Permanent Financing for Long-Term Rentals and Vacation Rentals
If you dream of a healthy passive income from commercial property, either through long-term rentals or short-term vacation properties, you may be dismayed by the high cost of getting involved. However, there are plenty of mortgage options to reduce the upfront cost and help you get started as a real estate investor.
What Is an Investment Property?
An investment property is purchased specifically to generate income; this could involve accommodating short-term renters, long-term tenants, or earning profits through resale, as seen with house flippers. These properties can be owned for a brief stint or for many years and can encompass both residential and commercial types.
What Is an Investment Property Loan?
A rental property loan supplies you with the necessary funds to acquire an investment property, whether intended for short-term or long-term use. Lenders offer financing for various types of properties, including:
• Long-term residential rentals
• Short-term vacation rentals
• Office buildings
• Fix-and-flip properties, typically consisting of residential homes
Because mortgages for commercial buildings often carry a higher level of risk, they typically come with elevated interest rates, particularly from private lenders. However, these loans also provide larger sums. You can opt for either short-term loans or those with extended repayment periods, allowing for the flexibility you require to manage your mortgage payments.
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Investment Property Loans vs. Conventional Home Loans
Let's begin by examining the fundamental similarities. When applying for both investment property loans and conventional loans, you will need to complete an application. The questions on this application may differ from those you encountered when purchasing your home. Lenders may show less interest in your personal income, assets, and employment history, focusing instead on your investment experience and strategy. Additionally, your credit score will be assessed, and the lender will arrange for an appraisal and initiate the title process. So, what are the key differences?
**Lower Maximum LTVs**
Investment property loans usually require significantly larger down payments. You should anticipate needing around 25% (although this may vary based on your credit score), in contrast to the 3% often necessary for some government-backed consumer mortgages.
**Higher Interest Rates**
Interest rates and fees for investment property loans are generally higher. Expect them to be between 100 to 400 basis points more than those for traditional mortgages. A basis point is one-hundredth of a percent. For instance, if a conventional mortgage is set at 6.5%, an investment property loan for the same property and borrower could be 7.5% or higher.
**Higher Reserve Requirements**
It is essential to demonstrate that you have sufficient liquid cash reserves equal to your down payment and closing costs, plus an additional 6-12 months' worth of monthly payments for principal, interest, taxes, insurance, and any association dues. If you own multiple investment properties, some lenders may require you to show reserves for all of them. In contrast, a conventional mortgage may only require reserves ranging from 0 to 6 months.
**Less Documentation**
With conventional loans, lenders typically focused on your employment history and personal income, requesting pay stubs and tax returns. Moreover, just before closing, you would have been asked to confirm that you remained employed in the same position you held when you started the loan process. For certain types of investment property mortgages, you’ll need to provide this information and possibly more, particularly if you already own other investment properties. Conversely, some investment property loan types will prioritize the cash flow from the investment property rather than your personal employment and income, greatly simplifying the documentation process. FundNow Capital can make the process smooth sailing. We work with 100 lenders daily so we know the ends and outs of the best way to get what you want.
How to Finance an Investment Property
For serious real estate investors looking to build an investment portfolio, there are essentially three investment property loan options: agency loans or GSE loans (Fannie/Freddie), local/regional banks, or an alternative lender such as Visio Lending. Sometimes rental investors will obtain owner financing or a hard money loan, yet those are rarer.
Let’s look at the three main options, as well as some less common alternatives:
Alternative Lenders that FundNow works with
Alternative lenders, sometimes referred to as Non-QM lenders or DSCR (Debt-service coverage ratio) lenders, offer investment property loan programs specifically designed to help SFR investors grow their investment portfolios. Since alternative lenders are not confined to the rules set by bank regulators or GSEs (government-sponsored entities), they offer a lot more flexibility and appealing terms.
Additionally, most alternative lenders underwrite investment property mortgages based on the rental income of a property rather than personal income. That means they have low documentation requirements and do not review your employment history or tax returns. There are some drawbacks to non-QM loans, yet most seasoned investors are comfortable with them:
Higher Interest Rates and Fees
Seasoned investors, particularly those in growth mode, are willing to pay higher interest rates and fees for more flexibility to achieve their wealth creation goals.
30-year terms, Prepayment Penalties, and Legal Entities
GSE loans typically have 30-year terms and no prepayment penalties; however, they require full income and asset verification, including fully completed tax returns. When using a GSE loan, you also have to borrow in your personal name. Banks that make investment loans typically do not offer 30-year terms and they include prepayment penalties.
Banks often will allow you to hold the property in an LLC or other legal entity and extend the investor loan to the entity rather than you personally. Alternative lenders offer 30-year terms, allow you to borrow in a legal entity, and include prepayment penalties. Again, experienced investors are willing to accept prepayment penalties if it means they can qualify for a loan that enables them to achieve their investing goals. Visio offers a variety of prepayment penalty options so investors can tailor their loan to their particular circumstances.
Agency (GSE) Investor Loans (Fannie & Freddie)
Agency loans represent the most affordable category of investment property financing, yet they are also the most challenging to secure. They tend to be more accessible for your initial investment property compared to subsequent ones. The guidelines set forth by Fannie Mae can be quite stringent.
