Investing in property can be a great way to generate income and build long-term wealth. However, there are some difficulties involved, particularly concerning financial matters.
This guide will cover everything you need to know about financing an investment property, from traditional mortgages to more creative (and potentially riskier) options.
An investment property is not the same as a primary residence. As a result, the criteria for obtaining a loan for an investment property vary. Here’s what you should expect and how you should prepare.
- Make a substantial down payment.
- Be a “tough borrower.”
- Consult a local bank or broker.
- Request owner financing.
- Utilize your home equity.
1. Make a Substantial Down Payment
Since mortgage insurance does not apply to investment properties, you will often need to put down at least 20% to receive traditional financing from a lender. If you can put down 25%, you may be able to get a lower interest rate.
A greater down payment gives you more equity in the property and potentially a lower monthly mortgage payment. It also means that you’ll have more skin in the game if the property doesn’t perform as expected, and you need to sell at a loss.
Furthermore, a larger down payment gives the bank greater insurance against losing its investment. If the investment fails, you will lose your whole stake before the bank begins to lose money on the property.
2. Be a “Tough Borrower”
When you apply for a loan on investment property, the bank will scrutinize your financials more thoroughly than applying for a loan on a primary residence.
This is because investment properties are generally seen as riskier ventures than primary residences. As such, banks will often require higher credit scores, lower debt-to-income ratios, and more cash reserves for investment property loans.
To make sure you look like a strong borrower, be prepared to provide the following documents:
- Your most recent tax return
- Proof of income
- A record of your current debts and their monthly payments
- Your credit score, and credit report
3. Consult a Local Bank or Broker
If your down payment isn’t as significant as it should be, or if you have other mitigating circumstances, consider going to a local bank for financing rather than a big national financial institution.
Local banks are often more willing to work with borrowers on an individual basis, and they may be more familiar with the market in which you’re looking to purchase an investment property.
Another good option is through a mortgage broker. Mortgage brokers have access to various lenders and can help you find the best loan for your circumstances. But always do research on the mortgage broker before working with one.
4. Request Owner Financing
In some cases, you may be able to finance an investment property directly through the owner. This is known as “owner financing.”
Owner financing can be a great option if you’re having trouble qualifying for a conventional loan, or if you want to avoid the hassle (and expense) of getting a mortgage. Since the closing costs are lower with owner financing than bank financing, this can be an excellent way to save money on your investment property purchase.
When pursuing owner financing, be sure to get everything in writing and have a lawyer look over the contract before signing anything.
5. Utilize Your Home Equity
If you have a primary residence, you may be able to use the equity you have in that property to finance an investment property. This is known as a “home equity loan.”
A home equity loan is like taking out a second mortgage on your primary residence. It will come with all the same risks and challenges as any other type of mortgage.
There are several options for tapping into your home equity:
- Home Equity Loan: This is a lump sum of money borrowed against the equity in your home. This loan has a fixed interest rate and term, and you make monthly payments until it is paid off.
- Home Equity Line of Credit: A HELOC is a revolving credit, much like a credit card. You can loan up to a certain amount against the equity in your home and repay it over time. A HELOC has a varying interest rate, and you only pay interest on the money you borrow as you use it.
- Cash-Out Refinance: This is a kind of mortgage refinancing in which you obtain a new loan that is bigger than your current loan and receives the difference in cash. You can use the equity in your home to get cash back with a cash-out refinance, but you need to pay closing costs and may end up with a higher interest rate.
What Are the Different Ways to Finance Investment Properties?
If you wish to invest in real estate, the first thing you should know is what your alternatives are for obtaining money for your investment. The source of your cash will significantly impact your budgeting and investment plan. This influence is so strong that you may want to get your finances to qualify for better loan terms rather than taking out a loan to start investing straight away.
Here are some ways to finance investment properties:
1. Conventional Bank Loans
A conventional bank loan is the most typical way to finance an investment property. Bank loans are usually the safest and lowest-cost option, but they can be challenging to qualify for if you don’t have a strong credit score and history.
A down payment of 20% of the home’s purchase price is often expected with conventional financing. However, the lender may need a down payment of 30% with an investment property.
Your ability to get approved for a conventional loan and the interest rate that you pay on a mortgage are both impacted by your credit score and your credit history. Lenders also scrutinize borrowers’ income and assets. Borrowers must also show that they can afford their current mortgage and the monthly loan payments for an investment property.
2. Hard Money Loans
Hard money loans are another common way to finance investment properties. Hard money loans are made by private lenders and secured by real estate.
Hard money loans are more costly than bank loans, but they are sometimes easier to obtain. Lenders often don’t care about your credit score or history when applying for a hard money loan; they’re more interested in the value of the property you’re buying.
