With rates low, it’s prime time for an investment mortgage
By Brian Boucher
Real estate is a good way to earn income and obtain tax advantages by exploiting inefficiencies in the market, and many Americans have built wealth through rental properties. There is no better time to get into the market, given the outlook on home prices and rents, coupled with low rates for borrowers.
“Real estate has historically outperformed gold and many other investments,” says Thomas Stepp, Mynd Management’s director of investment services. “And the influx of money into the markets from government stimulus creates inflation, and the best way to hedge against that is to own real estate.”
What’s more, a hot rental market makes it an exceptional time to be a landlord. CoreLogic’s Single-Family Rent Index showed that rent growth exceeded pre-pandemic levels across all price tiers, including, for the first time, low-end rentals. April 2021 data showed a national rent increase of 5.3% year over year, up from a 2.4% year-over-year increase in April 2020.
Some buyers are in a position to purchase an investment home with cash. But financing can make your money work harder for you, especially in the current environment, where even commercial loans are well below four percent.
“If you have cash and you can borrow at three percent, you’re borrowing it cheaper than your rate of return will be,” says Stepp. “This way, you don’t have the risk of putting all your money into one asset, and you leverage the purchase with money that costs less than what it generates in return. This is an ideal climate to finance, because you’re locking in fixed rates for thirty years. We’ll probably never see an interest rate environment like this again.”
How does the first-time buyer finance an investment property? Yes, the environment is conducive, but that doesn’t necessarily mean it’s easy. It’s more expensive to finance a rental property than a private residence, and the lending standards are more stringent, because the risk for the lender is higher. (That’s easy to understand: if an investor is squeezed and has to default on a mortgage on a home or an investment property, it’s not hard to imagine which one she’ll pick.)
But financing an investment property is within reach for many Americans, and there are a number of ways to do it.
What investors need to know going into the process
Always comparison shop
Shopping around can result in a better deal. But Sonia Eckard, a loan consultant with Mynd, points out that since everyone is selling the same mortgage widget, no lender can offer a drastically better deal.
“I tell all my clients the same thing: If it sounds too good to be true, do a little more digging to see why there is a disparity in quotes,” she said, “since there should never be that great a difference in any one client's quote.”
Also, Eckard points out, timing is everything. “Prices are live, so two quotes on two different days aren't an apples-to-apples comparison. Find someone you trust and who can explain pricing to you. Obtaining two or three quotes, in my opinion, is sufficient.”
Good credit is essential
Those who have bought a home know how important it is to have good credit. Anyone can get a credit score free from one of the main credit bureaus, but the more demanding FICO credit scores (created by the Fair Isaac Corporation) are the ones lenders scrutinize. Some credit card companies have started to offer FICO scores as a perk, but one often has to pay to see them.
FICO scores take into account factors like the borrower’s payment history, amounts owed on credit accounts, and the length of their credit history. Scores range from 350 to 850; a 740 will ensure access to the better loan programs, while scores north of 760 will secure a lender that offers the best available rates.
Got pre-approved? Let’s go shopping
Once a lender knows a potential borrower’s credit is good, getting pre-approved is a good idea since it dictates how much she can spend on a property. A pre-approval can also speed up the process of closing on a property since a lender has already vetted an investor for a loan.
It’s important to know the difference between prequalification and pre-approval. Prequalification is less stringent, since it takes into account only the borrower’s credit and estimates of income and assets; the process tells a borrower how much she might be eligible for, but doesn’t guarantee the loan. For that, the borrower has to be pre-approved, which requires a hard credit inquiry and proven income and assets.
A low debt-to-income (DTI) ratio strengthens an application
A borrower’s debt-to-income (DTI) ratio strongly affects a credit application. The lower an applicant’s debt obligations are as a percentage of her pre-tax income, the stronger her application will be. If the property has a documented rental history or a rental appraisal, lenders may reckon the rent as income to the borrower.
Liquid reserves ensure cash flow — for the bank
The investor will also have to demonstrate greater liquid reserves than for a mortgage on a primary home. It has become customary for banks to require reserves to pay all your expenses for six months, in case you should have vacancies.
An existing home can help via home equity
Homeowners who have equity in their homes can borrow against them to finance a purchase, and many beginning investors use this method to get a loan to buy their first rental property. A HELOC (Home Equity Line of Credit) typically has interest rates of three or four percent, making it affordable for many first-time investors.
“It’s effectively a bank account that you can reset at a lower interest rate,” says Stepp. “You can extract some capital, maintain the same payment you have today, and use that to buy rental properties. In this way, you have cash flow that pays down your primary residence, and then you have tenants creating an external bank account for you at better rates than an account with Chase or Wells Fargo.”
Don’t forget about closing costs
Buyers need to remember, says Eckard, that closing costs aren’t typically financed into the loan for an investment property, unlike a refinance when closing costs are typically rolled into the new loan amount.
“A lot of new buyers don’t expect this,” she points out. “Buyers should be prepared to bring closing costs to the closing in addition to the down payment. If a buyer wants to keep their costs low, the best way would be to avoid paying points to buy down their rate — or even choose a higher rate to receive a rebate or credit to be applied towards their costs.”
“My best tip,” says Eckard, “is that buyers should work with their lender to see what the lender is charging and ask to see some scenarios where they would receive a rebate so they can decide what works best for them.”
Financing an investment property? Let’s count the ways
There are various kinds of investors and many kinds of investment properties. Accordingly, there are numerous methods buyers can use to finance a purchase.
Conventional mortgages meet the standards dictated by the two major government-sponsored mortgage agencies, Fannie Mae and Freddie Mac. Most fixed-rate mortgages require at least a fifteen-percent down payment on a one-unit investment property, while on two- to four-unit investment properties, lenders customarily demand twenty-five percent.
Hacking the system
House hacking, or owner-occupant financing, is what it’s called when investors buy a multifamily property and live in one unit while renting out the others. Financing is easier to obtain, with lighter requirements for credit and cash reserves, lower interest rates, and lower down payments.
Commercial lenders typically take just two things into account: the borrower’s credit score and whether the property will generate enough cash to make the payments. Origination fees are higher, and borrowers will typically pay an APR of at least a percentage point higher.
Hard money lenders
Hard money lenders charge higher interest rates and generally lend for shorter terms. These loans are usually most useful for a buyer who is looking to flip a property.
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In the meantime, learn more about ways to start with a smaller downpayment here.