If you’re planning on investing in a rental property, then odds are you will need to take out a mortgage to do so. However, investment property loans are much different than mortgages for primary residences. Lenders have more stringent standards for borrowers, and the interest rates are generally higher because rental properties are considered riskier investments.
After all, if a rental property stays vacant for too long, it could make it difficult for the borrower to make their payments.
It’s also worth noting that mortgage rates in general are on the rise. During the pandemic, rates were at record lows. People took advantage of the low rates, resulting in home sales – and prices – skyrocketing.
However, as the economy recovers and rates start to climb, fewer people are looking to buy. Despite higher rates, this could prove to be an opportunity for investors. More people are being priced out of the market due to increasing rates and home values, which means the demand for rental properties is growing.
With that in mind, the following guide will cover everything you need to know about mortgage interest rates and how they could affect your investment strategy.
Current Mortgage And Refinancing Trends
Typical 30-year mortgage interest rates averaged around 3% throughout 2021. However, those mortgage rates spiked to above 5% in the latter half of 2022 due to out-of-control inflation.
Although many are hopeful that interest rates will stick around 5 to 6%, many experts believe interest rates will continue to rise until inflation is lower. Because of how fast rates have risen over the past year, very few homeowners are refinancing. It also means fewer homeowners are putting their homes on the market because they are locked into lower rates.
As fewer homeowners are selling and fewer buyers are buying, home sales have been decreasing. This trend will likely continue.
Interest Rates Vs. Annual Percentage Rates: What’s The Difference?
Understanding how interest rates work is critical to determining whether now is a good time to buy an investment property. Interest rates are the percentage of a loan a lender charges for borrowing money. However, don’t confuse interest rates with annual percentage rates (APR) (APR) – they are not the same thing.
The APR refers to the cost of borrowing the loan as a yearly percentage. It includes the interest rate plus any additional fees charged by the lender (such as origination fees) and discount points.
The Impact Of APR On Mortgage Rates
The APR is higher than the interest rate because it includes additional fees the lender charges. It’s why many lenders will advertise the interest rate of the loan and not the APR.
For example, let’s say you buy a house for $250,000 and make a 20% down payment of $50,000. Then, let’s say you’re taking out a 30-year loan for $200,000 at 4% interest. Let’s also say your loan fees total $1,500. This means that although your interest rate is 4%, your APR will be 4.062%.
Looking at the APR will give you a better idea of how much it will cost you to borrow the money than the interest rate will. Not only will this give you a better idea of how much a property will cost you over the long term, but it will make it easier to calculate a more accurate return on investment (ROI).
Why Investment Properties Have Higher Interest Rates
As you begin looking at rental properties and searching for investment loans, you will find that mortgage interest rates are higher for investment properties than primary residences. Investment properties will always have higher interest rates than primary residences, no matter the current market conditions. The following are the main reasons for this:
Loans Are Riskier For Lenders
The first and most obvious reason for the higher interest rates is that investment property loans are riskier for lenders. When a lender loans you money to purchase a rental property, they are taking on more risk than if they were lending you money to buy a primary residence.
The purpose of a primary residence is to live in it. The purpose of a rental property is to generate passive income. There is always a chance that the investment fails and the income needed to make the mortgage payments isn’t generated. As such, investment property loans are considered a more significant risk, and therefore lenders charge higher interest rates.
Shorter Terms Than Residential Mortgage
One of the reasons investment property loans have higher interest rates than typical residential mortgages is because they have shorter loan terms. The most common loan term for an investment property loan is 15 years, which contrasts to 30 years for a residential mortgage.
Shorter term loans have higher mortgage payments, meaning there is a greater risk of default. As a result, lenders charge a higher interest rate to compensate for this risk.
Increasing The Risk Of Mortgage Default
When it comes to homeowners, there is nothing more important to them than making their mortgage payments.
After all, if they default, they risk losing the roof over their head. However, an investor isn’t nearly as attached to their rental properties. If their rental property fails, they are not at risk of losing their home.
