Four ways to finance an investment property
Mynd Editorial Staff
There is no better time than now, with interest rates at once-in-a-generation lows, to invest in real estate that can generate income and build generational wealth. And with rents rising nationwide, it’s an auspicious moment to begin to invest in single-family rental homes.
Financing the purchase of a rental property is costlier than financing a residence, and the requirements are more stringent, because the risk for the lender is higher. But the rate of return makes it a promising investment option.
There are various kinds of investors and many kinds of investment properties. Accordingly, there are numerous methods buyers can use to finance a purchase.
1. Conventional mortgages
Conventional mortgages meet the standards dictated by the two major government-sponsored mortgage agencies, Fannie Mae and Freddie Mac. The agencies guarantee mortgages if they meet their standards, which takes some of the risk off the lender.
The amount of the down payment will be determined partly by the borrower’s debt-to-income ratio and amount of liquid cash reserves. The number of living units in the property also comes into play. Fannie Mae publishes an eligibility matrix that gives figures for purchasing and refinancing investment properties of various sizes.
Most fixed-rate mortgages require at least a fifteen-percent down payment on a one-unit investment property. On two- to four-unit investment properties, lenders customarily demand twenty-five percent. A larger down payment may secure a better interest rate, since the bank has greater security if the buyer has more skin in the game. Borrowers have to demonstrate at least six months of mortgage payments in reserve, and possibly as high as twelve months. This shows the lender that the borrower can make the payments even if there are periods of vacancy.
Lenders for investment mortgages, of course, will require the borrower to present documentation of their finances, including W-2s, tax returns, pay stubs, and bank statements, and authorize a credit check. Credit scores for a mortgage on a home can be as low as 620, but minimum credit scores for an investment property range from 640 to 680.
Some who are looking to invest might find it hard to come up with a sizable down payment or gather up cash reserves, or they might not have sky-high credit scores. They needn’t surrender all hope. There are alternative ways to break into real estate investing.
2. House hacking
Would-be investors may be able to get into the game by buying a multifamily property (with two to four units) and living in one unit while renting out the others. This is called house hacking or owner-occupant financing. With this method, says Thomas Stepp, director of investment services at Mynd Investor Services, “You’ve effectively acquired a rental property for the same rates as for a residence.” In return for these good terms, the owner must occupy the property for twelve months.
Financing is easier to obtain for an owner-occupied property, with lighter requirements for credit and cash reserves, lower interest rates, and lower down payments. Duplex properties can be had with a fifteen-percent down payment (the low end on investment mortgages). For a four-family property, borrowers who qualify for an FHA mortgage (originated by lenders approved by the Federal Housing Administration) can pay as little as three and a half percent down. Those who qualify can get a VA mortgage (guaranteed by the Department of Veterans Affairs) and make no down payment at all.
Disclaimer: the penalties are harsh for mortgage fraud, so the notion of buying this way and not living in the property is off the table.
3. Commercial lenders
The basic loan for an investment property is a residential loan, like the one homeowners have on their residence, most of which have a 30-year term. Residential loans are available only for properties with one to four homes.
But there are also commercial loans, which typically are provided by smaller and local banks. Financing a property with five units or more puts the borrower into commercial loan territory. These loans bear higher interest rates, and the loan terms are typically shorter (20 or 25 years versus 30), both of which mean higher monthly payments. Borrowers are also asked to make a bigger down payment, usually 25 percent.
Investors can use commercial loans for smaller properties, too.
If the lender already has the maximum number of ten residential loans to her name, she’ll have to go over to commercial loans. Real estate investors who don’t have a great deal of income on paper might find that commercial loans are the way to go, because the lender takes into account the income generated by the property, rather than the lender’s income. For those who want to buy a property in the name of an LLC (limited liability company), commercial loans may be the best bet. LLCs offer better legal protections for personal assets that do not exist when buying in one’s own name, and have some tax benefits.
4. Hard money lenders
Hard money lenders charge higher interest rates and generally lend for shorter terms. For example, a borrower might make interest-only payments for a term of five years, then repay the loan in full at the end of the term. But, Stepp points out, the expected term for this note is only about six months. These loans might be most useful for a buyer who is looking to flip the property, not those who plan to hold on to it and rent it out for years, or other investors who are planning to refinance with a commercial mortgage when the building is leased out and producing stable income.