10 Loan Options When Purchasing an Investment Property
Renters Warehouse Blog
Real estate can be a great investment opportunity, and is something that people have been using for generations as a way to secure, and grow, their wealth. But when it comes to investing, the type of loan that you secure can have a significant impact on your returns.
That’s largely because financing real estate allows you to use leverage to grow your portfolio. This wealth-generating strategy allows you to scale your real estate empire a lot more quickly than you’d be able to if you were paying all-cash for every property and paying for everything on your own. You can think of leverage as a way to shortcut your way to rental property success.
Of course, this isn’t to say that financing a property is always better than buying outright. The truth is, there are many different ways that you can go about investing in real estate, and there is something for everyone. Still, when it comes to investing, knowing the options that you have available to you can help you to find the best opportunity, one that’ll allow you to generate the returns that you’re looking for. That’s why it’s important to know what loan options are available for investors.
How Does Leverage in Real Estate Investing Work?
Before we go any further, let’s take a quick look at leverage, and see why this wealth-building tool is so valuable.
With leverage, you can use other people’s money (like the bank’s) to grow your investment, while at the same time generating returns on the entire portion that’s invested – not just the portion that you put in yourself. For a conventional loan, you could put in 10% or 20% as a down payment, and the bank would finance the rest. For this scenario, let’s say you’re financing a $300,000 property. In this case, 20% would be $60,000 - the portion that you put in. Meanwhile though, you can start generating rental income on the value of the entire property, while also experiencing appreciation (in most cases) on the entire property as well. If you were paying all-cash, it would take you a lot longer to grow your net worth this way as you’d only be getting returns on the portion that you personally were able to invest. So that $300,000 property suddenly becomes a $60,000 property in this scenario because that’s all you could afford.
Loan Options for Purchasing an Investment Property
Now that we’ve seen the value of leverage, let’s look at how an investment property loan works.
An investment property loan is a type of mortgage used to purchase a piece of real estate that’s bought as an investment. Investors take out these loans when they’re looking to acquire a rental property or if they’re looking for a property to buy and flip. You can take out a loan if you intend to buy single-family homes (SFR) and multi-family homes, such as an apartment building, but of course, in most cases, loans for SFR are usually much easier to obtain. Still, that depends a great deal on the property in question and its value.
As you consider different property investment options, you also need to factor in the different types of loans that you will have access to. The borrowing options range from credit unions and traditional banks to other loans by hard money lenders or private lenders. You can also get FHA loans, in some cases, for investment property or look for a seller who’s offering seller financing. There are a range of options out there and there really is something for everyone.
Whether you are buying your first property, refinancing an existing mortgage, or adding to your property portfolio, these rental property loan options are available to help.
With this in mind, here are ten loan options for you to consider:
- Conventional Bank Loan
These are the most familiar loans offered by traditional lenders like banks or credit unions and mortgage brokers who work with various lenders to help you find the best deal.
Here are the key factors that you need to be aware of before applying for a conventional bank loan:
- The typical expectation for a downpayment is about 20% to 25% of the home purchase price, some lenders may ask for 30%.
- Your credit score will help to determine your ability to get approved and the interest rate.
- Borrowers must prove that they can afford the existing mortgage and monthly payments. Keep in mind that with this type of loan, future rental income isn’t usually factored in.
- Lenders typically have stricter standards for those who want to qualify for more than four mortgages.
- Hard Money Loan
This is a short-term loan that’s often used for house-flipping or rental properties. Some investors will use hard money loans to purchase a property that’s in need of repairs. The hard money loan gives them the funding they need for repairs. Once it’s fixed up, they can sell it or refinance to a traditional mortgage.
The advantage of going for hard money loans is that they can be easier to qualify than a conventional loan. This is because the lenders will often focus on the home’s estimated after-repair value (ARV) and profitability.
However, hard money loans also come with several disadvantages:
- These loans are not cheap. The interest rates can be high.
- Some lenders will expect you to pay back the loan within one year.
- You might need to pay a 25% down payment and additional upfront costs to get the loan.