Hard money loans are typically short-term loans, with terms ranging from six months to a few years. Additionally, the interest rates attached to hard money loans are significantly higher than conventional loans.
3. Private Money Loans
Another option for financing investment properties is private money loans. Individuals or businesses make these loans rather than banks. Most private money loans are obtained from an investor’s friends and family. Attending local real estate investment networking events is a great place to start looking for private moneylenders if you don’t have any friends or family who can give you money for an investment property.
The actual loan terms and interest rates for private money loans can range from exceedingly beneficial to predatory, depending on the borrower-lender relationship. These loans are often secured by a formal arrangement that allows the lender to seize the property if you default on payments. Consider how your relationship with the person lending you private money might suffer if you default before signing an agreement with a loved one.
4. Tapping Home Equity
Another option is to use your home equity to secure an investment property through a home equity loan, HELOC, or cash-out refinance. In most situations, you can borrow up to 80% of the equity worth of your house to go toward the acquisition, rehabilitation, and repair of an investment property.
For example, if your home is worth $300,000, and you owe $100,000 on the mortgage, you have $200,000 equity. You can typically borrow up to 80% of that amount, or $160,000.
Like other loans, tapping into your home equity will require monthly loan payments. The interest rate on a home equity loan is usually lower than the interest rate on a conventional investment property loan. However, there are risks associated with using your home equity to finance an investment property, including the chance of losing your home if you are unable to make the payments.
What Are the Requirements for Investment Property Financing Approval?
To be approved for investment property financing, you must meet a few essential requirements. These include:
- Employment and Income Sources: To be eligible for investment property financing, you must provide proof of verifiable employment. As with owner-occupied home loans, you must demonstrate full-time, consistent income from the same job for a minimum of two years. Additionally, you’ll need to provide tax returns from the past two years and bank statements and investment account statements.
- Credit Score and Credit History: The minimum credit score required to qualify for investment property financing is usually 660. However, the higher your credit score, the lower your interest rate on your loan. Lenders will also look at your credit history to see if you have made late or missing payments.
- Down Payment: For most investment property loans, you’ll need to put down a minimum of 20% of the purchase price. Some lenders may require a bigger down payment, such as 30% or 40%. If you’re unable to come up with a sizable down payment, you may still be able to qualify for financing by using private mortgage insurance (PMI).
- Asset Reserve: In addition to a down payment, you’ll also need to show that you have sufficient money in the bank to cover several months’ worth of mortgage payments. This is referred to as an asset reserve, and it is intended to protect lenders if you experience financial troubles and are unable to make your loan payments.
- Debt-to-Income Ratio: Your debt-to-income ratio is a key factor that lenders will consider when determining whether to approve you for investment property financing. Divide your monthly debt obligations by your gross monthly income to arrive at this ratio. If your monthly debt payments are $1,500 and your monthly income is $5,000, your debt-to-income ratio is 30%. Most lenders demand a debt-to-income ratio of no more than 43%.
How Much Can I Borrow to Finance an Investment Property?
The amount you can borrow to finance an investment property will depend on several factors, including your employment history, credit score, and down payment. In general, the higher your credit score and the lower your debt-to-income ratio, the more money you’ll be able to borrow. You’ll be able to loan up to 80% of the equity in your home. However, some lenders may require a higher down payment, such as 30% or 40%.
If you’re unable to come up with a sizable down payment, you may still be able to qualify for financing by using private mortgage insurance (PMI). This type of insurance will protect the lender if you default on your loan.
You can use an online calculator or speak with a loan officer to figure out how much you can borrow. Remember that the amount you’ve been approved may not be the same as what you can afford. When deciding how much to borrow, it’s important to consider your monthly expenses and debts and your long-term financial goals.
Who Can Finance an Investment Property?
Several financial institutions provide funding for investment properties. These include banks, credit unions, and online lenders. Every financial institution has its criteria for determining whether an applicant is eligible for a loan, including a required minimum income and credit score.
It is critical to compare offers from multiple lenders to find the best investment property financing for your needs. Consider the interest rate, fees, and loan terms when comparing offers. It’s also good to speak to a loan officer to get more information before applying.
Is It Risky to Finance an Investment Property?
Yes. Every investment involves some level of risk. However, investment properties are riskier than primary residences because there is a greater chance that the property will lose value. Additionally, if you can’t make your loan payments, the lender may foreclose on the property, and you could lose your investment.
Before you finance an investment property, it’s essential to do your research and understand the risks involved. It would be ideal if you also had a solid plan for making money from the property.
If you’re considering financing an investment property, be sure to speak with a loan officer to get more information about your options. They can help you understand the risks involved and find the best loan for your needs.