Owning a rental property can be a rewarding and lucrative endeavor. Starting with a good rental property loan lays a solid foundation for your investment. Experienced investors that know how to invest in real estate understand that a critical indicator of rental property ROI is the loan terms when the property is purchased.
What Is A Rental Property Loan?
A rental property loan is a loan to purchase an investment property. Unlike a primary residence mortgage, a rental property loan is used for properties occupied by tenants instead of the owner.
These loans can be used for properties of various sizes. For example, a rental property with 1 to 4 units is considered residential real estate, and a rental property loan can be used for these purchases. An apartment building with more than four units is deemed to be commercial real estate, and a rental property loan can be used to purchase this type of property as well.
Rental Property Loans Compared To Conventional Home Mortgages
Most people are somewhat familiar with conventional home mortgages. If you have purchased a home, chances are you used a mortgage to get it. A rental property mortgage is different in a few critical ways compared to a conventional mortgage. Highlighting these differences can help create an excellent initial understanding of rental property loans and how they work.
Interest rates are almost always higher on rental property loans. For example, suppose an interest rate on a primary residence mortgage is 4 percent. In that case, the interest rate on a rental property loan for that same borrower is likely to be around 5 percent.
Lenders charge a higher interest rate on investment property loans because they are riskier. Borrowers are more likely to default on a rental loan than their home mortgage. Think about it: If you were short on cash and had to decide between paying your rental property mortgage and your home mortgage, which one would you choose? If you don’t pay your rental loan, you lose some income. If you don’t make your mortgage payment on your primary residence, you and your family will lose your home.
Higher Down Payment
Down payment requirements for investment property loans are generally higher than home mortgages. Depending on the borrower's financial profile and the property, down payments for rental properties are usually 25 percent of the purchase price or more.
In contrast, down payment minimums for a conventional mortgage to finance a single-family residence are usually much lower. In fact, many home loans require no downpayment at all. The discrepancies between these down payment minimums all come down to risk, much like the difference in interest rates.
More Savings Required
Continuing with the theme of mitigating risk, investment property lenders want to see some serious money in the bank before approving you for a rental property loan. With a conventional mortgage for a primary residence, you only need to show that you have enough money to cover the down payment if there is one.
For rental properties, lenders usually want to see that you have savings that will cover your downpayment and closing costs and 6 to 12 months of your monthly PITI. PITI refers to the factors that make up your monthly loan payment, including principal, interest, taxes, and insurance. If you have multiple investment properties, you may need to show that you can cover 6 to 12 months of PITI for all of them.
Debt To Income Ratio
Debt to income ratio (DTI) is an essential factor lenders consider when approving home and rental property mortgages. This calculation is done by tallying up all of your debt and determining what percentage of your total income it accounts for.
You typically need a DTI of 36 percent or lower for an investment property loan. That number can be as high as 50 percent for the home you live in. Requirements vary by loan type and borrower, so be sure to have your lender run the numbers that apply to your specific situation.
More Documents Needed
When you buy a home to live in, lenders are mostly just interested in your income and employment history. Verifying this involves providing them with W-2 forms, pay stubs, and 1099 forms. They may ask for your most recent tax return if you are self-employed.
For real estate investors, all of these same documents are required…and more. The rental income, operating expenses, and other documents determining how profitable your investment property is are needed. If you have other investment properties, documents for those will be required as well.
How Do Rental Property Loans Work?
You now know that rental property loans have more stringent requirements and less favorable terms than traditional home mortgages. That said, the way these loans work is pretty similar to conventional mortgages. An initial preapproval letter is created with some basic information, underwriting confirms the information, and the loan is closed so you can buy an investment property. Like traditional home loans, investment property loans are fully amortized over 30 years, which means the payments are the same amount from start to finish.
Unlike traditional mortgages, interest payments on rental loans can be deducted from your taxes. This is a result of the stricter requirement for these types of loans. Here’s a summary of some common requirements for an investment loan.
To be clear, these requirements can vary based on the borrower and the property. If you are looking to make an investment property purchase, talk to a lender about the specific requirements for you and the property you are interested in.
Types Of Rental Property Loans
Rental property financing comes in many shapes and sizes. Some have higher interest rates than others. Some require a larger downpayment than others. You get the idea. The loan you choose will affect every aspect of the terms, so research them before deciding.
These are the loans you are probably the most familiar with. Banks, mortgage brokers, credit unions, and other traditional lending institutions offer them to borrowers for both primary and investment properties.