In fact, if they have to choose between making payments on their primary home or their rental property loan, they’ll choose their primary home. As a result, investors are more likely to default on their rental property loan to keep their primary residence. Lenders know there is a much greater risk of mortgage default when lending to investors.
Rental Income Is Dependent On Vacancy Rates
Rental income is dependent on vacancy rates. A rental property with a high vacancy rate may not be able to generate the income needed to make mortgage payments. While a primary residence will always have someone living in it (the homeowner), there is no guarantee that a rental property will always have a tenant.
As such, lenders charge higher interest rates to protect themselves from the vacancy risk as it can lead to default.
Factors That Affect Mortgage Rates
Mortgage rates rarely remain the same because so many factors affect them. As an investor, there are several factors that you can control as a borrower. Still, many factors are out of your control. Therefore, it’s essential to understand what the controllable and uncontrollable factors are so that you can plan your investment strategy accordingly.
Controlled Mortgage Rate Factors
The following are the controllable factors that contribute to the interest rate of your loan:
- Credit Score: Lenders use your credit score to determine your risk as a borrower. The higher your credit score, the lower your interest rate will be. You can improve your credit score by paying your bills on time, maintaining a good credit history, paying down debts, and using a mix of different types of credit.
- Loan-To-Value Ratio: The loan-to-value ratio is the loan amount divided by the property’s value. The lower the loan-to-value ratio, the lower the interest rate will be. You can lower your loan-to-value ratio by making a larger down payment on the property.
- Down Payment Amount: In addition to lowering your loan-to-value ratio, increasing your down payment amount can also help to cancel your mortgage insurance. Mortgage insurance is an additional monthly cost added to your loan if your down payment is less than 20%.
As such, if you make a down payment of at least 20%, you won’t have to pay mortgage insurance, which means it won’t affect your ROI.
Uncontrolled Mortgage Rate Factors
The following are the factors that affect mortgage interest rates but that are out of your control. You must keep track of these factors as an investor to determine when the conditions are ideal for taking out a new loan:
- The Overall Economy: The overall economy has a direct impact on mortgage rates. If the demand for homes goes up, the demand for mortgages increases. Since lenders only have so much capital, they’ll charge higher interest rates as a result.
- Inflation: Inflation happens when the cost of goods and services goes up. It is measured by the Consumer Price Index (CPI). When inflation is high, lenders must charge higher interest rates to keep up with the rising costs.
- Job Growth: When there is job growth, more people are employed and have the income needed to buy a home. As a result, demand for mortgages increases, leading to higher interest rates.
- The Federal Reserve: The Federal Reserve controls the money supply in the economy. When the Federal Reserve increases the money supply, it leads to inflation and higher interest rates.
- Other Economic Indicators: Other economic indicators can affect mortgage rates, including the stock market, gross domestic product (GDP), and the purchasing manager’s index (PMI). These factors can all lead to higher or lower interest rates as they can affect the demand for mortgages.
How Mortgage Rates Are Set
Lenders set mortgage rates with consideration to all the factors mentioned above. First, they will use the market conditions to establish a base rate. They will then add a margin to the base rate based on the borrower’s credit score, loan-to-value ratio, and down payment amount. The margin is the risk premium the lender charges for lending money to the borrower.
The mortgage rate is set by the lender and can be either fixed or variable. A fixed mortgage rate means that the interest rate will remain the same for the life of the loan. A variable mortgage rate means that the interest rate will fluctuate with the market. Variable mortgage rates are typically lower than fixed ones, but they can go up or down, depending on the market.
Although lenders use the same factors to set mortgage rates, they may weigh them differently. One lender may offer a higher interest rate than another for the same loan. It’s why you should always shop around and compare rates before deciding on a lender.
Financing Options For Your Mortgage
There are various financing options to explore as a real estate investor looking to buy a rental property. The following are some of the best investment property financing options available:
- Conventional Loans: Conventional loans are the most common type of mortgage. Banks and credit unions usually issue them because they are less risky than other types of loans as they have strict guidelines for qualifying. This is because these loans are typically sold to Fannie Mae or Freddie Mac.
