How to Secure Financing for a Rental Property
An investment property is a home that you purchase with the intention of generating income — as in monthly rent, property appreciation, and potential tax benefits. They can also be “flipped” homes, where you purchase a fixer-upper, renovate it, and sell it for a profit. Regardless of your desire, it’s an effective way to achieve wealth; though it requires a lot of responsibility in addition to upfront funds.
For the sake of this article, we’ll focus on investment homes that are used as rental properties as opposed to house flipping. To help decide if rental property investments are right for you, let’s review options for financing.
Down payment and PMI
Unless you’re able to purchase your desired rental property in cash, you should expect to make a down payment. In most cases, it acts as proof you’re committed to buying the home.
Loans used for a second home or rental property financing typically require a minimum 20% down payment. That’s because mortgage insurance is not available for investment properties; so don’t expect to score a loan that requires as little as 10% or even 3.5% down. Of course, the exact amount required will depend on your credit score, income, and debt-to-income (DTI) ratio.
Planning to purchase — and live in — a duplex or a property with up to four units? If so, you could be looking at easier qualifications including less money down upfront, meaning you can forget what you read in the paragraph above. The FHA loan only requires 3.5% down, provided you are living on-site as your primary home. FHA loans are specifically for owner-occupied properties, so you must live on-site to use this type of rental home financing (at least for 12 months). You’re still able to rent out and earn income from the other units. Once you meet the owner-occupied terms and requirements of the FHA loan, you’re able to move out and still keep the loan in place (with its original terms). You can also look into new loan programs as well (more on that below).
Rental property loans
Finding money for rental home financing doesn’t have to be an obstacle. There are many avenues to consider, including:
Conventional home loans
Conventional mortgages conform to guidelines set by Fannie Mae or Freddie Mac. They’re not backed by the federal government (like an FHA or VA loan). If you already own a home, you’re probably familiar with them.
When choosing traditional financing (like a conventional mortgage) for an investment property, plan on the interest rate and upfront fees to be higher. Rates are about 0.25-0.75% higher for than rates for an owner-occupied mortgage.
Types of rental properties that may be excluded from traditional financing
Some manufactured homes
Bed and breakfasts
HELOCs or home equity loans (HEL)
With a home equity line of credit (HELOC) or home equity loan (HEL), you can pull equity out of your primary home and use it to buy a rental property. You can have access to lower rates and better terms, but you’re ultimately putting your home on the line. If something goes wrong with your rental property, you could lose your home.
Hard money loans
In need of a short-term loan with a fast turnaround? You may want to consider a hard money loan from a private investor that’s secured by your soon-to-manage rental property. House flippers often use this form of financing, but it can also be used for fund rental properties. Unfortunately, interest rates can be almost double what current mortgage rates are, and the same can be said about origination fees. But you have a higher chance of borrowing more money than you could via traditional financing.
Another option to secure rental property financing is through family and friends. That’s right; you can negotiate your terms by merely working with family investors, so long as they have a significant amount of money to invest. Think about trust beneficiaries or relatives with surplus cash who are interested in passive income streams. It’s a reasonable option for short-term financing, and it’s the least time-consuming loan option because there are no set lending requirements.
Though not very common, you may be able to finance your rental property directly through the seller. Instead of sending monthly payments to the bank or lender, you send payments directly to the previous owner. This option makes the most sense if there is not a mortgage on the property. If there is, you’re at risk of paying the mortgage in full by the “due on sale clause.”
Looking to purchase a home in another state? Check out our 6 tips for out of state home buying success!
Potential cash flow from rental property investments
Cash flow is the difference between the rental income of an investment property and its expenses, or whatever is left over after paying all of the bills. Bills can include utilities, property management, repairs, and season expenses (lawn maintenance or snow plowing). It goes without saying, but the more positive cash flow your property can earn, the better of an investment it will be.
Something that may not be as obvious, that financial income may also be used during the loan qualification process that is if you’re already a landlord. That’s right; you can use the rental income of your current investment property to qualify for a new investment property mortgage, assuming you want to manage multiple real estate properties. Just be prepared, you’ll need to document property management experience for at least two years.
Avoiding capital gains tax with the 1031 tax exchange
When the time comes for you to sell your investment property, you’ll likely have to pay a capital gains tax at the time of sale. That is unless you reinvest your proceeds in another, similar property.
IRC Section 1031 provides an exception to tax gain payments and allows you to postpone paying that tax if you reinvest the proceeds a “like-kind exchange.” To qualify, both the relinquished property you sell and the replacement property you buy must meet specific requirements. Both properties must be held for use for investment. Property used primarily for personal use, like a primary residence, a second home, or vacation home, does not qualify for like-kind exchange treatment in the eyes of the IRS. You have 45 days from the date you sell the relinquished property to identify potential replacement properties. The identification replacement property must be in writing, signed by you and delivered to the seller of the new property. While there's no limit on how many times you do a 1031, there are restrictions that accompany it. Be sure you consult with your real estate agent, investment broker, accountant, attorney, etc. to better understand 1031 rules.
Second home financing vs. rental property financing
Second home mortgages differ from rental property mortgages. They offer similar rates to those you receive on primary residences, which can make them very appealing to a borrower. However the loan terms are much different, and they point out:
You can’t rent out the home.
If you do rent it out, your entire loan balance could be called due and payable by your lender.
Don’t put yourself at risk of mortgage fraud to secure a lower rate. Instead, seek guidance from a trustworthy mortgage professional or real estate investor.
The bottom line
Take your time when researching locations, properties, and of course, options for financing.
According to Zillow, you should always “overestimate the amount it will cost to renovate a property, underestimate the rental income you will earn, and overestimate the expenses you will have to pay.” Rental property management can provide a nice cash flow stream with long-term equity gains, so long as you go about it the right way.