8 Types of Rental Property Loans for Real Estate Investors
As a real estate investor, finding "the one" is exciting — that property that checks all the right boxes and is just begging to become a rental. You can see the cash flow opportunities clearly and are ready to move further toward financial freedom.
But finding that perfect property is just the first step. There can't be a great rental property deal without reliable funding. That means your attention needs to turn toward finding a dependable lender to help you get into the deal.
You want to find the most competitive loan rates and favorable terms to maximize your return on investment (ROI), and several options are available for financing a rental property. Plus, each loan type offers its advantages and disadvantages.
What is the best option for you? Read on as we look at eight types of rental property loans and discuss their advantages and disadvantages for real estate investors.
How do rental property loans work?
Unlike standard home mortgages, rental property loans cater specifically to investors looking to purchase or refinance rental real estate. These loans typically require a larger down payment, often 20-30%, due to the higher risk associated with rental properties.
Interest rates for these loans are generally higher than for owner-occupied homes, reflecting the increased risk for mortgage lenders. The loan's approval and terms are heavily influenced by the property's projected income; lenders often want the rental income to exceed the monthly mortgage payment by a certain percentage, ensuring the property can sustain itself financially.
Is it hard to get a loan for investment properties?
Securing a loan for an investment property can be more challenging than obtaining a mortgage for a primary residence. Lenders perceive investment properties as riskier, often requiring investors to meet stricter criteria.
These include a higher credit score, a larger down payment (usually 20-30%), and a lower debt-to-income ratio than standard home loans. Lenders closely scrutinize the property's potential income, expecting it to cover mortgage payments comfortably.
While these requirements can make closing investment property loans seem daunting, investors with solid financials and a well-chosen property often successfully secure funding. Exploring various loan types, from conventional to more specialized options like hard money loans, and leveraging financial management tools can also enhance an investor's ability to acquire suitable financing.
Investment property loan options
Now that we understand how rental property loans work let's examine the available types, highlighting their pros and cons. This overview will provide a clear picture of the options at your disposal, helping you make well-informed choices:
1. Debt Service Coverage Ratio (DSCR) loan
The debt service coverage ratio – or DSCR – measures your ability to service or repay the annual debt service compared to the amount of net operating income (NOI) the property generates. The larger the DSCR ratio is, the more net operating income is available to service the debt.
Lenders use the debt service coverage ratio to determine the maximum loan amount when a borrower is applying for a new loan or refinancing an existing one.
A typical non-qualified (non-QM) DSCR loan allows a real estate investor to qualify for a mortgage based on the cash flow generated from a rental investment property instead of their income. This is also known as a rental investment loan or rental loan.
In real estate investing, timing is everything. Today's hot seller's market requires quick approvals. Many restrictions with traditional funding avenues are erased from the slate when targeted, goal-focused rental investment DSCR loans are used, making them a popular option for eager investors.
Because the lender is not looking at personal income, they can offer an easy documentation process (no tax returns or employment verification) and no cash reserve requirements. It's a more streamlined way to obtain funding than traditional banks that don't provide this added agility.
In fact, many investors who do multiple deals in a year will only do those deals using DSCR loans because they don't have time for conventional mortgages.
Pros of DSCR loans:
- Income flexibility: Focuses on rental cash flow, not the investor's personal income.
- Faster approvals: Quicker than traditional loans, aiding in seizing timely opportunities.
- Less documentation: Simplified application with fewer personal financial details.
- Emphasis on property potential: Approval based on the property's earning potential.
Cons of DSCR loans:
- Higher interest rates: Often higher due to perceived risk.
- Stricter property analysis: Emphasis on the property's cash flow can be a double-edged sword.
- Varied lender requirements: Different lenders might have inconsistent DSCR criteria.
- Risk of over-leveraging: Ease of qualification might tempt over-borrowing.
- Market vulnerability: If rental income drops, debt obligations might be challenging.
2. Conventional loan
You're most likely familiar with conventional financing if you have owned a home as your primary residence. A conventional — or conforming — mortgage must conform to guidelines set by Fannie Mae or Freddie Mac and is not backed by the federal government.
The minimum down payment required for a conventional mortgage varies by lender but is typically 3% of the purchase price. However, the lender may require a more significant percentage as a down payment, typically 20% or more, based on your credit score or debt-to-income ratio (DTI).
With a conventional loan, the borrower's personal information, like credit score and credit history, will determine whether or not they're approved and what kind of interest rate they'll receive. Conventional mortgage lenders will also review borrowers' income and assets, which requires a lot of paperwork and time from the borrower.
Using a conventional loan for an investment property differs from a residential one. Unlike residential property, an investment property loan may have higher interest rates, down payments, prepayment penalties, and minimum credit score requirements.
Additionally, the DTI requirements are often more strict, and there may be higher reserve requirements.