As a result, lenders often charge higher interest rates to offset any perceived risks.
- Portfolio Loans: Portfolio loans are typically issued by small banks or credit unions. They are held on the lender’s balance sheet instead of being sold to Fannie Mae or Freddie Mac.
As a result, portfolio loans often offer more flexible guidelines and lower interest rates, especially if the lender already has an existing relationship with the borrower.
- Hard Money Loans: Hard money loans are typically short-term loans secured by real estate. Investors often use them to finance the purchase and renovation of a property. Because they are short-term and easier to qualify for, hard money loans typically come with higher interest rates.
- Commercial Loans: Commercial loans are typically used to finance the purchase of commercial properties, such as office buildings or retail spaces. They tend to have stricter qualifying guidelines than other types of loans and often come with higher interest rates.
Why Use Investment Loans For Your Mortgage
If you want to purchase a rental property, you should consider using an investment loan instead of a traditional mortgage. Investment loans have several advantages, such as the ability to use a portion of the projected rental income to qualify for the loan, which makes it easier to qualify.
Additionally, investment loans are typically non-recourse, meaning the property is the only asset that can be seized in the event of a default. As a result, your primary residence won’t be at risk if you default on the loan.
How To Get A Lower Mortgage Rate
Because the interest rates on investment or rental property loans can be high, you may want to plan ahead. Doing so can help you to take steps to lower your interest rate. With that in mind, the following are a few tips on how you can lower your mortgage rate:
- Make A Bigger Down Payment: One of the most significant factors in determining your interest rate is how much you put down as a down payment. The more you can put down, the lower your interest rate will be. You may want to save enough money to make a sizable down payment before applying for a loan.
- Improve Your Credit Score: As previously mentioned, you’re more likely to get a lower interest rate if you have a good credit score. You may want to improve your credit score before applying for a loan by paying down any outstanding debt and making sure to keep up with your payments.
- Shop For The Best Property: If you can show that the rental property you want to buy is a good investment, you may be able to negotiate a lower interest rate. This is because the lender will see the property as a lower-risk investment. As such, do your due diligence and find a rental property with a potentially high ROI.
Monitor Your Credit Report And Scores: You’ll want to make sure that you’re monitoring your credit report and scores for any errors or changes.
Additionally, you should check your credit score periodically to see where you stand. If you see a significant drop in your score, it may be because of identity theft or fraud. In that case, you’ll want to correct the issue before applying for a loan.
- Talk To Multiple Lenders: Speak with multiple lenders before choosing one. This will allow you to compare interest rates and terms to find the best deal possible.
Consider Business Loan Financing: You may get a lower interest rate on a business loan than you would on a traditional mortgage. Business loans are typically used to finance the purchase of commercial properties, such as office buildings or retail spaces. As such, they tend to have stricter qualifying guidelines than other types of loans. However, they also often come with lower interest rates.
Can You Use Seller Financing For Property Investments?
Seller financing is a type of financing in which the seller of a property provides funding to the buyer. The seller can either lend the buyer the money to purchase the property or can offer a lease-to-own agreement.
Seller financing can be a good option if you’re looking to invest in a rental property and you don’t have the full amount of the purchase price. In these circumstances, the seller can act as the bank and provide you with the financing you need. This can be an excellent way to buy a property without going through the traditional bank loan process.
However, it’s important to remember that seller financing is a loan, and you will be responsible for making the monthly payments. If you default on the loan, the seller can foreclose on the property. As such, it’s important to ensure you can afford the monthly payments before entering into a seller financing agreement.
Get The Best Rate For Your Investment Property
When it comes to real estate investing, you must understand how interest rates work. Interest rates can make or break your ability to generate a profit on your investment. With that in mind, it’s important to be aware of the factors that influence your mortgage rate and how you can get the best rate possible.