How to Finance Investment Properties
Most mortgage loans today are issued to someone buying a home in which to live, referred to by lenders as a primary residence. Both conventional loans and government-backed loans have programs to buy and finance a primary residence but only conventional loans can be used to finance rental properties. Government-backed loans can only be used to finance a primary residence, not a rental. But what are the guidelines that need to be followed when financing an investment property?
When borrowers first apply for a loan they are asked what the loan is going to be used for. Is it for a primary residence? A vacation home? A rental? When the “rental” box is checked, there are a few additional requirements. When financing a primary residence the minimum down payment for a conventional loan can be as low as 3.0% of the sales price of the home but with a rental property, the minimum down payment his higher. How much higher? For a rental property, the minimum down payment is 20 percent of the sales price but if you put 25 percent you’ll get slightly better terms.
You can also expect your interest rate to be a bit higher on a rental property compared to one for a primary residence. Lenders assign more risk to a loan the borrower doesn’t live in compared to one where the borrowers live in the property being financed. How much higher will interest rates be? Not a lot but you can expect the rate on a 30 year loan to be around 0.25% to 0.375% higher.
Some ask how rental income is used during the approval process as it relates to qualifying. For those buying their first investment property, the borrowers must qualify without the benefit of any existing rental income. Even if the rental income is more than enough to cover the mortgage payment which includes an amount for principal and interest, an allotment for annual property taxes and insurance, the rental income can’t be used to help qualify. But that’s with the first rental property.
When a real estate investor buys a second rental property, things change. Now, rental income can be used to help qualify and in many cases the income from the property not only pays for the mortgage, taxes and insurance but also provides a monthly cash flow as income. One caveat here, borrowers who finance their second property must be able to show at least two years of landlord experience before a conventional loan can be approved. This is done by providing two years of federal income tax returns, specifically a copy of Schedule E.
Closing costs aren’t necessarily higher with perhaps the exception of the appraisal. Lenders also ask for a Rental Market Survey to accompany an appraisal but the cost here is marginal. Otherwise, closing costs are very similar compared to costs associated with a primary residence. Once someone gets past the first rental property, any subsequent purchases are much easier to qualify for.