Guest Post by G. Brian Davis
If you’ve ever thought about buying an investment property, your first question was probably “How do I finance it?”
Investment property loans don’t work identically to home mortgages. The underwriting standards are tighter in most — but not all — ways, and they inevitably cost more.
As you explore how to fund your first rental property or flip, keep the following differences in mind.
Yes, you can borrow an investment property loan from traditional banks and mortgage lenders. But they’re slow, difficult to work with, and inflexible. Worst of all, most conventional loan programs only allow you to have up to four mortgages appearing on your credit report before they disqualify you.
Even if you use traditional mortgage lenders for your first few rental properties, you can’t use them forever.
Instead, many rental investors turn to portfolio lenders: lenders who keep their mortgages on their own books — their own portfolio — rather than selling them off like traditional lenders do. These lenders charge comparable interest rates and fees to traditional lenders, sometimes slightly higher.
But, they offer far more flexibility, since they don’t need to fit you into a rigid loan program to sell off your loan. That means they can also settle much faster than traditional lenders.
Of course, you may not be in the market for a long-term rental property mortgage. If you plan to flip a house, you need a hard money loan: a short-term, purchase-rehab loan in order to have money to buy the property and money to renovate it.
Compare interest rates, fees, loan terms, and more for investment property loans before you commit to a lender, as they vary widely.
The government backs several mortgage programs designed to help first-time buyers with bad credit become homeowners. The most well-known example is FHA loans, which allow you to buy a home with a credit score as low as 500.
Real estate investors don’t get the same subsidies on the backs of taxpayers.
While there are a few portfolio lenders who allow credit scores as low as 620 or even 600, most require a minimum score of 660 or 680. If your credit score sits below 700, expect turbulence when shopping for an investment property loan.
Traditional mortgage lenders look at your debt-to-income ratio to determine how much to lend you. Your home mortgage is a personal expense, and they need to make sure you don’t overstretch your budget.
But rental properties aren’t an “expense” in the traditional sense. Instead, they should generate positive cash flow for you.
So instead, portfolio lenders calculate what they call “debt service coverage ratio” or DSCR. Rather than looking at your income, they look at the ratio of the property’s loan expenses to its market rent.
The DSCR formula looks like this: Annual Net Operating Income (NOI) / Annual Debt Service.
For example, say a property produces $6,000 in net income annually, after vacancy rates, management fees, repairs, and so on. If the annual cost of the debt service is $4,000, then the DSCR is 1.5: $6,000 / $4,000 = 1.5.
Most investment property lenders require a minimum DSCR of 1.25.
As a general rule of thumb, expect the interest rates on investment property loans to cost 0.5–0.75 percent higher than homeowner mortgage rates.
So, if you would pay 5 percent for a homeowner mortgage in today’s market, expect to pay 5.5–5.75 percent for an investment property mortgage.
Portfolio loans can cost a little more, perhaps one percentage point higher than homeowner mortgages.
Expect hard money loans to cost more. They typically cost at least two percentage points higher than homeowner mortgages, and often closer to four or five percent.
Then there are the fees. Mortgage lenders charge percentage fees called points, plus flat fees (also known as “junk fees” within the industry). Investors should expect to pay at least two points on investment property loans, and hundreds of dollars in flat lender fees.
These higher fees and interest rates combine for overall higher APRs on rental property loans than homeowner mortgages, borrower beware.
Many homeowner loan programs allow low down payments, such as the 3.5 percent down payment on FHA loans, 3 percent down payment on some Fannie Mae and Freddie Mac loans, and the famous 0 percent down payment on VA loans for military service members.
You won’t be so lucky as an investor.
Expect to pay a minimum down payment of 15 percent, and usually 20–25 percent or even higher if you have weak credit.
That’s the bad news. The good news: portfolio lenders and hard money lenders allow you to borrow the down payment, unlike conventional lenders.
That means you can tap into home equity loans, HELOCs, credit cards, or your rich Aunt Susan to help you come up with a down payment.
If you like the idea of investing in real estate but aren’t quite ready to buy a property, you have a few other options for investing.
First, you can invest in real estate through crowdfunding platforms. Some allow you to invest with as little as $10.
You can also buy shares in publicly traded real estate investment trusts (REITs). Some high-dividend REITs pay yields as high as 20 percent.
Alternatively, you can invest in real estate syndications. They pay high returns, but come with high minimum investments unless you pool funds with friends, family, or an investing club.
Lastly, if you like the idea of buying an investment property but worry you won’t earn enough yield in today’s market, you can always buy a vacation rental to list on Airbnb. As an added perk, you can use it in the off-season when vacancies are high.
The bottom line: you don’t need to cough up a $50,000 down payment to start investing in real estate. Start with a strategy you’re comfortable with, and expand your real estate portfolio slowly from there.
G. Brian Davis is a real estate investor and co-founder of SparkRental.com, which helps everyday people build passive income from rental properties on the side of their full-time jobs. Brian’s goal is simple: to help as many people as he can reach financial independence, so they can cover their living expense entirely with rental income. Connect with him through SparkRental at any time.
April 12th, 2023
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