In the past, it has been possible to obtain a conventional loan for a rental property with very little down payment and relatively low interest rates.
But times have changed. The cost of borrowing is going up, which means traditional mortgage loans are harder to get—and when you do get one they are much more expensive than before.
If you are going to invest in a rental property, then it is crucial that you understand why interest rates are so high right now, and what you can do to secure more favorable interest rates in today’s challenging economic environment.
What To Consider Before Investing In A Rental Property
Rental property investments can be an excellent way to generate passive income over the long term. However, when it comes to real estate investing, there is no such thing as a sure thing.
As such, you must consider these financial factors to determine whether it is not only worth your while to invest in the property but also whether it is financially feasible for you to do so.
The Rental Ratio
The rental ratio (also referred to as the price-to-rent ratio) is used to determine whether it is cheaper to buy or rent a property in any given location.
It is calculated by dividing the median home price by the median annual rent (in the same area).
If the resulting quotient is less than 15, that means it is better to buy rather than rent in that area, while anything above 15 indicates it is better to rent.
Knowing the rental ratio will help you identify whether owning a rental property in any given location will benefit you (there may be less demand for a rental if the rental ratio is below 15).
The Cap Rate
The cap rate gives you an idea of what the rate of return will be for your rental property.
To calculate the cap rate, simply divide the net income (the revenue of your rental property minus all expenses) by the property’s value (what you purchased it for).
The higher the cap rate, the better. Generally speaking, a cap rate between eight and 12 percent is considered good.
The Cash-on-Cash Return
A cash-on-cash return is calculated by dividing your initial cash investment by the net cash flow the property will generate. The cash-on-cash return might seem similar to the cap rate. Keep in mind, the cap rate factors in everything you invest, including the debt you take on.
The cash-on-cash return only considers the actual cash you invest, such as the down payment and your monthly mortgage payments. As such, the cash-on-cash return is crucial to determining the estimated cash flow you will need and what type of financing will benefit you most.
You should never look to invest in a rental property if you do not have any money in savings, because you need a buffer to make it through those tough real estate times that inevitably arise.
If you do not have any savings, then your investment will be at risk as soon as something goes wrong. As an investor, you should have between six and 12 months’ worth of income saved up before you start your first real estate venture.
How Are Conventional Rental Property Loan Rates Set?
When you apply for a real estate investment loan, the interest rate depends on various factors, the most significant being your credit score. If you have a good to excellent credit score, then lenders will be more willing to provide loans at favorable interest rates because there is less risk that you will default on the loan and not pay back your real estate investment.
In addition to your credit score, the type of loan you take out affects your interest rate. The longer the loan term, the higher the interest rate. The larger the down payment, the lower the rate will likely be.
Finally, the rates also vary based on the lender. Private lenders will offer higher rates than those on the real estate market. However, they may be easier to qualify for.
If you have bad credit or no credit history and cannot get a loan from a bank, you may need to consider these private lenders.
Interest rates are not static unless you secure a fixed rate. The rates in a variable interest loan can change depending on the real estate market, your credit score, and other factors that affect lending practices.
What Has Triggered This Rate Increase?
Although many factors determine the interest rate on any given loan, interest rates on conventional loans for investment properties have increased dramatically recently. There is one significant factor for this: a change made by the U.S. Treasury Department last year.
The two biggest mortgage companies in the country, Fannie Mae and Freddie Mac, both underwrite mortgage loans. They essentially “buy” loans from smaller lenders, allowing lenders to approve more loans to the borrowers.
However, the Treasury passed an amendment limiting how many investment property loans Fannie Mae and Freddie Mac can buy. The number of investment property loans they can purchase is now limited to 7 percent of the total loan volume recorded in the past year.
As a result, banks and other private lenders have less of an appetite for approving new rental property loans. There is more risk involved since Fannie Mae and Freddie Mac may not purchase them.
As a result, these lenders have increased their interest rates substantially in an attempt to cover the new risk that they are taking on.
Reasons For High Rates Of Loans For Rental Property
The recent restriction on rental home loan purchases made by Freddie Mac and Fannie Mae is not the only reason investment property loans tend to have higher interest rates than regular mortgages.
The following are a few additional reasons why you can expect higher interest rates when applying for a rental property loan:
Rental Income Can Be Unpredictable
Lenders understand that your ability to make payments on your rental property loan is highly dependent on your ability to generate income from that property. Unfortunately, rental income can be very unpredictable.
First of all, you could have difficulty finding tenants, leaving you with no income and your property vacant.
Secondly, even if you have tenants, they could become delinquent on payments or break their lease. Your rental property could bring in $1000 per month one year and then just $500 per month the following year, making it difficult to estimate how much money will be coming in to repay the loan.
Full-Time Real Estate Investing Isn’t Considered Stable
Another significant factor is the stability of real estate investing as a full-time source of income. Most people earn their income by having a regular paying job (e.g., hourly wage or salary), and they invest in real estate on the side to add some variety and boost long-term savings.
