As an entrepreneur, you might be fascinated by the movements in the real estate market over the last few years. The appeal of large, consistent income from tenants makes businesses like rental properties very attractive. As you get close to buying your first rental property, you might be considering financing options.
This is a pretty reasonable way to approach purchasing rental properties. For some, buying a property outright may be simply too expensive. However, for others, leveraging themselves can allow them to buy more properties and use the rent from those properties to pay down mortgages that they take out.
Learning how to finance a rental property efficiently can lead to better returns. This is because it increases the number of properties you can add to your portfolio, increasing your leverage capabilities. If your dream is to become a real estate mogul or acquire more properties for your real estate business, understanding the world of financing as it relates to rental properties is important. Whether this is your first rental property, your only rental property, or the start of many, you are in the right place to begin exploring the world of financing rental properties. In this article, we’ll cover the following topics in detail:
Understanding Financing for Rental Properties
Before we get into an analysis of the different financing options for a rental property, it is important to understand the unique dynamics affecting rental properties as compared to more traditional properties.
Traditional properties in this case would be considered to be like a home. If you are going to buy a home, you can get a mortgage on your home to finance it. This type of loan is distinct from other kinds of mortgages, like for rental properties, for several reasons.
First, if a person is purchasing a home through a mortgage in order to live and work from that home, that home will have a lot of value to the borrower. When you consider this from the perspective of the lender, this makes the loan less risky. The reason for this is that the borrower will likely attempt to make payments first to their home mortgage before other types of mortgages. This is because the borrower probably greatly values the specific roof over their head that they purchased through a home loan. However, if the borrower did not live in this home, and instead rented it, it might have less value relative to their actual home.
As a result, in dire financial circumstances, the borrower would be willing to default on the loan for their rental property before the borrower defaults on the mortgage for their primary residence, or house. While this theory makes sense, it does have some serious implications that you should consider as a prospective rental property buyer.
This might make the most amount of sense again in the consideration of a home loan, but in this sense in the financial terms of the loan. For a home loan, there can typically be a lower down payment. Homes loans come along with lower interest rates and increased term lengths since the bank knows that a person is likely to continue to live in that house and pay the mortgage payments. As a result, a home loan can be quite cheap. They are also relatively easier to get approved for.
Once you move to the world of financing a rental property, however, the loans that are offered are usually more expensive. This usually manifests itself in an increased down payment, increased interest rate, and decreased term length relative to a home loan. In all, these make buying a rental property off of a loan a lot more difficult and expensive. However, understanding these pricing dynamics can help you maneuver your financial situation to be as good as possible.
Increased Down Payment
If you are looking to buy a rental property with a loan, you will likely experience an increased down payment size relative to that which you might get on a home loan for your primary residence. This is because of the increased risk of default on a rental property as compared to a home loan. A bank needs to be convinced that people will rent your property, pay you regularly, know that the value of your rental property is at its actual level, and that the collateral can be recovered in good condition if something goes wrong. This increased down payment price will raise your initial cost of purchasing a rental property. It is not a small expense to write off. To be successful in this business venture, you should be sure you have an ample down payment to be able to make on your loan.
Increased Interest Rate
Another expense that you will need to account for is the increased interest rate that you will be paying on your mortgage payments. Your rental property loans will demand a higher interest rate as a result of the increased risk that the lender is experiencing in terms of default with your rental property loan. Since this will represent a higher ongoing cost for you as a property owner or manager, you need to be ready to factor this into your calculations.
Decreased Term Length
One of the other disadvantages of rental property loans relative to those of home loans is the decreased term length on the loans that lenders are likely to offer you. Due to the increased risk of default on a rental property loan, a lender is likely to make the loan term shorter than that of a home loan, for example. As a result, you should expect a higher amount of monthly mortgage payments on your rental property. Your rental income will need to be able to cover your monthly payments and more. This is important to factor into your expected expenses and the relative profitability of your decision to use leverage to acquire a rental property.
