Buying a rental property as an investment can feel like a big step. It is a smart way to generate passive income and can hold its value in a volatile market when stocks are fluctuating. If you find the right property, it may not require a lot of maintenance or upkeep on your part.
At the same time, buying rental properties requires some upfront cash. You will also need to secure the right kind of financing. It’s important to understand the different types of loans for rental properties and how you can qualify.
Qualifying for a Loan
Loans for rental properties are different than getting a loan for your primary residence. When you finance your primary residence, a lender looks at your income, debts, and credit score to approve the loan.
A rental property is considered more of a risk. If the property is vacant, you are losing money. So lenders have to look at some additional factors in approving a loan for real estate investments.
Some home loans for a primary residence require little or no money down. For rental properties, lenders want a more sizeable down payment to offset the risk of the loan. Typically, this is anywhere from 10 – 25% of the home’s value.
The lender – and you! – will want to understand the cash flow generated from your rental property. Cash flow is your total rental income minus your total expenses. Your expenses will include not only the mortgage payment but also taxes, insurance, and other costs related to owning the property.
A good property investment will be above the “break-even” mark. This is sometimes referred to as Debt-Service-Coverage-Ratio or abbreviated, DSCR. You want to be realistic about your cash flow. Consider the impact that maintenance costs, repairs, and other costs will have. Also, think about whether or not you would pay a property manager to help you if you are looking at a property that has a lot of units.
Your Credit Profile
The lender will look at your credit score as part of your loan approval. If your score is high, it demonstrates that you have handled your obligations well in the past. A lower credit score might make a lender more hesitant.
If you are looking to own multiple investment properties, you will be able to get financing more easily in the future. Having an established real estate loan portfolio will show a lender that you manage your investments well.
Types of Loans for Rental Properties
Depending on the type of rental property you are looking at, the lender will have different guidelines for approval. You will find that loans for Single Family homes with 1-4 units are treated differently than Multifamily homes that have 5+ units. The types of loans available will also depend on the lender you choose.
If you take out a conventional loan, you will have a mortgage from either a brick-and-mortar bank or an online bank. A conventional loan conforms to the underwriting guidelines of Fannie Mae and Freddie Mac, which are mortgage companies created by the government. It can be difficult to qualify for a conventional loan for a rental property.
A conventional loan requires a significant down payment. You’ll also need to have excellent credit and a low debt-to-income ratio. The lender will want to see that you can afford the monthly loan payment on the rental property in addition to your home.
Lenders will also review your assets, including other savings. Because future rental income isn’t factored into your current debt-to-income, you’ll usually also need to have six months of cash set aside in reserves.
Home Equity Loan
If you have a lot of equity in your current home, you can use this to finance your rental property. If you own your primary residence free and clear, you can take out a new mortgage on your home and use the money to buy your rental property. In this case, your rental property is not considered by the lender, and you qualify for your home loan only.
If you do not have enough equity, you can use the equity you do have as the down payment. This may make some lenders for conventional loans nervous, as you are increasing your debt to finance the purchase of the rental property.
Using your own home’s equity also increases your risk. If something were to happen and you could not make payments, you could lose your home along with your rental property.
An alternative to a conventional loan is going through a private lender. Private lenders can offer flexible terms. Whereas a conventional loan relies considerably on the borrower, rental loans through private lenders focus more on the property itself and its cashflow.
With a conventional loan, one loan can only finance a single property. Through a private lender, you can also get a rental portfolio loan. This loan allows you to finance multiple properties into one loan, simplifying your payment, and reducing loan processing costs.
You may consider forming an LLC as the “owner” of your investment property. This offers you some legal protection in the event of a liability or a lawsuit. A conventional loan cannot have an LLC as the borrower, but a rental loan can.
Your rental loan can be to purchase or refinance your investment property. If you have built up some equity, you can also do a cash-out refinance. You can then use the cash to finance your next investment property.
You may have found an investment property that has great potential but needs some work. Another type of investment on a rental property is a fix-and-flip loan. This real estate funding looks at the value of the property after the repairs are completed.
Fix-and-flip loans are temporary. Once you have completed the repairs or rehab, you would sell the property and pay off the loan.
Conventional loans are not designed for fix-and-flip situations. Because they only look at the property’s current value, you would be unable to get the funding needed to finance the work. Private lenders can give you a fix-and-flip loan.
Financing Your Rental Properties
As you look to grow your real estate portfolio, you want to work with lenders experienced in rental properties. These lenders understand the cash flow and potential income a rental can offer as an investment.