Investing in rental property can feel like a significant step. It is a smart way to generate passive income and can maintain its value in a volatile market with fluctuating stock prices. If you find the right property, it may not require you to perform a great deal of maintenance or upkeep.
However,
purchasing rental properties requires some cash up front. You must also secure
the proper type of financing. It is important to understand the various types
of rental property loans and how to qualify for them.
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Qualifying a Loan
Loans for
investment properties are distinct from loans for principal residences. When
approving a loan for a primary residence, a lender considers your income,
debts, and credit score.
A rental
property is viewed as a greater risk. If the property is vacant, you incur a
financial loss. Therefore, lenders must consider additional factors prior to
approving a loan for real estate investments.
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Down Payment
Some primary
residence mortgages require little or no down payment. For rental properties,
lenders require a larger down payment to offset the loan's inherent risk.
Typically, this is between 10 and 25 percent of the home's value.
Cash Flow
The lender, as
well as you, will want to understand the rental property's cash flow. Cash flow
is the difference between total rental income and total expenses. In addition
to the mortgage payment, your expenses will include taxes, insurance, and other
costs associated with home ownership.
A profitable
real estate investment will exceed the break-even point. This is also known as
Debt-Service-Coverage-Ratio or, abbreviated DSCR. You should be realistic
regarding your cash flow. Consider the impact of maintenance, repair, and other
expenses. Consider whether you would pay a property manager to assist you if
you are considering a property with multiple units.
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Your Credit Profile
Your credit
score will be considered as part of the loan approval process. If your score is
high, it indicates that you have successfully fulfilled your obligations in the
past. A lower credit score may cause a lender to be more cautious.
If you plan to
acquire multiple investment properties in the future, you will have an easier
time obtaining financing. A well-established real estate loan portfolio will
demonstrate to a lender that you effectively manage your investments.
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Types of Loans for Rental Properties
The lender's
approval guidelines will vary based on the type of rental property you are
considering. Single-family homes with one to four units are treated differently
than multifamily homes with five or more units. The loan types available will
also depend on the lender you select.
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Conventional Loans
If you obtain a
conventional loan, you will obtain a mortgage from either a physical or an
online bank. A conventional loan adheres to the underwriting guidelines of
government-sponsored mortgage companies Fannie Mae and Freddie Mac. It can be
challenging to qualify for a conventional rental property loan.
A conventional
loan requires a sizeable deposit. Additionally, you must have an excellent
credit score and a low debt-to-income ratio. The lender will want to see that
you can afford the rental property's monthly loan payment in addition to your
primary residence.
Lenders will
also evaluate your assets, such as your savings accounts. Due to the fact that
future rental income is not factored into your current debt-to-income ratio,
you will typically also need six months of cash reserves.
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Home Equity Loan
If you have a
substantial amount of equity in your current residence, you can use it to
finance your investment property. If you own your primary residence free and
clear, you can refinance it and use the proceeds to purchase a rental property.
In this case, the lender will not consider your rental property, and you will
only qualify for your home loan.
If you lack
sufficient equity, you can use the equity you do have as a down payment. As you
are increasing your debt to finance the acquisition of a rental property, this
may make some conventional loan lenders nervous.
Using the equity
in your own home increases your risk. If you were unable to make payments for
any reason, you could lose both your home and your rental property.
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Rental Loans
Utilizing a
private lender is an alternative to a conventional loan. Private creditors may
provide flexible terms. Unlike conventional loans, which rely heavily on the
borrower, private lender rental loans place greater emphasis on the property
and its cash flow.
One conventional
loan can only be used to finance a single property. You can also obtain a
rental portfolio loan through a private lender. This loan allows you to
consolidate the financing of multiple properties into a single loan, thereby
streamlining your payments and reducing loan processing fees.
Consider forming
a limited liability company as the "owner" of your investment
property. This provides you with some legal protection in the event of
liability or litigation. A conventional loan cannot be taken out by a limited
liability company, but a rental loan can.
Your investment
property can be purchased or refinanced with your rental property loan. A
cash-out refinance is also an option if you have built up some equity. The cash
can then be used to fund your next investment property.
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Fix-and-Flip Loans
You may have
discovered an investment property with great potential but requiring
maintenance. A fix-and-flip loan is an alternative form of investment in rental
property. This real estate financing takes into account the property's
after-repair value.
Rehab-and-flip
loans are short-term. After completing the repairs or rehabilitation, you would
sell the property and repay the loan.
Conventional
loans are not intended for purchase-and-resale transactions. Due to the fact
that they only consider the property's current value, you would be unable to
obtain the necessary funding to finance the project. You can obtain a rehab
loan from private lenders.
Financing Your Rental Properties
As you seek to
expand your real estate portfolio, you should seek out lenders with rental
property expertise. These lenders comprehend the cash flow and income potential
that a rental property can provide as an investment.