- Closing costs are usually higher than conventional loans, which affects your returns.
- Some lenders will have a prepayment penalty.
- Blanket Mortgage Loan
A blanket mortgage loan is designed to cover multiple investment properties. This type of loan can be ideal for investors who are looking to buy multiple rental properties and finance them with a single loan. You can get these loans from private lenders or mortgage brokers. However, each of these lenders will have different terms, such as interest rates, length of the loan, down payments, and credit score requirements. These terms can be customized to meet the needs of the lender and borrower.
With blanket mortgage loans, the rental units are often cross-collateralized; therefore, every individual property can act as collateral for another rental unit. However, it is possible to request a release clause that allows you to sell one or more of the properties covered by the loan without having to refinance the other units.
- Home Equity Loan and HELOC
You can secure an investment property using a home equity loan and home equity line of credit (HELOC). But of course, for this option, you’ll need to own a home already in order to access this equity. In most cases, it’s possible to borrow up to 80% of the home’s equity value which you can then use to buy, refinance, or renovate an investment property.
A home equity loan usually works like a type of second mortgage with a fixed rate, and the funds are paid in one lump sum, while a HELOC works more like a credit card that you can use and pay off for a specific period. Each of these loan options has advantages and disadvantages that you need to consider before you opt for one.
For instance, with a HELOC, you can borrow against the equity in the same way as a credit card and pay monthly interest. However, this rate may be variable, which means it could increase if the prime rate changes.
Want to learn more about how to buy rental property with little to no capital? Read How to Buy Rental Property With No Money!
- Private Money Loan
Private money loans are provided by individuals or in some cases, companies, that are essentially private lenders. This means instead of working with the bank or a large institution, the investor can get funding directly from the private money lender. Private money loans are often a good choice for experienced investors who are looking to purchase subsequent properties, when funding from the banks often becomes difficult. Since the investors understand how the real estate business works, they often offer loan terms that fit better for investors.
Some private lenders might offer lower interest rates and fees in exchange for equity in the project and future potential profits. The loan terms from private lenders can vary depending on the relationship between the lender and the borrower. To ensure that everything goes smoothly, these loans should always be secured by a legal contract. Keep in mind too, that usually the private lender will want to include a clause that allows them to take over the property in case the borrower defaults on payments.
- FHA Loan
Federal Housing Administration (FHA) loans are provided by mortgage brokers and traditional lenders. With this type of loan, you can buy a two to four-unit multi-family home. FHA loans are government-backed; therefore, the credit score and down payment requirements will be lower. Because they’re designed for homeowners, not investors, you must live in the property yourself, residing in one of the units. This type of loan can be a great way to “house hack,” that is, get your way onto the housing ladder by renting out the other units and allowing your tenants to pay for your mortgage, while you essentially live rent-free. But don’t be fooled: this option is great if you know what you’re doing, but you’re going to want to make sure you have the resilience to make sacrifices while you start building your wealth. In most cases, house hackers try to live in the smallest unit to maximize their income-producing potential.
- FHA 203K Loan
If you like the idea of buying a fixer-upper property, the FHA 203K loan could be a good option. This loan provides financing for the cost of the property as well as the repairs. Just keep in mind that the FHA 203K loan isn’t for everyone–you’ll need to reside in the property as an owner occupant with this loan as well.
- Portfolio Loan
Most mortgages don’t stay with the lender that originated the loan, instead they are usually sold on the secondary mortgage market. A portfolio loan, on the other hand, is different. With this type of loan the lender retains the mortgage. This means that the lender gets to pick and choose the standards for the loan, including the credit score or how much they will lend. One advantage of these loans is their flexibility. However, the downside is that because these loans usually involve more risk for the lender, they often come with higher interest rates as well.
- Seller Financing
Seller financing is also known as seller carryback or owner financing. This happens when the sellers act as the lender. Seller financing is an option for sellers who own rental units or have minimal mortgage debt. Since the seller is essentially providing a mortgage, borrowers may still be required to have a credit check and make a down payment. Seller financing is subject to the seller’s preferences, and can vary considerably from seller to seller.
