You gotta have money to make money! Luckily, an investment property makes money so efficiently that there are many options available to finance your dreams. Some of your options may require more money upfront to have more reasonable interest rates and a longer period of payback; other options will require less money upfront but come with higher interest rates and a smaller payback window. You’ll know which choice is best for you when you get into the real nitty-gritty of your own financial situation.
Know Your Mortgage Options
The first thing you need to know is what your options are for securing funding for your investment. The source of your funding will greatly impact your budgeting and your investment strategy. So profound is this influence that you may even want to get your own finances in order to qualify for better loan terms rather than going for a loan just to start investing right away.
Option #1: Conventional Bank Loans
Since an investment property means taking on additional risk for the lender, the requirements for the loan are a little stricter. You should expect to give 20% to 25% as a down payment, have a good credit score, and have a debt-to-income ratio under 36%. Your debt-to-income ratio is the total amount you spend monthly to pay off your debts divided by your gross monthly income, which is the money you earn before taxes and other deductions are taken out.
Option #2: Fix-and-Flip Loans
Flipping a house is when you buy it, only make the repairs the property needs, and then sell it ASAP. The fix-and-flip loan you’re going to get is basically a hard money loan, which is a loan that is secured by the property you’re hoping to sell. There are both hard money lenders as well as crowdfunding platforms that specialize in these types of loans.
Rather than focusing on credit or income, the primary motivator for the hard-money loan lender is the property’s estimated after-repair value (ARV). The lender wants to make sure its loan will be paid back! Many hard-money lenders are able to provide the funds within days rather than weeks or even months. But the cost of such easy access to money is high fees and small windows to pay back the loans. Origination fees and closing costs are also higher to make up for the ease with which the money is accessed.
Option #3: Tapping Home Equity
Using your home equity you can get a one-time loan, a home equity line of credit (HELOC), or facilitate a cash-out refinancing. Since the loan is secured using the value of your home you will have access to more favorable interest rates. The downside is that since your home is the collateral that you risk losing your home if you fail to make payments. It’s riskier if you use your money on an investment property since your investment can always flounder.
Home equity loans aren’t a great idea if you only need a little bit of money. Most lenders won’t give you a loan that’s for less than $25,000. Add all the fees and closing costs and you may have tied yourself to something that’s more of a drag than an asset. You may even have to pay prepaid interest, known as “points” at the time of the closing. Getting a loan for 100k with 1 point at closing? That’s an extra $1,000 added to all the other closing costs.
Points may make it easier for you since you’re paying off some interest in advance, but they may also make things harder since you’re left with less money. Check if your lender is open to negotiating the number of points you pay. It’s not uncommon to negotiate down to zero points!
A HELOC is when the money afforded to you thanks to your home equity can be used at your discretion. The lending institution may offer a variety of ways to access those funds: a credit card, an online transfer, or a check that you deposit. Unlike a loan, there are relatively less, if any, closing costs. Most but not all HELOCs come with variable interest rates. The advantage of a HELOC is also its biggest disadvantage: it’s money that’s easy to spend. The more you spend the more challenging it is to pay back, but if you use your money wisely you should be able to emerge without a huge economic hit.
With your HELOC you should expect two phases: a period during which funds can be withdrawn and a period during which you pay off your balance. During the withdrawal period, you may have some interest payments to make or you could request being able to make payments directly toward the principal. During the payback you pay back all the money you’ve borrowed plus interest at a variable rate, although some lenders offer the option of converting the HELOC into a fixed-rate loan.
One of the dangers of a HELOC is that while the interest rate payments may be manageable during the withdrawal period, they can jump to almost twice as much during the repayment period. The shock to one’s finances may be big enough to lead one to default on one’s payments. Since the foundation of the HELOC is the equity in your home, then there’s a significant risk of losing your house if you default.
Given the above, cash-out refinancing may actually be your best bet. Cash-out refinancing is when you refinance your home for a sum greater than the value of your home. The extra money is usually used for emergencies, a big purchase (a car, roof repair, a downpayment on a rental property, etc), or to pay off high-interest debts. Since the terms are favorable it’s easier to pay the loan back, and the sum of the cash-out itself can be just large enough to accomplish your goals.
Investment property and FHA and VA loans
Investment in properties is such a big source of income that the federal government has created opportunities to help people get started in investing. This assistance takes the form of leveling the playing field for those who may otherwise be unable to invest, and to make investment easier for those who have already contributed so much to the federal government by serving in the military.
The Department of Veteran Affairs (VA) lets active service members, veterans, and surviving spouses get loans with no money down and with low-interest rates. The one stipulation is that the borrower also lives in one of the units in the building for at least a year (after a year the borrower can move out and rent the entire building).
Rental properties can have upwards of four units, be duplexes or triplexes, or even be a room or separate apartment within the home in which you live. The process of living on the property and then moving out can be done multiple times until reaching a cap known as the entitlement limit.
Another bonus of VA mortgages is that potential rent from other units on the property can help you qualify for the very loan you’re hoping to get! You don’t even have to have tenants lined up to take advantage of this opportunity, which can add upwards of 75% of the rents toward your income. Before your loan gets approved, however, your property needs to be in move-in condition and pass an inspection from a VA home appraiser.