As an entrepreneur seeking a rental property loan, you will need to be prepared to have your debt-to-income (DTI) ratio assessed. As it sounds, debt-to-income is the ratio of your monthly debt to your monthly income. Your monthly debt reflects the total of all outstanding debt payments that you need to make relative to your income. This represents a measure of risk to lenders.
As you prepare to get into real estate investing, you need to be sure that your debt-to-income ratio is at acceptable levels. You should aim to have a debt-to-income ratio level of less than approximately 35% to 45%. Otherwise, you might need to turn to less conventional options in lending. Nevertheless, this post has you covered. You can find all the information you need to know about a wide variety of lending available to accommodate your entrepreneurial needs.
Another important aspect of financing a rental property is being sure that you have a good credit score. For a rental property loan, you will likely want a minimum credit score of 620. While this will vary between lenders, this is a good starting point to cross-reference your credit score. The higher your credit score the better, as lenders will likely accommodate those with a higher score at a lower interest rate.
As a result, establishing a good and robust credit history can contribute to your rental property business being even more profitable. This is because less interest reduces the monthly payment obligation on the property loan. As you become a more experienced real estate investor, spending time on improving your credit score can be a great idea to make your leverage more affordable.
Having reviewed many of the aspects of rental property loans, it is now time to consider how you can finance a rental property. There are many loans available to you, which can be especially useful in different situations. Reading through your loan options and comparing them to your financial situation can help make your decision to buy an investment property as smooth and cheap as possible.
Firstly, the majority of homes are bought through conventional loans. It might be the first option you think of when considering financing a rental property. Banks and credit unions are popular sources of conventional loans. They usually have longer terms, lower interest rates, and notoriously long and difficult application processes.
When you go to apply for a convention loan, you should be prepared to have your finances scrutinized by the bank. Your credit score, debt-to-income ratio, employment, debt, and income information will likely be asked for. Conventional loan lenders will likely also ask you for a few additional details since you are considering using the loan for an investment property.
As mentioned earlier, your credit score here will be important. You should have a credit score of 620 or greater. You will also need to provide information on how much of a down payment you are prepared to place on the property. Investment property loans will typically require 15% down for a conventional loan alongside something called private mortgage insurance. Private mortgage insurance is a type of insurance that insures a lender against losses in a mortgage. The borrower is responsible for paying the insurance.
This insurance can add an additional cost to your rental property business. If you are looking to avoid paying for private mortgage insurance, you will likely need to make a down payment of 20% or greater on the property.
Overall, conventional loans, while a cheaper option, are not great for everyone. Those who are interested in the fast and easy processing of a loan may not find a conventional loan to be for them. Moreover, conventional loans do regularly reject people who do not meet specific financial criteria. While conventional loan lenders may reject people who do not meet their specific requirements, there are other types of lenders available to them. One of these types of lenders is known as an online mortgage lender.
Online Mortgage Lenders
Online mortgage lenders are exactly as they sound. They are convenient, alternative lending options that allow you to apply for a loan from the comfort of your home. The processing and paperwork for the loan can be done online from a computer. This makes the process very easy and convenient. Debt-to-income ratios and income requirements are usually not required by these lenders. Thus, getting an online mortgage loan is becoming more popular. It can allow you to get financing for a rental property much easier than a conventional loan.
Aside from other loaning options, if you are getting denied from loans for your rental property, you may want to consider an owner-occupant strategy. An owner-occupant strategy involves you purchasing the rental property and making it your primary residence for a year. At the end of the year, you move out and your residence will become a rental property that you can rent to tenants. This strategy can allow you to access cheaper loan terms and interest rates.
Lenders can have their loans de-risked with an owner-occupant strategy. This is because the lender is paid by the mortgage payments from you in the first year before the property is converted to a rental property. As a result, the lender can start to recuperate some of their money. By the time the property becomes a rental property, they have recovered enough of their money to be relatively sure that they will not lose money on the collateral at the risk of default.
If you are not investing in many rental properties and have the flexibility to pursue an owner-occupant strategy, it might be a great and cheap way to finance a property for your entrepreneurial venture.
Buy With Existing Tenants
In trying to get a lower rate on loans or qualify for the loans that you are applying to, pursuing a strategy of buying a rental property with existing leases may help.
