Get an overview of some of the most popular financing options available to rental property owners.
As a real estate investor, it's exciting to find "the one" — 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 down the path 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 own 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.
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 personal income. This is also known as a rental investment loan or rental loan.
In the world of real estate investing, timing is everything. Today's hot seller market requires quick approvals. Many restrictions that come 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.
If you have owned a home as your primary residence, you're most likely familiar with conventional financing. 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 and other terms 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. Compared to a residential property, an investment property loan may have higher interest rates, higher down payments, prepayment penalties, and higher 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.
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. 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.
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:
Note that 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, a strategy sometimes referred to as "house hacking." If you want to refinance for better investment property loan rates, you can use an FHA Streamline Refinance.
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.
A blanket mortgage loan is used to purchase 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. But 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 portfolio and sizable assets, including a good portion of cash on hand, to be approved.
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 onto 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.
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 still need to follow specific federal and state laws. With a private loan, the lender maintains a lien on the property. Failure to make payments or defaulting on the loan could result in legal action or seizure of the home — and damage a personal relationship in the process.
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 an 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 end up being 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.
Azibo offers a range of online calculators to help investors as they consider their options for rental property loans. Here are a few that may be particularly useful:
By using these calculators, investors can better understand the financial implications of various rental property loans and make informed decisions about which option is best suited for their needs.
A successful real estate journey hinges on having the right financing in place. With a myriad of loan options available for rental investment properties, it's essential to fully understand your choices, as selecting the wrong type of loan could jeopardize your ability to close the deal.
This is why it's crucial to find a trustworthy lending partner who can help you navigate the various loan options and secure the funding necessary to grow your rental business. Azibo, although not a direct lender, provides valuable information and resources, including an array of calculators and comparison tools to support investors in making informed decisions about where to obtain their loans.
By carefully assessing your financial situation, investment goals, and the unique features of each loan type, you can position yourself for success in the competitive world of rental property investment.
A loan specifically designed for purchasing an investment property is commonly referred to as an investment property loan or rental property loan. These loans are designed for real estate investors who aim to purchase residential or commercial properties to earn rental income or achieve capital growth.
Investment property loans often have slightly higher interest rates and stricter qualification criteria than primary residence loans. This is due to most lenders perceiving investment properties as higher risk due to the potential for vacancies, tenant issues, or fluctuating market conditions.
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 rental income each month 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, operating costs, local rental market demand, or vacancy rates. Investors should consider it as one of many tools in their toolbox to assess potential investments and perform a more comprehensive financial analysis before making a final decision.
Obtaining a mortgage for an investment property can be more challenging than securing one for a primary residence. Lenders typically perceive investment properties as carrying a higher risk, given that the borrower may prioritize their primary residence's mortgage in case of financial hardship.
Consequently, lenders often impose stricter requirements for investment property loans, such as demanding a high credit score, larger down payment, and more substantial cash reserves. Additionally, interest rates on investment property mortgages are generally higher, making it essential for investors to carefully assess their financial situation and plan accordingly before proceeding.