The Federal Housing Administration (FHA) can help you finance a rental property under the condition that you also occupy a space within the building (this so the asset achieves “owner-occupied” status). The role of the FHA in financing rental properties is that they insure loans made by private lenders. It’s a risk for lenders to make loans on rental properties since someone is more likely to default on a rental than a primary residence, so backing from the FHA goes a long way to sweeten the deal for a lender.
The FHA provides more flex room as far as credit scores, down payment sizes, and real estate experience is concerned. The down payment for an FHA mortgage is 3.5% for a building with one to four units. That’s much more manageable than a standard loan that demands a 20% down payment on a two-unit property or 25% on a property that’s three to four units. The FHA let’s people with credit scores as low as 500 get loans. That’s 100 points less than what most lenders, including the VA, will accept!
The FHA also lets you use cash gifts and municipal grants toward your down payment. You could theoretically get a rental property without using your own money! And if you’re suddenly low on money, the FHA will offer you an allowance if you’ve experienced a bankruptcy, foreclosure, or short sale due to unforeseen circumstances such as illness or loss of employment. The FHA also lets you reapply for a mortgage 12 months after a major credit event, whereas most lenders will make you wait for four years.
Where to get an investment property loan
Before you get the property you need to get the money. Well, what you really need is some of the money. How much money you have will determine where you should go for a loan.
Most major banks offer both conventional and government-backed loans. This money can be used to purchase any sort of home!
Online mortgage lenders
The advantage of online mortgage lenders is that all the forms are done electronically and you can get your results faster. This way you are not bound to business hours! Remember, investment never rests.
Hard money lenders
A hard money lender will look at what you have to offer as collateral before making you an offer. They’ll be more interested in your collateral than your credit score or income. The cost is higher interest rates and shorter repayment windows, but if you need the money fast they are a good way to go.
How to qualify for an investment property loan
An investment property is different from a primary property. As such, the criteria for getting a loan for an investment property is different as well. Here’s what you should expect and what you should prepare.
Make a sizable down payment
Mortgage insurance doesn’t cover investment properties, so you’ll be expected to put at least a 20% downpayment. Although, if you can swing 25% you can end up with a better interest rate.
Be a “strong” borrower
It’s best to get your loan when your credit score is greater than 740. Any less than that and you’ll have to start paying fees to maintain the same interest rate! So, you may find yourself paying .25 points to 2 points just to get the same rate! Those charges uptop can be a significant barrier if you’re already starting with a lower credit score. One alternative is to accept a higher interest rate to begin with. Come to think of it, paying those points up top may not be the worst case scenario (remember, a point is equal to 1% of your loan’s value)!
Go to a local bank
Working with a local bank may be advantageous because they’ll know the lay of the land well enough to create loan terms that will accommodate both you and themselves. A mortgage broker is another option. They may have access to a variety of loan products. Just make sure to research the broker adequately enough that you end up with someone skilled and reputable working with you.
Negotiate owner financing
Owner financing is when the terms of the loan are set by the buyer and seller themselves. Once terms are agreed upon, the buyer will make the interest and principal payments directly to the seller. In a buyer’s market, owner financing can be beneficial because it lets you make the sale faster.
The seller does, however, take on the risk of the buyer defaulting on the loan. To make up for the risk, the seller may request a greater down payment. The downpayment can range from 3% to over 20%! But the risk may be worth it because the seller’s monthly income will be greater (remember, interest payments!). Owner financing is also advantageous for the buyer because there’s greater flexibility. The buyer can also save money because the closing costs are less with owner financing than when you work with a bank.
If you found a property that you are near certain is going to bring you profit, you can be creative enough to finance it. Credit cards, personal loans from crowdsourcing sites, friends or family, a life insurance policy if you have one, etc. Don’t give up; get creative!
Because you’re investing in a rental property, there are tax advantages to make investing more accessible. Depreciation, which is a tax deduction you take yearly, will make investing more affordable. The income made monthly will help you hold onto your property long enough for it to appreciate in value and likely get you a better loan down the line if you refinance.
These are the sorts of terms you should be thinking in rather than what would make a good home. That’s because a rental property is not your home; it’s your investment! It’s for this reason that you can allow yourself to buy cheaply. Doing so will make it easier to make your payments and hold onto your investment. A cheap property may even be the first of several properties that you own!
When looking for your rental property, look for a place where a lot of people rent that also provides a reason to keep renting. Amenities, a good school district, and access to public transportation are all useful markers. As is a university, since students always need housing.
Closing a rental property is different from closing a primary residence because you’re potentially dealing with units and tenants. You’ll have to make sure units are empty, that tenants are either in place or out of the place (depending on the situation), that security deposits are under wraps, etc. For this reason, a property management company may be a good idea since they’ll take care of all of these concerns and more. Sure, you may have to pay 6% to 12% of the collected rent to the company, but the peace of mind provided by a property manager is priceless!
Investment is what drives the American economy. That’s why the American government has gone out of its way to make investing more accessible to so many Americans. With these financing options, you can take the first steps to building an empire or simply create yourself a steady source of income to finance your life. No matter what your aspirations may be, the tools are out there to make your dreams a reality!