Conversely, the income generated from full-time real estate investing may not be regular and stable, due to the unpredictable nature of renting.
Whilst you may generate sufficient income to repay your loan, lenders may consider you at risk of being unable to repay your loan if that income is not stable, and that you may not have enough income potential to cover any payments for the rental property. Lenders will therefore tend to offer higher interest rates to protect themselves in case such events should occur.
Less Personal Stake In Owning A Rental Property
If the loan is for an investment property, the rate will be higher than for a primary residence. The reason for this is simple: lenders trust that you will do everything not to default on a loan for your actual home so that you don’t get evicted.
If you are in financial trouble and you own both a primary home and an investment property, you are more likely to default on your investment property.
Assets Aren’t Liquid
If you suddenly find yourself having financial problems and fall behind on a real estate loan, you will have a hard time securing the funds you need immediately, even if you have an extensive real estate portfolio.
Simply selling off one of your properties to cover your mounting debt can take a lot of time since real estate is not liquid, and it can take months to convert such assets into cash. Banks are aware of this issue, and therefore use higher interest rates to reflect this risk and protect themselves.
Why Is It Important To Get Lower Rental Mortgage Rates?
Since real estate loans tend to have higher interest rates than conventional mortgage loans, it is crucial for real estate investors who require these types of loans to find a way to get lower rates. After all, a high interest rate can severely limit your potential profits. Since the whole point of investing in a rental property is to make money, securing a low interest rate is an important step.
How To Secure More Favorable Interest Rates
As high as interest rates currently are for rental property loans, there are ways that you can secure lower rates. Some of these methods take some time, however, being patient can pay off in the long run, especially since rental property investments are long-term investments.
The following are opportunities to capitalize on when seeking to secure more favourable rental loan interest rates.
Improve Your Credit Score
There are many ways that you can boost your credit score.
For instance, ensure that you pay off your existing debts, avoid opening new accounts, avoid late payments, and report any discrepancies on your credit report. Keep your credit utilization ratio low and consider consolidating your debts using a credit card transfer or a personal consolidation loan.
Doing so can reduce the amount of interest you need to be paying and the number of monthly payments you have to make, thereby making it easier to pay off debt.
Time The Real Estate Market
Do your research to determine how the rental market is doing. Is demand high or low? If rental property vacancies are at an all-time high, it is probably best to wait until the market improves. Timing the market effectively can help you get in when rates are lower.
Make A Larger Down Payment
If you have the funds available, it is always a good idea to make a larger down payment. The bigger your down payment is, the less of a risk you present to lenders since your monthly payments will be smaller. As such, they’ll be more willing to offer lower interest rates.
Ensure That You Have Liquid Assets Or Cash On Hand
If you are financing real estate investments with a real estate loan, it is important to have cash on hand or liquid assets. Having emergency cash is especially useful if you are a real estate investor who earns your primary income by investing in property.
Lenders will view your loan as less of a risk if they know you can make payments for an extended period, even without rental income.
Calculate Potential ROI And Cash-On-Cash Return
Before you invest in a real estate loan, be sure that your potential return on investment (ROI) is high enough. If your potential ROI and cash-on-cash return are high, you can present your figures to your lender to convince them that your investment is a smart one with little risk involved. As a result, they may be more willing to offer a lower interest rate.
Establish A Long-Term Relationship With Your Lender
It is essential to establish a long-term relationship with your lender so that they understand your investment goals and can offer advice on real estate loans that will meet your needs.
If you have an existing relationship with a lender, they will be more likely to provide reasonable rates since they trust you (as long as you have made your previous loan payments on time and in full).
How To Get Financing For Investment Properties
The news that Fannie Mae and Freddie Mac are limiting the number of rental property loans they are buying is not great. However, obtaining a loan through traditional lenders is not your only option. There are plenty of other alternatives when it comes to securing financing for an investment property.
For example, you could secure a loan from a private lender or obtain private funding from a friend or family member. Another option is to get a Home Equity Line of Credit (HELOC) or Home Equity Loan using a property that you already have equity in as collateral.
If you need a fast turnaround, another option is to secure a hard money loan from a private investor. Hard money loans can be a great alternative if you are having trouble being approved for more conventional investment property loans.
Understand Why Interest Rates Might Be High
When it comes to investment property loans, interest rates have always been higher than for conventional mortgages. There are a multitude of reasons for this. However, interest rates have sharply risen recently due to a change in operation by Freddie Mac and Fannie Mae.
But do not let this be a detriment to your investment goals. The market is not set, which means that interest rates fluctuate and could trend downwards eventually. Not to mention, there are many strategies that you can employ to lower your interest rate further.
A good understanding of why interest rates may be high can help you determine the best course of action when it comes to your rental property investments.