Home prices have been skyrocketing over the past year or so, which means it’s no surprise that the demand for rental properties has gone up as a direct result. In fact, rent has increased by 11.3% nationally. The reason is relatively simple: fewer people can afford to buy homes, which means more people are looking to rent. This presents an excellent opportunity for investors.
However, if you’re thinking about investing in homes or apartment buildings to rent out, you’ll likely need to secure financing in the form of a rental property loan.
Types Of Rental Property Loans
Taking out a loan for an investment property is a little different than taking out a mortgage for a primary home. Fortunately, there are lots of options when it comes to rental property loans. The following are some of the loan types that you can take out for your rental property investments:
Federal Housing Administration (FHA) Loans
FHA loans are insured by the federal government and are made by approved lenders. The loans are made to purchase or refinance a one- to four-family home. FHA loans tend to have excellent terms and are easier to qualify for because they’re insured by the government, which means there is less risk for the lender.
An important thing to note is that the FHA requires the borrower to live on the property for at least a year. After that, the property can be rented out.
Veterans’ Affairs (VA) Multi-family Loans
The VA multi-family loan is a great option for investors who are looking to purchase or refinance a rental property. These loans are backed by the VA, which means there’s very little risk for the lender.
VA loans are available for both one- to four-family homes and multi-family properties with up to seven units. One of the biggest advantages of a VA loan is that no down payment is required.
However, to qualify for a VA loan you’ll need to meet certain unique requirements. Mainly, you need to be a veteran, service member, or reservist. You can also qualify if you are the spouse of a service member, veteran, or reservist who was killed in the line of duty. Like an FHA loan, you’ll be required to live in one of the units for at least a year before you can rent it out.
A portfolio loan is a type of loan that is held by the lender instead of being sold on the secondary mortgage market. This means that each lender can set their own terms, which gives them the flexibility to work with borrowers who might not qualify for a conventional loan or who may be looking for better terms.
Portfolio loans can be used to finance multiple one- to four-family homes and multi-family properties. These types of loans are also easier to secure once you’ve built a relationship with a lender and you’ve earned their trust because they know you’re a reliable borrower.
However, because they are easier to qualify for and because they’re often used to finance multiple properties, fees and prepayment penalties may be higher.
A blanket loan is a single loan that covers multiple properties. These types of loans are usually used by investors who own more than one property or by developers who are building several properties at once.
Blanket loans can be used to finance both one to four family homes and multi-family properties. However, they’re more commonly used to finance multi-family properties because they can be used to finance up to 10 properties at once.
If you’re just starting out as a real estate investor, a blanket loan is probably not the best option for you because they’re more difficult to qualify for and they usually have higher interest rates.
It’s essential to note that properties financed with a blanket loan are usually cross-collateralized, which means that if you default on one property, the lender can foreclose on any of the properties in the blanket loan.
Private loans are made by individuals, groups of investors, or companies. Because they’re private, the terms can vary widely. Private loans can be used to finance one- to four-family homes, multi-family properties, and even commercial real estate.
One of the biggest advantages of a private loan is that they can be used to finance properties that don’t qualify for traditional loans. For example, if a property is in need of major repairs or you’re looking to do a short sale, you might not be able to get a traditional loan. In these cases, a private loan might be your only option.
Another advantage of private loans is that they’re often more flexible than traditional loans. For example, private lenders might be willing to work with you on a longer loan term or they might be willing to give you a grace period if you’re having trouble making your payments.
Some private lenders may even be willing to provide better terms in return for a percentage of your profits.
Seller financing is when the seller of a property agrees to provide financing to the buyer. Essentially, the seller of the property will also act as your lender. This type of financing is often used when the buyer is unable to qualify for a traditional loan.
The reason why a property owner might decide to offer seller financing is that they can generate interest income. They can also earn a monthly mortgage payment instead of getting the proceeds of the sale in a single lump sum, which can help them spread out their capital gains tax payments.
Home Equity Line of Credit (HELOC)
A HELOC is a loan that’s secured by your home equity. Home equity is the portion of your home’s value that you own outright or the portion that you’ve paid off. For example, let’s say your home is worth $200,000 and you still owe $100,000 on your mortgage. In this case, your home equity would be $100,000. As such, you could take out a HELOC of up to $100,000.