Another thing to remember about conventional home loans is that your ability to get approved shrinks as you purchase more properties. That's because banks and mortgage companies apply stricter credit requirements each time you apply for a new loan.
Larger down payments and cash reserves are also often required when several mortgages are in play, which can detract from investors who are scaling their rental portfolios.
Pros of conventional loans:
- Well-known: Familiar process for many investors.
- Wider acceptance: Accepted by most sellers and real estate agents.
- Potentially lower interest rates: Especially with good credit.
- Flexibility: Can be used for primary residences, second homes, or investment properties.
Cons of conventional loans:
- Stricter qualifications: Higher credit scores and lower debt-to-income ratios are often required.
- Higher down payments: Especially for investment properties, often 20% or more.
- Property limitations: Lenders may limit the number of properties you can have loans on.
- More paperwork: Compared to some alternative loan types.
- Private mortgage insurance (PMI): Required if the down payment is less than 20%, increasing monthly payments.
3. Veterans Affairs (VA) home loan
A VA loan is designed to provide military members and veterans with housing during and after service. This loan type offers terms like no required down payment, lower interest rates, low closing costs, and no property insurance required. Depending on state eligibility, the borrower may qualify for property tax reductions.
The Department of Veterans Affairs restricts VA loans from being used to purchase properties solely for investment purposes. Thus, only owner-occupied properties qualify for VA loans.
The owner-occupied stipulation also leaves room for investors to purchase and live in a property with more than one unit. So, you can buy a multi-unit house and rent out the other units so long as you occupy at least one unit.
You can also refinance an existing loan with VA Streamline Refinance loan program. The VA loan option doesn't require you to live in the residence after refinancing it if it was already your primary residence before applying.
Pros of VA home loans:
- No down payment: Enables 100% financing.
- Competitive interest rates: Often lower than conventional loans.
- No PMI: No need for private mortgage insurance.
- Reusable: Can be used multiple times under certain conditions.
- Foreclosure protection: Assistance provided by the VA.
Cons of VA Home Loans:
- Primary residence only: Can't be used for pure investment properties.
- Funding fee: This can be rolled into the loan but is a cost to consider.
- Size limit: Depending on location, there may be a cap on loan size.
- Potential VA inspection: Some properties may not meet VA criteria.
- Limited scope: Only available to veterans, active-duty service members, and certain National Guard and Reserves members.
4. Federal Housing Administration (FHA) loan
Many people are drawn to FHA loans because this financing option offers low-interest rates for lower-income buyers. The terms and benefits of this loan type include a lower required down payment, lower qualifying credit score, more flexible DTI requirements, and lower monthly insurance rates.
An FHA loan does not allow for single-family rentals. Like a VA loan, the FHA loan has residency requirements. You can still rent a multi-unit home if you live in one of the units. But at least one person on the loan must use it as their primary (not second) home.
For an FHA loan, this residency requirement is only one year. Owners can then use it as an investment property after that time, sometimes referred to as “house hacking.” You can use an FHA Streamline Loan to refinance for better investment property loan rates.
An FHA loan also requires a stricter appraisal process. Unfortunately, an investment property you're trying to scoop up “for nothing” might not pass the test.
Pros of FHA Loans:
- Lower down payment: As low as 3.5% with qualifying credit scores.
- Flexible credit requirements: More forgiving of lower credit scores.
- Potentially lower interest rates: Especially for those with less-than-perfect credit.
- Upfront MIP can be financed: Upfront mortgage insurance premium can be rolled into the loan.
Cons of FHA Loans:
- Primary residence stipulation: Can't be used for standalone investment properties.
- Mortgage insurance: Both upfront and annual premiums are required.
- Property standards: Must meet specific FHA property guidelines and standards.
- Loan limits: Maximum loan amounts based on the location of the property.
- Longer approval process: Due to the government involvement and additional criteria.
5. Blanket mortgage loan
A blanket mortgage loan purchases multiple properties under the same investment loan terms. When investing in multiple assets, real estate investors and developers use them to save time and money.
With a blanket loan, each of the multiple investment properties is cross-collateral for the loan. However, investors can sell off individual properties without closing the entire loan. These loans usually have comparably higher investment property loan rates and down payments than conventional loans.
Blanket mortgages are not meant for primary residences, vacation homes, or brand-new landlords who are just getting started. Large commercial lenders are more likely to approve established real estate companies and seasoned investors buying properties in bulk.
Typically you must already have a real estate or investment portfolio and sizable assets, including a good portion of cash on hand, to be approved.
Pros of blanket mortgage loans:
- Consolidation: Finance multiple properties under one mortgage.
- Flexibility: Sell individual properties without refinancing the entire mortgage.
- Time and cost efficiency: Fewer closing costs and paperwork compared to multiple separate loans.