One of lenders’ key challenges in providing loans for a rental property is being able to be sure that the property the borrower wants to buy will provide enough rental income to be able to pay down the mortgage. This can be especially true if the property is not rented or you have yet to build the structure you need to rent a property. However, if there are already existing leases on the property that you want to purchase, this can help make the prospect look more appealing to lenders.
As a result, you can expect the likelihood of being approved for your real estate financing to go up. You may be even offered a lower interest rate.
There are, however, also downsides to this strategy. You may want to buy a new location, renovate a location, or buy some other form of property without existing tenants. This strategy can limit the extent to which you can develop and rent a property. However, it might also be a great idea in that you can be confident of cash flow from rental income just as the lender would perceive it.
One of the ideas to finance a rental property that you should explore is a way of financing known as seller financing. If you are unable to get financing from a bank or alternative lender, you may want to consider seller financing. Seller financing is essentially where the seller sells the property to you on a loan and you will pay back the loan over time. While certain real estate holders may have seller financing programs, others may not.
As you get ready to enter negotiations in buying a rental property, you might be concerned about asking for seller financing. It may give the impression that you are unable to secure funding elsewhere. Going about this conversation carefully and intelligently may be the right strategy to get the funding you are looking for.
The exact details of the financing, agreement, and loan amount will vary between different seller financing agreements. Negotiating an agreement may be a way to get favorable terms in pursuing the financing of a rental property.
Borrow With Your Existing Home
If you are looking to finance a rental property and are still experiencing trouble finding a loan, you might consider borrowing using your existing home. There are many options for doing so. This might be a unique way to help get the loan you need to finance your first rental property.
The first option is known as a cash-out refinance mortgage. In this situation, you would get a larger mortgage on your home in place of a smaller mortgage on your home. The new mortgage value minus the old mortgage value would give you an amount that a lender would give you in cash. This cash can be used to purchase your rental property. While this strategy can make borrowing easier, it might also place an additional financial strain on you and keeping your house. You need to make sure that you can afford this strategy before you go through with pursuing it.
A home equity line of credit loan (HELOC) is another popular way to borrow to buy a rental property using your home. The way a HELOC works is by allowing a lender to use your loan as security against default. You can borrow down on a HELOC and pay interest on what you borrow. These loans are usually meant for short-term use, so they do not tend to be fixed-rate loans. These loans usually come with variable interest rates. A HELOC can be a good way to get an amount of capital up to the value of your home for a quick loan to help you acquire a rental property. However, HELOCs are also a likely more expensive option for a loan for your rental property.
Another idea you might consider borrowing with your existing home is a home equity loan. A home equity loan is pretty similar to a HELOC in that homeowners can take on a second mortgage based on the equity that they own in their home. You get a lump sum payment from your lender after you sign and can use that money to put toward your rental property. This type of loan is usually paid back in fixed payments ranging from a term of 5 to 30 years.
In all, borrowing with your home can provide you with extra options and flexibility when choosing to finance your property. However, your single-family home may not be enough to cover a multifamily rental property you may be considering. Moreover, adding a second mortgage or adding to your current mortgage may not be a smart idea given current mortgage rates. You must assess current market conditions and loan options in the context of how expensive repayment will be and the risk you are taking.
Convert Your Current Home to a Rental Property
If you are hesitant to add an additional mortgage or add to your mortgage to finance your rental property, you may have some options in using your home as a rental property. One way to avoid the high costs of some rental property loans is to simply convert your current home or property to a rental property and become a home buyer yourself. You can then use a conventional mortgage to purchase a new home for you.
While this does shift some of the risks from the investment back to you, it can allow you to bypass some of the harder restrictions and higher interest rates on a rental property loan. It can allow you to get a lower interest rate, longer term, and lower down payment on your new house. However, there can be some hassle associated with this. You may have to rent your home first before being able to buy a new home, which can put a difficult short-term financial burden on you. It might also create logistical problems with moving.
Your home may or may not be situated in a location where renting is possible. This can make the prospect of renting your home dependent on the location, among other characteristics. While this option is not ideal, it may be a good possibility if you are unable to access funding elsewhere.