One of the biggest advantages of a HELOC is that they’re relatively easy to qualify for if you have equity in your home. They’re also flexible because you can use them for a variety of purposes, such as home improvements, investments, or even to consolidate other debts.
Another advantage of a HELOC is that they usually have lower interest rates than other types of loans. This is because they are secured by your home equity. However, it’s important to note that HELOCs typically have variable interest rates, which means that your payments could fluctuate up or down over time.
As a rental property investor, a HELOC can be a great option if you already own equity rental property and it’s in need of repair, or you’ve bought a second property that needs work done on it. In this case, you could take out a HELOC on your first property to pay for the renovations needed on the second one.
How Does A Rental Property Loan Work?
The reason why rental property loans are a little different than home mortgages is that lenders know that homeowners will do everything they can to pay their mortgage on time and in full. The last thing a person wants is to have their home foreclosed on and to be without a place to live, after all.
This kind of urgency to pay back a home loan isn’t the same for real estate investors since they’re not at risk of losing their homes. At worst, they may lose their investment.
Lenders will also be wary about the quality of your investment. They want to make sure that the property you’re buying is a sound investment. If it’s not, it presents a greater risk to the lender because if the property goes into foreclosure they may have to resell it at a loss.
Additionally, investors will often need more than just the purchase price, especially if renovations are required. As a result of all of these factors, lenders tend to charge higher interest rates and require larger down payments for rental property loans. They may also have large financial reserve requirements that help put their minds at ease.
What’s Included In The Loan?
The following are some of the typical expenses that a rental property loan can help cover:
- Construction: If you’re planning on building an addition to an existing property or building a new building from scratch, your loan should cover the cost of construction.
- Purchase: The loan will cover the price of the property, not including the down payment that you’ll have to make out of pocket.
- Rehab: If a property is in need of repairs or renovations, a rental property loan can include the funds needed to do so.
Properties That Qualify For Rental Property Loans
It’s worth mentioning that not all properties qualify for a rental property loan. For example, a property designed as a retail space probably won’t qualify for a rental property loan. The following are the types of properties that will qualify for a rental property loan:
- Single-family homes: A single-family home is the most common type of property that you can purchase. They are homes that are meant for a single-family – the kind of property often used as a primary residence for homeowners.
- Small multi-family homes: These are apartment buildings with two to four units. They are a little larger than a single-family home, but not too large.
- Condominiums: Condominiums, or condos, are units that are part of a larger complex. Condos tend to be popular among renters and can often be found in large cities.
- Townhomes: Townhomes are similar to single-family homes but are attached to other units. They usually have common walls with other units.
The Minimum Requirements
As previously noted, giving a loan to an investor always presents a greater risk than lending money to a homebuyer who plans to live in the house. As such, lenders have much stricter minimum requirements in place for a rental property loan.
The following are the minimum requirements that you’ll need in order to qualify for a rental property loan:
- Minimum credit score of 620: Your credit score indicates to the lender how likely you are to repay your loan. A higher credit score means a lower risk to the lender. Few lenders will accept borrowers with a credit score of under 620 for a rental property loan.
- Maximum of 36% debt-to-income ratio (DTI): The DTI refers to the amount of debt that you have compared to your income. If you’re using more than 36% of your income to pay off your existing debts, most lenders will assume you can’t afford to take on more debt.
- Down payment of 25% or more: For a conventional rental property loan, you’re going to need to have a down payment of 25% or more. This is a much higher down payment requirement than you’ll find with a primary residence loan due to the inherent risk involved with investment properties.
- Cash reserves to cover 6 months’ worth of payment: Lenders will require that you have a cash reserve to ensure that you’re able to make your payments, even if the property isn’t generating enough income to cover the mortgage payment.
How To Reduce Rental Property Loan Costs
Even if you meet all of the minimum requirements, the cost of the down payment combined with the cost of your interest rate can be quite expensive. Fortunately, there are a few ways that you can reduce the total cost of your rental property loan. For instance, you can do the following:
Make Sure The Property Is Rent-Ready
When you’re looking at properties, make sure that the property is “rent-ready.” In other words, it should be a property that doesn’t need any repairs or renovations. The more money you need for renovations, the larger the loan amount will be. Lenders will charge you more interest as a direct result, which means you’ll end up paying more over the long term.
