FHA Rule For Homebuyers Keeping Their Current Home

There are new rules in effect for buyers who are retaining a primary residence but want to purchase a new home with FHA financing.  In an effort to keep borrowers from walking away from their obligations on their current mortgages, FHA has changed the rules for home buyers who want to retain their current home as a rental property and offset the payment with rental income. 

This new rule, as outlined in Mortgagee letter 2008-25, is intended to be a temporary guide while a more permanent solution is considered.  The rule is effective immediately (as of September 19th, 2008) and will exist "until further notice".  

I expect HUD to keep at least some form of this rule in effect for a long time or perhaps even permanently since the guidelines for offsetting mortgage payments with rental income have been very lax in recent years.  Up until this point, most underwriters rarely verified the legitimacy of offsetting leases, which opened up the floodgates to fraud and higher default rates.   In many cases, home buyers would walk away from the mortgage on their other home after closing on the new one, which has contributed to significant losses for both FHA and many other mortgage insurers and investors.  It was only a matter of time until they changed these rules.     

So what does this mean for home buyers who want to retain their current primary residence? 

• If they are able to qualify with both mortgage payments (i.e. their debt-to-income ratio is acceptable), then there's no need to worry unless there's a "common sense" issue about the legitimacy of their claim to occupy the new property.   No lease agreement would have been required to offset the payment prior to this rule, and none will be required now.  At the very least, underwriters might require a "letter of disposition" from the borrower that states their intention with the property (i.e. list it for sale, find a renter in the future, give it to a relative, etc). 
• If the home buyer is relocating or transferring jobs to an area that's not within reasonable and locally accepted commuting distance, then they CAN offset the payment with a lease with no equity requirement in the current property provided they present a fully executed lease with a term that extends at least 12 months from the date of closing on the new property.  Furthermore, FHA recommends that underwriters verify evidence that the lessee paid either the first months rent or a security deposit.  A cancelled check would suffice in this situation. 
• If the borrower DOES NOT qualify with both payments but has at least 25% equity in their current home, then FHA will allow rental income to be counted.  The equity must be verified by either obtaining an appraisal or comparing the amount owed on the current mortgage with the original sales price. 

Does this mean that borrowers can't offset mortgage payments on other rental property?

• No, provided they are claiming the income on Schedule E of their tax returns, they will still be allowed to offset those payments.  Again, this has always been the case and will not be affected by this new rule.  This new rule only pertains to offsetting the mortgage payment for property the borrower currently occupies as a primary residence. 

Can borrowers offset the mortgage payment dollar-for-dollar with the rental income?

• No.  There are specific guidelines outlined for this in HUD's Vacancy Cost Factors.   For example, the Vacancy Cost Factor in Texas is 15%.  If a borrower's PITI on their current home is $1000 and they are leasing their home for $900 per month, we can only give credit for 85% (100% minus the vacancy factor of 15%) of the gross monthly rent.  So in this example, the result would be a $235 debt added to the borrowers debt-to-income ratio ($1000-($900X.85))=$235.  This would affect the borrower's DTI the same as a $235 car payment or a $235 minimum payment on a credit card.  The result is far from a dollar-for-dollar offset because HUD maintains that an average of 15% of the rental property in Texas is vacant at any given time.  Therefore, 15% of the amount of the rent is deducted. 

Home buyers must also be careful not to overstate the amount of rental income they receive for their property.  Underwriters reserve the right to deem excessive amounts unreasonable, so it's never a good idea to set a "target" for the sake of qualifying for the loan.  Many underwriters will require the appraiser to state market rent amounts on the appraisal as well, and those must be consistent with the amount of rent shown on the lease or the underwriter may lower the rent for qualification purposes.