Financing rentals and investment properties.
Many people who want to invest their money in something other than stocks and bonds and who want to collect regular income buy real estate. They can purchase properties that people are already renting, homes that can be converted into rentals, or properties in a below-average condition that can be fixed up and resold for a profit.
If you haven’t purchased a rental property or one strictly for the investment potential, there are a few more hurdles than existed when you applied for the mortgage on your main house.
Financing an investment property is a higher risk proposition than loaning money for a person’s primary residence. After all, it’s much easier for a person to walk away from a home they don’t live in than one they do.
As such, lenders will typically charge higher interest rates on mortgages intended for rental and investment real estate. They will also require larger down payments and higher credit scores.
Mortgage insurance is not available on investment properties. Therefore you can anticipate having to make at least a 20 percent downpayment on the purchase price of the property, if not more.
Lenders will consider whether you can afford to own both your primary residence and an investment property. In addition to the monthly payments, lenders may factor in the costs of maintaining a rental, such as taxes, insurance and maintenance costs.
Under Fannie Mae guidelines, borrowers who apply for mortgages on investment properties must have a minimum amount of cash in reserve in order to obtain financing. The reserve requirements are based on how many financed properties the borrower currently has.
For up to four financed properties the borrower must have six months of reserves on the property being financed, and two months reserves on each of the other financed second homes or investment properties the borrower already owns.
If the borrower already has five to 10 financed properties (10 is the limit under Fannie Mae guidelines), the borrower must have six months in reserve on the rental being financed and six months of reserves on all other properties the borrow owns and has financed.
A prospective lender will also consider your monthly debt payments as a percentage of your gross monthly income. Some lenders may allow you to borrow an amount that makes your debt-to-income ratio 43 percent, while others will cap it as low as 36 percent. In most cases, the higher the ratio, the higher the interest rate you’ll pay on the investment property.
You may be able to use the property’s rent revenue as income to help you qualify for the loan, but the lender may also require documentation that shows current rent income and a minimum number of years of property management experience before granting the loan.
Using a home equity loan
If you have a considerable amount of equity in your primary residence, a home equity loan, a home equity line of credit or a cash-out refinance could be an option to financing a rental or investment property.
Lenders will typically allow you to borrow up to 80 percent of the equity in your home for any purpose. So if you own a $500,000 home with a mortgage balance of $250,000, you have $250,000 in equity. If you borrowed the full 80 percent, you could pay cash for investment properties of up to $200,000.
One of the advantages of using a home equity loan is that it’s secured by the primary residence. From the lender’s perspective, the investment property doesn’t matter since a home equity loan can be used for anything. The only factors that will matter are your income, your credit and the amount of equity you have in your primary residence.
From the lender’s perspective, a home equity loan is less risk than a mortgage on an investment property because borrowers typically have a stronger commitment to their main homes than they do to second homes. Therefore, you should be able to obtain a lower interest rate on a home equity loan than you could on a second home.
You can also use a home equity line of credit to either finance the purchase, the downpayment or ongoing expenses. The advantage of using a HELOC is that you don’t have to begin paying back the loan for several years, and you will only owe interest on what you borrow.
Another option is to refinance your home for more than what you current owe on it, and using the difference to make the down payment on the investment property or pay for it altogether.
The main downside of these tactics is removing a large chunk of equity from your main home. But assuming you can use the amount to pay for the entire cost of the rental, you will have plenty of equity in that property.