As long as you cautiously balance risk and benefit, borrowing money from other people to purchase a rental property can be a terrific strategy to boost potential earnings. A rental property loan and a mortgage on your principal residence have many parallels and significant distinctions. Loan applications are processed similarly by all lenders: The lender will look at your credit score and require proof of your income, assets, and debt.
However, because the property is not owner-occupied, lenders see a rental property loan as carrying a higher amount of risk. They are aware from past experience that some financiers might decide to forego repayment of the loan altogether in hard times if the property doesn’t provide a profit.
loans for a residential rental property come with slightly higher interest rates and require larger down payments. Rental property loans are still fully amortized over 30 years so that the payment amount is the same every month, which makes putting together an accurate pro forma for cash flow easier.
Interest rates are higher and down payments are bigger because lenders view investment property loans as being more risky compared to a mortgage for an owner-occupied home. That’s because banks know from experience that if the investment doesn’t go as planned, an investor-borrower is more likely to walk away and give the keys back to the bank.
However, the slightly more restrictive terms on a rental property loan can work in favor of the real estate investor. Interest payments can be completely expensed as a tax deduction by investors. A bigger down payment creates a lower loan-to-value (LTV) ratio, with a lower mortgage debt service payment amount and potentially increased cash flow.
Although every lender is different, these are some of the typical requirements to expect when applying for a residential rental property loan:
- A minimum credit score of 620
- Maximum of 36% debt-to-income (DTI) ratio
- Down payment of 25% or more based on the property type and borrower’s credit
- Interest rates and loan fees are slightly higher to compensate lenders for additional risk
- PMI (private mortgage insurance) is not applicable when the down payment is 20% or more (LTV is less than 80%)
- The borrower must have cash reserves to cover six months of mortgage payments
- Single-family, small multifamily, condos, and townhomes qualify for residential rental property loans
Here are some of the options to look at when you need a loan for buying a rental property or refinancing an existing mortgage:
Conventional or conforming loans are mortgages that most people are familiar with. They are offered by traditional lenders like banks or credit unions, and also by mortgage brokers who work with a variety of lenders and can help you find the best deal.
Interest rates are usually lower than other options provided you have a good credit score, and down payments may be less than 25%. Conforming loans must meet Fannie Mae or Freddie Mac guidelines. While Fannie and Freddie allow up to 10 mortgages by the same borrower, banks often set a lower limit of around four loans total.
- Also known as “conforming loans”
- Offered by mortgage brokers and traditional lenders such as banks and credit unions
- Guaranteed by Fannie Mae or Freddie Mac and must meet the government-sponsored enterprise (GSE) guidelines
- Lowest interest rates and fees with a good credit score
- Down payment requirements of between 15% and 25% (depending on the property)
- Up to 10 mortgages, although most lenders have an in-house limit of no more than four
Federal Housing Administration (FHA) loans are also offered by traditional lenders and mortgage brokers. Credit score requirements and down payments are usually lower than a conventional loan, and income from an existing rental property can be used to help qualify.
FHA loans are a good option for multifamily property investors looking for a rental property loan for a new purchase, new construction, or renovation of an existing property. To help qualify for an FHA multifamily loan, the investor will need to use one unit as a primary residence for at least one year.
- Multi-family loan backed by the Federal Housing Administration (FHA)
- Offered by mortgage brokers and traditional lenders
- Good for new construction, substantial property rehabilitation, and purchases
- Down payment and credit score requirements lower than with conventional loans
- Can use existing property rental income to help qualify
- Must reside in one of the units for one year or more
Veterans Affairs (VA) multifamily loans are a third option for rental property loans offered by banks, credit unions, and mortgage brokers. Mortgages backed by the U.S. Department of Veterans Affairs are available to active-duty service members, veterans, and eligible spouses.
Read Also: 5 Top FAQs I Get Asked as a Broker
There are several benefits to using a VA loan for a rental property if you qualify. There is no minimum down payment or minimum credit score, and you may be able to purchase up to seven units. However, one of the units must be your primary residence.
- Multi-family loan backed by the U.S. Department of Veterans Affairs (VA)
- Offered by mortgage brokers and traditional lenders
- Available to active-duty service members, veterans, and eligible spouses
- No minimum down payment or credit score
- Purchase up to seven units and borrower must reside in one of the units
Portfolio loans are mortgages on individual single-family or small multifamily properties by the same lender. Although each property has its own loan, the mortgage brokers and private lenders who offer portfolio loans may offer the borrower a ‘group discount’ for multiple loans.
Loan terms such as interest rate, down payment, credit score, and loan length can be customized to fit the specific needs of the borrower. However, because portfolio loans can be easier to qualify for when an investor has multiple properties, there may also be higher fees and prepayment penalties.