There are some positives to this model, however. When buying your new home, you can get a mortgage using an FHA loan, which is a loan given by lenders and is backed by the Federal Housing Administration. This loan can make borrowing much cheaper and make converting your home into a rental property much more accessible.
Another option for getting a low-cost mortgage on a new home, which is not a rental property, would be a VA loan. A VA loan is run through Veterans Affairs, which means that you will need to have served in the US military to be able to qualify. However, if you have served, you may be able to get a cheap loan for buying a new home to live in.
Things to Keep in Mind When Selecting Your Rental Property
While there are several ways of financing the purchase price of a rental property, there are some additional things to keep in mind during the purchase process.
One of the most important things in getting ready to finance a rental property is to be sure about your investment. Especially if this is your first time buying a rental property, you will want to be careful about the potential costs involved. You may have to do renovations on the property, be prepared to fix broken appliances, construct new things, hire property management, and deal with acquiring tenants and abiding by local laws. In addition, you will need to be prepared for the cost of bank loans, loans from private lenders, or other parties. Being ready for these terms means being able to have enough room to be sure that you can make payments on time.
Your rental property will be an incredibly valuable asset. You want to make sure that you can pay the bill regarding your financing arrangements to be sure that you retain control over your property. You should be prepared to deal with bad tenants and understand that there will be unexpected costs.
As you go to buy your property, you should consider its location and the demand for rental properties in the area. If your property has existing tenants, you should understand why the owner is looking to sell the property and anticipate if there will be any problems with the current setup. You should also make sure that you will get an ample return on your investment so that you can profit from your rental property. While the passive income from rent is attractive, there are also a lot of costs involved in acquiring it.
The best way to be on top of these potential issues is to do your research beforehand. Speaking with brokers, tenants, or those who are knowledgeable about the local community is a great start for doing diligence on a potential property.
The other part that you should exercise caution with is choosing the right loan or financing option for your rental property. Lately, the increase in interest rates has made things like refinancing unprofitable and has made borrowing substantially more expensive. For a business like commercial real estate, which heavily relies upon cheap borrowing, the prospects of using leverage to buy a rental property are now dimmer.
In all, you should project out your potential costs and revenue. You should be sure that your rental property will be able to handle fluctuations in revenue due to a variety of factors, not the least of which includes economic recession or downturn. You do not want to lose your collateral, so you should work to be sure that the financing plan you select for your rental property will be able to be supported in almost all economic conditions or incidental circumstances.
One of the other things to consider about your projections is the financing option that you go with. Choosing a rental property loan with a longer term will help reduce the burden of the amount that you will owe each month. This is the idea of trying to get lower interest rates on your loan. Overall, this can leave you with more spare cash to cover expenses.
Financing your rental property can be a complicated process. Yet, once you are sure of the kind of loan you want, you can head over to a lending provider. Whether you are applying with a bank, credit union, alternative lender, or otherwise, the typical process is to apply and get your prequalification. From this prequalification, you will know what kind of rental property you can afford and get a broker to assist you in the process. Your commercial real estate broker will help guide you through the process of finally purchasing your first rental property.
Owning rental properties and being a landlord can be an incredibly lucrative and fulfilling business venture, whether it’s a small business or a large-scale operation. Like any business, many good rental businesses rely heavily on financing in order to acquire new properties and grow their operation. Financing is also the way many landlords get their start since it can be critical in allowing them to buy their first property. Fortunately, there are a variety of options for financing rental properties that individuals can take advantage of, many of which we have detailed here.
As with any form of financing, the key is to do your research beforehand and be diligent in considering your different options. Comparing your options is critical in order to get the best terms and conditions on your loan. Making sure you get a good loan with the right interest rate and conditions can make a huge difference in the long run, especially with any real estate business. Remember, the above information is just a starting place so that you have an idea of where to begin. Now, it’s up to you to start the research process for yourself and to understand the different financing options in relation to your specific situation and business. With the right approach, you could be well on your way to financing your first or next rental property.
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