- Cash flow management: Simplify payments with one monthly mortgage instead of multiple.
Cons of blanket mortgage loans:
- Higher rates: Typically comes with higher interest rates compared to traditional loans.
- Cross-collateralization: If one property faces issues, it might impact the entire portfolio under the loan.
- Stricter lender requirements: Often requires a proven track record and sizable assets.
- Limited availability: Not all lenders offer blanket mortgages.
- Higher down payment: A larger down payment is typically required compared to individual property loans.
6. Portfolio loan
A portfolio loan is similar to a hard money loan or a blanket loan in that multiple properties are held by the same lender. The lender originates and retains the loans and doesn't sell them to the secondary market — the loans stay within the lender's portfolio.
Because the lender holds the loan, they decide the qualifying standards and terms. Additionally, the lender can offer more flexible terms than a conventional or blanket loan, like easier qualification, customized loan terms, optional mortgage insurance, and less strict property condition requirements.
And, since the lender assumes more risk by holding onto the loan, they may take steps to modify that risk by imposing higher investment property loan rates or higher fees and penalties.
Pros of Portfolio Loans:
- Flexibility: Since the loans are held by the lender (not sold on the secondary market), they might offer more flexible terms and criteria.
- Customization: Lenders can often tailor the loan to the borrower's needs or situation.
- Alternative qualification: It might be easier to qualify for a portfolio loan if you don't meet conventional lending standards.
- Diverse portfolio: Suitable for investors looking to finance multiple types of properties.
Cons of Portfolio Loans:
- Higher rates: Interest rates may be higher than traditional financing options.
- Lender's risk management: Because the lender retains the risk, they might impose stricter requirements or more considerable penalties.
- Limited availability: Not all banks or lenders offer portfolio loans.
- Balloon payments: Some portfolio loans may have short terms with a balloon payment at the end.
7. Private loan
A private loan is issued by a private company or an individual lender instead of a bank, credit union, or federal institution. Lenders generate profits from the interest and often offer private loans to family, friends, or someone they have a personal relationship with.
Some investors consider this option if they may not qualify with a traditional lender or want to close a deal quickly with less red tape. Private loans make qualifying easier, have a shorter approval process, and offer flexibility.
While private loans are less regulated than bank or federal loans, they must still follow certain federal and state laws. With a private loan, the lender maintains a lien on the property. Failure to make payments or default on the loan could result in legal action or seizure of the home — and damage a personal relationship.
Pros of private Loans:
- Speed: Often faster approval and funding process than traditional banks.
- Flexibility: Terms can be negotiated based on personal relationships or specific deals.
- Easier qualification: Less stringent credit and income requirements.
- Short-term solutions: Ideal for bridge financing or quick-turnaround investments.
Cons of private loans:
- Higher interest rates: Typically come with higher rates than traditional financing.
- Shorter terms: Often structured as short-term loans requiring refinancing or paying off quickly.
- Personal relationships: Borrowing from personal connections can strain relationships if issues arise.
- Potential for less regulation: This could result in less protection for the borrower than institutional loans.
8. Owner-financed loan
Owner financing is another alternative to a traditional mortgage in which the homeowner who's selling the property finances the purchase for the buyer. The seller sets the loan terms, allowing you to skip a lengthy mortgage process.
The loan process of owner financing is quicker and easier than applying for a loan through a financial institution. Unlike a traditional mortgage, the seller doesn't give money to the buyer. The seller extends credit to the borrower that covers the price of the home, and the buyer makes the monthly payments until the amount is paid in full.
There are risks involved with owner financing, however. The interest is typically higher on these types of loans for investment property, and there's often a balloon payment at the end of 5 or 10 years. Also, if you don't obtain title insurance, the property title could have mortgages, outstanding taxes, and liens that are your responsibility as the buyer to repay.
There could also be property line disputes and erroneous square footage listings that affect the home's value as an investment property.
Pros of owner-financed loans:
- Speed: Often faster to close than traditional mortgages.
- Flexibility: Terms can be mutually negotiated between buyer and seller.
- Less red tape: Typically fewer administrative hurdles and credit requirements.
- Potential cost savings: May avoid some bank fees or lender charges.
Cons of owner-financed loans:
- Higher interest rates: May have a higher rate than bank-financed loans.
- Balloon payments: Some owner-financed contracts require large lump-sum payments after a few years.
- Dependence on seller's terms: Unlike banks, individual sellers might be less flexible if financial hardships arise.
- Potential for unclear terms: Without proper due diligence, terms might be less clear or unfavorable.
Loan calculators and comparison tools
Azibo offers a range of online calculators to help investors considering real estate investment loans. Here are a few that may be particularly useful:
- Cap Rate Calculator: This calculator helps investors determine the capitalization rate, the ratio of the property's net operating income to its purchase price. This can be useful for comparing different investment properties' profitability and understanding the potential return on investment.
