A successful investment comes down to the margins — controlling costs to make it profitable. With investment property, getting a cost-effective mortgage can have a long-term impact on your investment’s success.
Financing investment property is somewhat like getting a residential home mortgage, but with more detail and a higher degree of difficulty. Think of it as a master class compared to an introductory course.
Knowing what to expect when you apply for an investment property mortgage can not only help you get approved, but also get a better loan. The key is knowing the differences between residential and investment property mortgages and how to minimize your borrowing costs.
[SEE: Current 5/1 ARM Mortgage Rates]
Investment Property Mortgages vs “Regular” Home Loans
Investment property loans are generally more demanding than ordinary mortgages in a few key ways:
— They typically have higher interest rates.
— Credit standards are stricter.
— They require larger down payments.
— There’s greater emphasis on debt-to-income ratio.
Josh Katz, a CPA and founder of Universal Tax Professionals, explains that it’s understandable for lenders to set a higher bar for investment property mortgages:
“This is because rental properties are viewed as riskier investments — there’s a higher chance of vacancies, and borrowers may prioritize their own home’s mortgage over their rental if financial difficulties arise.”
Being aware of the lender’s perspective can help you take steps to minimize the perceived risk factors. This could help you get approved and earn better loan terms.
Investment Property Mortgage Rates: How Much Higher Are They?
One way lenders make up for the higher risk of investment property loans is by charging higher interest for them. To compensate for the added risk of investment property loans, lenders add a premium to the market rate for primary residences.
Generally speaking, investment property mortgage rates run 0.50 to 0.75 percentage points higher than rates for a primary residence. So, if residential mortgage rates are currently 5%, you can expect to pay 5.50% to 5.75% with an investment property loan. These differences vary from lender to lender, so shopping around is vital.
Whether your rate is .25% higher, .75% higher or even more depends on your borrower profile. Fannie Mae and Freddie Mac, which support over 70% of the mortgage market, require lenders to add risk-based surcharges to their loan pricing, and these translate to higher interest rates. These loan level pricing adjustments, or LLPAs, are higher for investment properties than for residential properties. The amount depends on your LTV and credit score.
How to Get a Lower Investment Property Mortgage Rate
Fannie Mae’s lending guidelines specify that investment properties with LTVs of 60% or lower get an LLPA of 1.125% of the loan amount, in addition to other charges related to property type, credit score and other factors. But those 80% investment loans come with an extra LLPA of 4.125% — 3 percentage points more, or $12,000 more for a $400,000 loan.
Note that most borrowers don’t write big checks for LLPAs when they close on an investment property mortgage. Instead, the lender covers the fee by increasing the interest rate. But one way or another, you still pay more for an investment property mortgage. The takeaway here? Making a bigger down payment can reduce the cost of your loan drastically.
According to Katz, factors in addition to your down payment can squeeze down the difference between residential and investment property mortgage rates:
“Borrowers with a strong credit history, significant cash reserves, and a low DTI ratio can help narrow the cost difference between rental and residential mortgages.”
How to Qualify for an Investment Property Loan
Qualifying for an investment property loan involves some of the same factors as those for a primary residence. These include your down payment/LTV, credit score, debt-to-income ratio, cash reserves and the total size of your loan.
However, the standards for these factors are likely to be a little higher for investment property mortgages. Below is a description of the standards you should expect to have meet:
Down payment
The size of your down payment determines your loan-to-value ratio. For single-unit investment properties, Fannie Mae allows LTVs of up to 85%. However, since private mortgage insurance isn’t available on investment properties, expect lenders to err on the side of caution and allow LTVs of no more than 80%. That would mean a down payment of at least 20%.
For properties with more than one unit, the maximum LTV drops to 75%. That would require a 25% down payment.
Credit score
Loans that just meet the minimum down payment require a minimum credit score of 680. However, you can qualify with a lower credit score if you put at least 25% down and meet other standards, such as low debt-to-income and high cash reserves. Under those conditions, you could qualify with a credit score of 620 or higher.
Debt-to-income ratio
DTI measures the amount of your total monthly debt payments (including the new loan) divided by your monthly income. So, if you earn $10,000 a month and the mortgage you’re applying for would give you total monthly debt payments of $4,000, your DTI would be 40%.