- VA Loan
Another government-backed financing program is the Veteran Affairs (VA) loan. This loan is offered by credit unions, banks, traditional lenders, and mortgage brokers. However, it’s restricted to military borrowers. Provided by the U.S. Department of Veterans Affairs (VA), these joint loans are exclusive to veterans, active duty military personnel, and eligible spouses.
As a military borrower, you can buy a rental property with seven units as long as you live in one of them as the primary residence. The U.S. Department of Veterans Affairs (VA) guarantees these loans, and unlike many other loans, they don’t come with a down payment or credit score requirement.
Minimum Requirements for Investment Property Loans
Investment property loans are different from typical home loans and are often considered riskier. Because of this, borrowers have to prove financial stability.
While lending criteria varies across the board, here are the most common minimum requirements to get a loan:
- Higher minimum credit score requirements: The typical conventional bank loan comes with a minimum credit score of 620 or 640. Since investment properties pose more risk, lenders may raise the requirement to 700 or more for an investment property loan although you may be able to get away with a lower credit score by making a larger down payment, sometimes 25% or higher.
- A down payment: Most lenders require a 20% down payment when mortgaging an investment property. However, some options like FHA loans might have a 3.5% minimum down payment.
- Mortgage reserves: Also known as cash reserves, mortgage reserves refers to how much cash you have on hand to cover the mortgage. Lenders usually ask for proof of mortgage reserves of between two and six months. This varies depending on the property type and loan.
- Rental income proof: If you’re planning to use your rental income as a source of income, your lender might also ask for proof of the income. You’ll need to provide evidence like tax returns accounts, rental history, and copies of tenant leases.
- Property management history: Some loan lenders might request documents to show your experience with rental properties. For instance, you might need to provide tax returns to show that you’ve previously managed rental homes.
- Debt-to-income (DTI) ratio: Lenders generally require a borrower’s DTI ratio to be below 36%.
Tips to Get an Investment Property Loan
Before investing in rental property, you need to have the right strategies in place. Here are some helpful tips to use as you look for an investment property loan.
- Make a Large Down Payment
As you apply for a loan, you’ll need at least a 20%-25% down payment to secure a conventional bank loan. If you have a bigger down payment, you could qualify for a better interest rate. Before approaching a lender, consider saving some reserves for a bigger down payment which allows you more flexibility when shopping for loans. There’s another reason you’ll want to make a larger down payment: if your down payment is 20% or higher, you may be able to do without private mortgage insurance (PMI). Lenders usually require this but if you’re able to make a larger down payment, they usually remove this requirement.
- Work on Your Credit Score
Your credit score also affects the interest rates and eligibility for the loan. If you have a good or excellent credit score, you may be able to qualify for better loan terms and you’ll have an easier time getting approved. In most cases, this means a lower interest rate, something that can help you to save considerably over time.
- Try to Shop Around
Finally, don’t be afraid to shop around. Even if you know what type of loan you’d like, don’t feel like you have to go with the first bank that you speak to. Instead, take some time to shop around to find the best deal, often you may be able to secure a lower interest rate if you’re diligent with your research.
Investing in the real estate business can be a profitable venture. If you don’t have the cash to pay for the purchase or would like to take advantage of leverage, then a loan will come in handy. Since there are a wide range of different loan options available it’s important to ensure that you take your time to carefully research your options to find the best financing option for you.
As you compare the different options, factor in the short and long-term costs of each and how it affects your profitability as an investor. Additionally, ensure that you can afford the down payment and the monthly payments on the loan before signing up for any of them.
Want more financing options? Check out: 30 Tips for Financing Your First Investment Property.
Looking to grow your portfolio? See how you can get started today. And if you’re looking for new markets to invest in, be sure to check out your free guide: How to Find and Buy the Perfect Investment Property.
Note: The information contained in this article intended to inform and to guide. It is not meant to substitute for advice from a lender. As always, it’s important to consult with a bank or lending institution to see what loan options are available along with their terms and conditions.
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