By investing in a rent-ready property, not only will you save interest due to borrowing a smaller sum, but lenders will view the investment as less of a risk and possibly charge less interest as a result.
Research The Best Loan Terms
Not all rental property loans are created equal. In other words, some lenders will have better terms than others. It’s important to do your research and compare different loan options before making a decision.
Maintain A Good Personal Credit Score
Even if your credit score meets the threshold for qualification, lenders may still view you as a risk. As such, the higher your credit score is, the less of a risk you present to a lender. Lenders assume that if you have a high credit score you’re financially responsible. As such, they’ll be more flexible with their terms.
Use A Loan-To-Value (LTV) With Down Payment Of 25%
An LTV is the ratio of your loan amount to the appraised value or purchase price of the property. The lower the LTV, the lower the risk to the lender. You can use an LTV to your advantage by putting down a larger down payment. For instance, if you’re looking at a $200,000 property you could put down $50,000,which would give you an LTV of 25%.
Not only will this reduce the amount you need to borrow, but it’ll also lower the interest rate on your loan. In general, the lower the LTV, the lower the interest rate.
Prepare All The Documents Ahead Of Time
Preparing all of your documents ahead of time, including your tax documents, bank statements, income statements, capital expense reports, cash flow statements, and mortgage documents, will show lenders that you’re a responsible and organized borrower.
Having all of these documents available will give lenders a better idea of your financial capabilities and, as a result, they may be more likely to offer you better terms on your loan. Not to mention, it’ll also speed up the loan process and make it more likely that you’ll be approved for a loan.
Figures Lenders Need To See Before Approving Loans
Besides the minimum personal requirements needed to secure a loan, you’ll also need to prove to the lender that the investment you plan to make is a good one.
A lender won’t lend you $300,000 for a property that is only worth $100,000, especially if it’s in a neighborhood where the rental market is down. The risk that your investment will fail (in this scenario) will be too great. While they’ll be able to foreclose on your property, it’s likely they’ll end up having to sell the property at a loss.
As such, lenders want a comprehensive understanding of how much the property will cost, both in the short term and the long term, along with an accurate estimate of the income that it will generate. To demonstrate that your investment is worthwhile, you’ll need to provide the following figures:
- Gross potential rental income: This number refers to the total amount of money you could potentially make from renting out your property. This figure is important because it shows lenders how much money you’ll be bringing in each month and that you’ll have no trouble covering your loan payments.
- Vacancy allowance: This is the amount of money you’ll need to set aside each month to cover any vacant units. Lenders want to see this number because it shows them that you’re prepared for any unforeseen circumstances, such as an extended period of vacancy.
- Leasing and property management fees: These are the fees you’ll need to pay a leasing company or property manager to handle the day-to-day tasks of running your rental property.
- Operating expenses: Operating expenses are the ongoing costs associated with owning and operating your rental property. These costs can include things like repairs, maintenance, landscaping, and more.
- Utilities: The utility costs represent another sum of money you’ll need to set aside each month.
- Homeowners’ Association (HOA) fees : If your rental property is located in a community with an HOA, you’ll need to set aside money each month to cover the fees.
- Property taxes: You’ll also need to set aside money each month to cover your property taxes.
- Insurance: You’ll need to purchase insurance to cover your rental property. The amount you’ll need to set aside each month will depend on the type and amount of coverage you’re required to purchase.
- Mortgage payments: Lenders will want to see what other mortgage payments you have. This is important to them because it shows how much debt you’re currently carrying and whether or not you’ll be able to make your new mortgage payment.
Choose The Right Loan For Your Real Estate Investment
Choosing the right loan for your rental property is crucial as it will determine how much you’ll need to pay each month and over the life of the loan. There are a number of factors to consider when choosing a loan, including the type of property you’re buying, the down payment you’re able to make, the interest rate, and more.
By choosing the right financing option, you’ll be able to maximize the potential profit of your rental property at minimum cost.