- Finance single or multiple rental properties with the same lender
- Offered by mortgage brokers or private lenders
- Portfolio loans are held by the lender and are a good option for ‘creative financing’
- Down payment, credit score, interest rate, and loan terms can be customized to fit the needs of the borrower
- Less stringent borrower requirements also mean higher fees, prepayment penalties, and balloon payments where the entire loan balance is due at the end of a short-term loan
A blanket loan is a good option for real estate investors who want to purchase several rental properties and finance all of them using a single loan or refinance a portfolio of existing rental homes. Mortgage brokers and private lenders are two sources for finding a blanket mortgage loan for any type of income-producing property. Interest rate, length of loan, down payment, and credit score vary from lender to lender, and loan terms can often be customized to meet the needs of the borrower and lender.
Rental properties in a blanket loan are usually cross-collateralized, which means that each individual property acts as collateral for the other properties. However, you can ask for a release clause that allows you to sell one or more of the group of properties under the blanket loan without having to refinance the remaining properties.
- Finance multiple rental properties under a single loan
- Can be used for any type of income-producing property
- Offered by mortgage brokers or private lenders
- Properties are ‘cross-collateralized’ with each property serving as collateral for the others
- Down payment, credit scores, interest rate, and loan terms vary based on the lender and the specific properties
- Possible to refinance existing individual property loans under one blanket mortgage
- Release clause can be negotiated that allows you to sell one or more of the properties within the blanket loan
Private loans are offered by experienced real estate investors and business people pool their capital and offer debt financing to rental property owners. Because these private investors know how the real estate business works, they often offer loan terms and fees customized to match the deal potential and the experience of the borrower.
Some private lenders may even take a small equity position in the project and accept future potential profits in exchange for lower fees or interest rates. If the investment performs according to plan, private lenders can also be an excellent source of funding for future rental property investments.
- Offered by private investors or groups who make loans to real estate investors
- Good source for funding future investments based on current property performance
- Loan terms and fees can be customized for each individual investor
- Some private lenders may ‘take a piece of the action’ by participating in the project in exchange for lower interest rates or fees
7. Seller Financing
Sellers who own a property free and clear (or with very little mortgage debt) are sometimes willing to act as a lender. By offering owner financing or a seller carryback, property owners who finance a sale to the buyer can generate interest income and earn a regular monthly mortgage payment instead of receiving the sales proceeds in one lump sum.
Seller financing can be a good option for owners who want to spread out capital gains tax payments over the life of the loan as an alternative to conducting a 1031 tax-deferred exchange. However, because the seller is offering the mortgage, borrowers should expect similar underwriting requirements such as credit checks and minimum down payment.
- Also known as a seller carryback, owner financing, or a purchase-money mortgage
- Offered by sellers who own property free and clear
- Good option for buyers investing when the real estate market is in a down cycle or for property that is difficult to qualify for conventional financing
- Loan terms can be completely customized based on the needs of the buyer and seller
- Sometimes used by sellers as a way to spread out capital gains as an alternative to conducting a 1031 tax-deferred exchange
A home equity line of credit (HELOC) and a home equity loan are two options for pulling money out of an existing property to use as a down payment for another rental property loan. This strategy is an example of the waterfall technique where investors use the cash flow and equity build-up from existing rental properties to fund future purchases.
A HELOC acts as a line of credit secured by the equity in an existing property that an investor can tap into at any time, and repay the loan with monthly payments similar to the way a credit card works. On the other hand, a home equity loan is a second mortgage that provides funds to the borrower in one lump sum.
With both a HELOC and a home equity loan lenders generally set a borrowing limit of between 75% – 80% of the property equity. Interest rates and fees may also be higher compared to doing a cash-out refinancing using a conventional loan.
- Home equity line of credit draws on the accumulated equity in one property as a source of funds to buy another
- Works similarly to a credit card, with monthly payments and loan amounts secured by the property
- Home equity loan is a type of second mortgage with the funds paid in one lump sum
- Loan is usually at a fixed rate with payments made over a certain amount of time
- Can borrow between 75% or 80% of the property equity, depending on the borrower and lender
- Interest rates may be higher than with a long-term, cash-out refinancing
- A good source for funds when and if they are needed
The lower your loan costs are, the larger your cash flow could be. Here are some of the best ways to keep your loan costs low when applying for a rental property mortgage:
- Research the best loan terms and conditions by speaking with lenders and mortgage brokers who know the local real estate market.
- Maintain a good personal credit score and use a conservative LTV with a down payment of around 25%.
- Prepare your mortgage application docs ahead of time – items such as W-2s, bank statements, and tax returns – to show the lender you’re a serious real estate investor.
- Generate income statements, net cash flow, and capital expense reports for any existing properties by automatically tracking income and expenses