Becoming a investment property owner is an easy way to generate regular passive income, diversify your investment portfolio, and build equity for the future. But, unless you have lots of idle cash, you’ll need to get external financing to purchase an investment property. In fact, even if you can buy in cash, borrowing is still an excellent option due to the ample benefits it offers.
Financing an investment property is quite different from financing your primary home or car. Financing for investment property comes in different forms, timelines, and involves specific criteria you must meet to be eligible for one. Opting for the wrong type of rental property financing loan can harm your investments in the long run.
So, you must understand the different types of investment loans, their requirements, and offering before approaching a mortgage lender. In this article, you will learn about several investment property financing options and what they entail.
Option 1: Conventional Bank Loans
If you own a personal home, chances are that you may have heard of the term “conventional bank loan or conventional mortgage.” It is important that you don’t confuse this type of loan option with government-backed loans like the VA loan or FHA loan. A conventional mortgage meets the limits set by Freddie and Fannie and is not controlled or backed by the government.
Generally, conventional bank loan lenders require a downpayment of 20% of the home purchase price, but for an investment property, your lender may require that you put down up to 30% of the home purchase price. However, the credit score and downpayment required of you by a lender is usually based on your debt-to-income ratio (DTI) and liquid reserves. Also, some lenders may take into consideration the number of living units.
Furthermore, conventional loans for investment property have higher interest rates when compared to personal or second home loans. Lenders will typically evaluate your income, assets, and the number of living units. Also, it can be challenging to have more than four conventional mortgages on your credit report.
If you plan on opening four conventional bank loans at a time, then you will need to set aside six months’ worth of mortgage repayment funds at the time of the closing. For more than five, then you will need to have 25% down for a single-family home and 30% down for a multi-family apartment. You can check out Fannie Mae’s recent eligibility matrix for conventional loans.
Option 2: Fix-and-Flip Loans
While being the owner of a rental property comes with a lot of benefits, it also poses some risk and stress. From having to deal with tenants, toilets, and termites, you are also faced with managerial headaches. For some real estate investors, fixing and flipping a property is a better alternative because it allows them to recoup their investment and profits in a lump sum when the property is sold instead of waiting on monthly rental income.
A fix and flip loan is a type of short-term loan used exclusively for residential real estate opportunities that you are looking to fix and sell within a short period. For most lenders, this type of loan comes with a timeline of 6 to 9 months from the date of its purchase. Furthermore, fix and flip loans are hard money loans offered by private individuals and are secured by the real estate itself.
Just like conventional loans, there are several upsides to using a fix and flip or hard money loan to finance a house flip project. One of the major advantages is that is easier to qualify for a fix and flip loan unlike conventional loans with complex requirements. While some hard money lenders still take into consideration the borrower’s credit and income, the primary focus is on the property’s potential profitability after the fix-up.
Hard money lenders also look at the home’s estimated after-repair value (ARV) to determine if you qualify for the loan and how much you should receive. More importantly, it is possible to receive the mortgage funding in a matter of days instead of weeks or even months as seen with conventional mortgages.
The major downsides to using a fix and flip loan to finance a house flip project are the ridiculously high costs. Hard money loans do not come cheap and the interest rate can go as high as 18%, depending on the lender, and with a shorter repayment timeline. Also, when compared to conventional loans, fix and flip loans tend to come with higher origination fees and closing costs which may reduce your potential returns.
Option 3: The Home Equity Route
Another way to finance the purchase of your investment property is through the use of a home equity loan. This type of loan can be used to finance a long-term investment rental property or a flip. A home equity loan is a loan on the equity you have accumulated in your primary or rental property. Generally, it is possible to borrow up to 80% of your home equity value without having to sell the property to receive the loan amount.
For example, you purchased a multi-family apartment building for $950,000 cash and it is now worth $1,600,000 due to an appreciation in home prices. You will have $1,600,000 in equity to pull out of the house. However, your bank may decide to finance up to 80% loan to value though so you will get 80% of $1,600,000 in a home equity loan to reinvest in the purchase of your new investment property.
Financing the purchase of your investment property with the use of equity comes with its peculiar pros and cons depending on the type of loan you opt for. If you are using a home equity line of credit or HELOC, you can borrow against the equity like you would with a credit card and the monthly payments are usually interest-only. However, some lenders will only allow for a minimum amount of draws.
For a cash-out refinance, you will need to replace your existing home mortgage with a larger loan. A cash-out refinance typically comes at a fixed rate, but it may increase the repayment timeline of your existing home mortgage. An increase in your existing mortgage term will result in you paying more interest for your primary residence.
Before taking out a HELOC or cash-out refinance, you must weigh your financing options against the potential returns of the investment property in the long run. Remember that failure to repay the loan as at when due may result in you losing your home to the lender as a repayment of the loan.
Investing in rental property offers multiple investment benefits but also comes with a certain amount of risks. Financing the purchase of your investment property doesn’t always have to be a challenge if you know where and how to access the right financing option.