Lenders usually assess agency loans through a comprehensive evaluation of an investor’s cash flow, incorporating both personal income from stable employment and net operating income from rental properties. However, these loans come with certain disadvantages for investors, including:
- Substantial documentation, including two years of completed tax returns with all schedules
- Lengthy and uncertain underwriting process with substantial reserve requirements that increase with the number of loans outstanding (Basically, the more mortgaged rental properties you own, the more cash reserves you need)
- Down payment requirements that increase with the number of loans outstanding (the more mortgaged rental properties you own, the more money you must put down for each new property)
- Restrictions on cash-out refinances for investment property mortgages
- Inability to borrow in a legal entity to protect your other assets and identity
- High enough income to have a solid Debt-to-Income ratio (DTI)
Regional Banks
Certain real estate investors achieve success in securing loans for investment properties from local or regional banks. Since these banks intend to hold onto the loans rather than sell them, they can afford to be more flexible with their underwriting criteria, albeit at the cost of higher rates and fees. However, banks are unable to manage 30-year loans in their portfolios, which leads them to typically offer five- or ten-year loans with amortization periods of 15, 20, or 25 years. Some of the disadvantages of partnering with a bank include:
- Exposure limits typically mean an investor will have to line up multiple local banks to finance a good-sized portfolio
- Uncertainty in that local banks often change direction quickly in response to their most recent regulatory review. This means they might be offering loans for an investment property one month and then not the next month
- Local banks are not set up operationally to originate mortgages in high volumes and tend to work slowly
- High enough income to have a solid Debt-to-Income ratio (DTI)
Other Loan Options
While these are rarer, there are additional loan options for buy and hold real estate investing, including:
Hard Money Loans
Hard money lenders provide short-term financing for investment properties. Generally, real estate investors turn to hard money lenders for construction endeavors, but they can also be utilized for rental properties. If you’re contemplating partnering with hard money lenders, make sure to have an exit strategy ready for loan terms that can extend up to two years and come with elevated interest rates. We offer a comprehensive guide that delves deeper into the process and intricacies of collaborating with hard money lenders.
Home Equity Loans
If you own a primary residence, you can utilize a home equity loan to tap into your equity and invest in another property. Remember that your primary residence will serve as collateral when securing the loan. Staying current with your monthly mortgage payments is crucial to maintaining ownership of your home.
VA Loans
A VA loan is a loan program offered through the U.S. Department of Veterans Affairs for active military and veterans and their surviving spouse. VA loans are one of the strongest loan programs available for those eligible. If this applies to you, it is worth talking to a mortgage lender about obtaining a VA loan.
Investment Property Loan Qualifications
When qualifying for an investment property loan, the lender will make sure both the property and the borrower meet loan qualifications.
Choose the right size down payment.
Plan on a 25% down payment. If you have stellar credit, you might only need 15%. If you have less than stellar credit, you may need as much as 35%.
Ensure you are financially ready.
Financial stability is key to success. In addition to a more substantial down payment, plan on having 6-12 months of liquid cash reserves. This will help you in the event of hard times and make sure that you won’t immediately lose the property due to missed payments and foreclosure. You'll also need to have cash for closing costs and underwriting fees. Further, the larger your down payment, the lower your interest rate and the better your DSCR. Therefore, it is best to have the highest possible down payment.
Improve your credit score.
Lenders tend to vary pricing, terms, and conditions more on loans for rental properties than on owner-occupier loans. Do what you can to raise your credit score before applying. And, importantly, protect your credit score once you've applied so your loan closes smoothly. Most lenders will do a hard credit pull to get the full scope of your credit score, so it is wise to be prepared.
Demonstrate qualifying income.
If you're applying for an agency or bank loan, get your documents in order. You'll need pay stubs and tax returns with all of your tax return schedules. Get ready to answer questions about your tax returns for a year or two back. Also, make sure you have sufficient personal income, including any net operating income from your rental properties, to afford the monthly payment on your rental property. If you are applying for a non-qm or alternative loan, you will need to make sure the rental income covers the cost of the monthly payment.
Make sure the property is rent-ready.
Construction is financed separately from rental loans (usually in the form of fix and flip loans or hard money loans), so most mortgage lenders will check to make sure the property does not need any significant repairs.
Meet the minimum requirements.
In addition to having a minimum down payment, most lenders also have a minimum loan amount and specific requirements based on their loan programs. A conventional mortgage always has the most stringent requirements, while investment property loans are more flexible. Do your due diligence on the mortgaged lenders you are looking to borrow from.
Investment Property Loan Process
The investment property loan process is very similar to any other mortgage loan process. Here's how it works.
Find a lender.
The loan programs available for an investment property are more involved than the loan programs available for an owner occupier. The first step in searching for a lender includes determining which loan programs work best for you. If this is your first rental property, then you should consider a government sponsored loan. If you own multiple mortgage rentals, you'll want to consider an alternative or Non-QM loan program. Many banks and lenders offer loans for investment properties. Ask your real estate agent or other investors for a recommendation.
Fill out an application.
Be sure to dot all your I's and cross your T's to make sure you like the lender before filling out an application for an investment property loan. You don't want to get an unnecessary hard credit pull.
Move into processing.
Like any other mortgage loan, once you apply for an investment property loan, your loan file will move into processing. Here, the loan processor will collect any remaining documentation.
Get funded.
Once your investment property loan has been processed, you will move into the closing stage and your loan will be funded.
Investment Property Mortgage Rates
Investment property mortgage rates are higher than those for residential loans because they are a greater risk for the lender. Generally, this means that they are about 125 to 300 basis points higher than that for a residential conventional loan. So, for example, if the current mortgage rate for a 30-year fixed-rate loan on a residential home is 6.75%, the range for commercial real estate loans would be 8% to 9.75%.
We provide a breakdown of current rates, as well as an explanation of the reason they're higher, in our discussion of investment property mortgage rates.
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