The U.S. Department of Housing and Urban Development (HUD) announced today that lenders will now be able to count income from ADUs when underwriting FHA loans.
Doing so may allow many more home buyers to qualify for a mortgage, even if the ADU doesn’t yet exist!
The new guidelines are part of the Biden-Harris Administration’s Housing Supply Action Plan, which aims to increase access to homeownership by addressing affordable housing challenges.
It also speaks to the immense affordability challenges in today’s housing market, driven by a severe lack of available for-sale inventory and much higher mortgage rates.
Ideally, the growing popularity of ADUs addresses these concerns by increasing the housing stock and easing mortgage qualification.
New ADU Rule Aims to Ease Affordability Woes and Increase Housing Stock
The new FHA rules regarding accessory dwelling units (ADUs) will help more borrowers qualify for a home loan when purchasing a property with an ADU.
They will also make it easier to add an ADU to an existing structure, or construct new homes with ADUs, because it’s being extended to the FHA 203k loan and FHA construction loan.
The revised FHA policy allows lenders to count income (rent) from these small housing units that are built inside, attached to, or on the same property as a primary residence.
Additionally, the presence of these housing units will effectively increase the supply of affordable housing and help families create generational wealth via homeownership.
Per the FHA, an ADU is “a single habitable living unit with a means of separate ingress and egress that meets the minimum requirements for a living unit.”
It “is a private space that is subordinate in size and can be added to, created within, or detached from a primary one-unit single-family dwelling.”
Using ADU Income to Qualify for an FHA Loan
Those who purchase a property that features an ADU will now be able to use 75% of the estimated ADU rental income to qualify for an FHA-insured mortgage.
The income is the lesser of the fair market rent reported by the appraiser or the actual rent reflected in the lease or rental agreement.
For example, if the ADU on a property will be rented for $1,000 per month, the borrower can use $750 of that income (added to their total gross income) to qualify for the mortgage.
This will lower their debt-to-income ratio (DTI) and potentially turn a declined file into an approved one.
While DTI ratios of 31/43 are generally the limit for an FHA loan, this would effectively lower the borrower’s ratios and boost their chances of approval.
It differs from so-called boarder income, which is income derived from an individual living in the primary dwelling, such as a roommate.
It should be noted that the amount of the rental income derived from the ADU must not exceed 30% of the total monthly income used to qualify the borrower.
In other words, their primary source of income shouldn’t be the ADU itself, for obvious reasons.
Borrowers who use ADU rental income to qualify must also verify and document two months of reserves (PITI).
Of note, the rental income from the ADU cannot be used to qualify for a cash out refinance.
See all the pertinent guidelines in Mortgagee Letter 2023-17.
You Can Use ADU Income Even If You Don’t Have an ADU on Your Property
Yes, you read that correctly. Even if the property you buy doesn’t have an existing ADU, you can use estimated rental income to qualify for an FHA loan.
The caveat is that you can only use 50% of the proposed income, and you must construct an ADU via the FHA’s Standard 203k loan program.
The new ADU can be attached to the existing structure, such as in a garage or basement conversion.
Using our same example of $1,000 in monthly rent, the borrower would gain $500 in monthly income to push down their DTI ratio.
Lastly, ADUs are being added to the types of improvements that can be financed when using an FHA loan for new construction.
This is intended to spur accessory dwelling unit production by allowing more new homes to be built with them from the ground up.
To that end, the new changes also include ADU-specific appraisal requirements to help determine the rent that can be generated.
And appraisers will identify and analyze ADU characteristics to more accurately determine the market value of a property that contains an ADU.
This too should advance the adoption of ADUs as more cities and states approve of their use.
FHA-approved lenders can implement the new ADU policies effective immediately.