For investment property mortgages, rental income from the property can be included in your monthly income, along with money you earn personally. However, there are specific requirements for how you account for rental income, which are discussed below.
In most cases, your total DTI should not exceed 36%. However, it can be as high as 45% if you meet higher credit score and cash reserve requirements.
Cash reserves
Cash reserves are assets that can be readily accessed to pay your mortgage if you have a sudden drop in income.
You may not need cash reserves if you are highly-qualified. However, lenders often require sufficient reserves available to pay the mortgage for six months if necessary.
If the lender views you as a higher-risk borrower or you are applying for a higher-risk loan, you may need up to 12 months of cash reserves.
Loan limits
There are limits to how much you can borrow in mortgages that are backed by Freddie Mac and Fannie Mae. Other lenders may go higher.
These mortgage loan limits depend on the number of units in the property and its location. Check out the current limits in your area before you start shopping for properties.
Documentation requirements
You’ll have to document your income with current pay stubs or recent tax returns. Lenders will likely ask you to document a two-year earnings history.
Additional requirements
Lenders may require proof of your experience as a landlord and/or a detailed plan projecting the income the property will earn.
You also generally cannot have more than 10 properties financed at one time. And the more properties you have financed, the harder it might be to meet debt-to-income requirements.
Subjective criteria
Along with all the hard-and-fast qualification requirements, there are some subjective criteria that can help you qualify if your application is a little outside the box.
If your application is weak in some respects, Rachel Stringer, a real estate agent at Raleigh Realty, encourages buyers to try to make up for it in other ways.
“”Don’t lose hope just yet,” she says. “There are things you can do to improve your chances of qualifying.”
Stringer cites some examples of things you can do to make up for other shortcomings:
— Make a larger down payment
— Pay down some existing debt to improve your DTI
— Bring in a co-borrower or co-signer with stronger finances
Showing you’ve had past success with rental properties can also help.
“Demonstrating experience as a landlord or property manager can give lenders confidence in your ability to generate consistent rental income, which may help reduce the perceived risk and result in better loan terms,” Katz says.
Finally, if you get the cold shoulder from one lender, remember that you have plenty of options.
“Not all lenders are created equal, and some specialize in working with clients who have unique situations,” Stringer explains. “Community banks or credit unions, for example, often have more flexibility than larger banks. They might be more willing to work with you to find a solution that fits your financial situation.”
For Newbies: Multi-Unit Property Hack
One way around many investment property mortgage obstacles is to buy a duplex, triplex or fourplex and live in one of the units. This allows you to finance a rental property as a primary residence, and it allows you to get around many requirements for reserves and landlord experience.
How to Calculate Investment Property Income
Where investment property is expected to earn income, it is possible to add that to the borrower’s income for the purpose of calculating DTI.
Only 75% of any investment property income may be included in DTI. The remaining 25% accounts for possible vacancies.
Borrowers can document investment property income either:
— From lease agreements if the property is currently rented and the lease is going to be transferred to the new buyer, or
— From a rental income appraisal, based on the property’s characteristics and rents paid on comparable local properties
For the purposes of qualifying for a loan, the income from the property is calculated by taking the rents (or estimated rents) on the property. Again though, only 75% of the total rents can be used, to leave an allowance for vacancies.
Investment Property Loans Can Set You Up for Success
There is a fair amount of detail involved in applying for a loan to buy investment property, but going through the process can work to your advantage.
The process requires you to think about how much income the property will generate compared to expenses. It also makes you account for the possibility of vacancies. These are business considerations that you should be examining anyway before investing in rental property.
In addition, there are a variety of qualifying criteria such as LTV, DTI and credit score. Looking at each of those is an opportunity to think about ways you might improve your qualifications. Doing that can not only help you get a loan, but also earn you better terms that make your investment more profitable.
After all, mortgages are for the long term. The care you put into making the strongest application to get a better interest rate can pay off for years to come.
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Investment Property Mortgage Rates: How to Finance a Rental originally appeared on usnews.com
Update 09/18/24: This story was published at an earlier date and has been updated with new information.
