortgages, and other government-backed programs.

What if the seller’s lender doesn’t approve the short sale?

If the seller’s lender doesn’t approve the short sale, you can submit another offer. Otherwise, you’ll likely need to look for a different property to buy. Consult a reputable real estate attorney to help you navigate this issue.

Can I use an FHA-financed short sale as a rental?

Typically, no. However, you can use an FHA-financed short-sale property as a rental if you live in one unit and rent out the others (for up to four total units). Alternatively, you can occupy the property for a year (thereby fulfilling the FHA’s occupancy requirement) and then move out to turn it into a rental.

How long does it take to buy a short-sale home with an FHA loan?

A short sale can take 3 - 6 months. However, lender approval, FHA appraisal issues, and multiple lienholders can delay the process.

The bottom line: Consider an FHA loan for your short-sale home purchase

Buying a short-sale home with an FHA loan can open the door to homeownership at a lower price, but it comes with unique challenges.

While FHA loans offer flexible credit and down payment requirements, you and the property must meet strict eligibility standards, which can complicate the sale. Before moving forward, carefully weigh the pros and cons to see if this path aligns with your goals and timeline.

If you’re ready to take the next step, start your FHA mortgage application with Rocket Mortgage today!