Interest rates for conventional loans are usually lower than other loan types. To qualify for them, you typically need a good credit score. As with all loans, the less risk you present to the lender, the better your interest rate and other terms will be.
The Federal Housing Administration (FHA) backs certain loans that mortgage brokers and other traditional lenders can offer. The minimum credit score requirements are usually lower than conventional loans. In addition, unlike conventional loans, FHA loans allow borrowers to use income from rental properties when applying.One type of loan offered by the FHA is the multifamily loan. This allows investors to purchase multifamily properties, build new rental properties, or renovate an existing property. A requirement for approval is that the owner must use one unit in the investment property as their primary residence for at least one year.
The Department of Veterans Affairs (VA) offers rental property loans dispensed through credit unions, banks, and mortgage lenders. These loans are only available to active-duty military service members, veterans, and eligible spouses.
There are numerous benefits to using a VA loan to purchase a rental property if you qualify. There is no minimum credit score or down payment required, and you can purchase up to seven rental units. However, much like the FHA loan, you must use one of the units as your primary residence.
Private real estate investors can fund the purchase of your next rental property as an alternative to traditional lending approaches. The loan terms don’t have any minimum requirements so that they can be as favorable or unfavorable as the lender desires.
Private investment property lenders usually have a great deal of experience with these deals. That means they can offer terms tailored to the borrower's needs and the potential of the investment project. They can also provide beneficial terms to them, but not the borrower, so beware when taking out private loans.
Private lenders often will take a stake in the project as part of the loan. This means they have some “skin in the game,” so to speak. When the lender and borrower have aligned fortunes, it can help an investment project’s chances of success.
Investment property owners that owe little or nothing on their mortgage will occasionally be willing to serve as the lender for the new buyer. This benefits the seller because they can make more money, in the form of interest, than they would if they sold the property to a borrower for cash or with a traditional loan.
The seller doesn't get a lump sum at the closing like they would from a traditional sale. Instead, they receive monthly payments from the buyer until the sale price and interest are paid. The seller also enjoys the benefit of spreading out their capital gains tax over the life of the loan.
Seller financing can benefit buyers who don’t qualify for a traditional mortgage. However, there are no regulations for the terms, so buyers need to make sure they are favorable before proceeding.
Portfolio loans are individual mortgages on multiple rental properties given to the same borrower by the same lender. Each mortgage and property are independent contracts with their own terms, but the lender may offer some benefits to the borrower for carrying multiple mortgages with them.
Lenders with portfolio loans may offer more favorable interest rates, down payment amounts, and other loan terms. These loans can also be easier to qualify for if you are an investor with multiple rental properties.
Blanket loans are good options for real estate investors looking to purchase several properties using a single loan. These can also be used for refinancing a group of investment properties all at once. The monthly mortgage payment for all of your investment properties is rolled into one single payment.
Blanket loans are cross-collateralized. This means that each of the individual rental properties under the loan act as collateral for each other. However, some blanket loans have a release clause that allows the borrower to sell one or more of the individual properties without having to refinance the remaining real estate assets.
Rental Property HELOC
Home equity loans and home equity lines of credit (HELOCs) allow borrowers to get cash for the existing equity in their property or properties.
A HELOC is a line of credit given to the borrower with the property serving as collateral for the loan. This line of credit can be used at any time, much like a credit card.
A home equity loan is a second mortgage that provides the borrower with a lump sum of cash instead of a line of credit. This can be useful for renovating a property or putting a down payment on a new one.
HELOCs and home equity loans are useful for investors looking to use the equity they have built up in their existing rental properties to purchase more properties to add to their portfolio. The amount that can be borrowed using these loans is usually between 75 and 80 percent of the equity in the property.
How To Reduce Your Rental Property Loan Costs
You will need to reduce your loan costs as much as possible to get the most out of your investment. Here are a few of the best ways to do that when you review rental property loan options.
Determine Cash Flow Before Applying
Mortgage lenders will want to see your cash flow statement before approving you for a loan. This is to ensure your investment will be profitable so you can afford to pay back the money they will lend you. Here are a few necessary expenses and income sources to include when estimating your potential cash flow:
An investment property purchase can be an exciting and financially beneficial project. Knowing how loans for these properties work will set you up for success. Review your finances and then research the requirements and different rental property loan types before moving forward. Also, keep in mind that if you already have a rental property loan, you might be able to improve your terms with a rental property refinance.