- Cash Flow Calculator: A cash flow calculator estimates the monthly cash flow generated by a rental property after accounting for expenses like mortgage payments, property taxes, insurance, and maintenance costs. This can help investors assess the viability of a rental property investment.
- Loan Amortization Calculator: This calculator provides a detailed breakdown of the repayment schedule for a loan, including principal and interest payments. It helps investors understand how much they will pay over the loan term and how the balance will decrease over time.
- Loan-to-Value (LTV) Calculator: LTV is a key metric that lenders use to assess the risk of a loan. A lower LTV generally means lower risk, which can result in better loan terms for the investor. This calculator helps investors determine the LTV of their loans.
- Rental Property ROI Calculator: This calculator helps investors estimate the return on investment for a rental property by considering factors such as property appreciation, rental income, and operating expenses. This can be beneficial for comparing the potential ROI of different properties and loan options.
- Debt to Income (DTI) Ratio Calculator: Lenders often use The DTI ratio to evaluate a borrower's ability to manage their debt obligations. A lower DTI can result in better loan terms and a higher chance of approval. This calculator helps investors determine their DTI ratio based on their monthly income and debt payments.
- Closing Costs Calculator: This calculator estimates the closing costs associated with purchasing a rental property, which can be an essential consideration for investors when evaluating different loan options.
Using these calculators, investors can better understand the financial implications of various loans and make informed decisions about the option best suits their needs.
Tips to reduce rental property loan costs
It’s crucial to adopt a strategic approach to reduce rental property loan costs. Begin by shopping around with multiple lenders to compare interest rates and terms, as even a slight reduction can save thousands over the life of the loan.
Improving your credit score can also significantly lower interest rates; aim for a score above the lender’s minimum requirement for the best rates. Consider making a larger down payment if feasible, as this reduces the loan amount and can sometimes secure a better interest rate.
Additionally, negotiate with lenders for lower fees and consider shorter loan terms if possible, as they often have lower interest rates. Regularly reviewing and refinancing your loan can also lead to cost savings, especially when market conditions are favorable.
Lastly, efficient management of your rental property mortgage, income, and expenses, using tools like those provided by Azibo, can help maintain rental properties in strong financial health, making refinancing or loan negotiations more favorable.
Moving forward with the right loans for investment property
Navigating real estate investments requires a keen understanding of the various types of rental property loans available. This guide has explored eight distinct loan options, each with its pros and cons, to help you make an informed decision that aligns with your investment strategy. Whether you’re a seasoned investor or just starting, the right investment property financing choice can significantly impact the success of your rental property venture.
Securing the ideal property is just the beginning. The real challenge, and opportunity, lies in finding the most suitable loan to maximize your investment’s potential. With options ranging from DSCR to owner-financed loans, it’s essential to assess each type carefully, considering factors like interest rates, loan terms, and eligibility criteria.
To ensure financial stability and efficiency, consider tools like Azibo’s range of calculators, which can provide deeper insights into potential investments. Regularly reviewing loan options, negotiating terms, and managing your property’s financial health is key to reducing costs and enhancing returns.
Investment property loans FAQs
What is a loan for an investment property called?
A loan specifically designed for purchasing an investment property is called an investment property loan or rental property loan. These loans cater to real estate investors looking to buy residential or commercial properties to generate rental income or capital appreciation.
Investment property loans often have slightly higher interest rates and stricter qualification criteria than primary residence loans. Most lenders perceive investment properties as higher risk due to the potential for vacancies, tenant issues, or fluctuating market conditions.
What is the 2% rule for investment property?
The 2% rule is a popular guideline used by real estate investors to evaluate the potential profitability of an investment property. According to this rule, a property is considered a good investment if the monthly rental income is equal to or greater than 2% of the property's purchase price. For example, a property purchased for $100,000 must generate at least $2,000 in monthly rental income to meet the 2% rule.
It's important to note that the 2% rule is a rough guideline rather than a strict one, and it doesn't consider various factors like property appreciation, taxes, maintenance costs, or vacancy rates. Investors should consider it one of many tools in their toolbox to assess potential investments and perform a more comprehensive financial analysis before making a final decision.
What credit score do you need to buy a rental property?
Lenders typically require a credit score of at least 620 to buy a rental property. However, a score of 720 or higher is often recommended for more favorable loan terms and interest rates. Remember, requirements can vary depending on the lender and the type of loan.
Disclaimer: The information provided in this article is for educational and informational purposes only and should not be construed as financial, legal, or investment advice. Readers are advised to conduct their own research or consult with a qualified professional before making any investment decisions. The author and publisher are not responsible for any actions taken as a result of reading this article.