The Ultimate Guide to Financing a Rental Property
A rental property loan is often the first major step a person takes toward becoming a landlord. The loan you use to buy a rental property helps you acquire a great building without paying outright; however, it also means you’ll have significant debt for years to come.
Your mortgage payments will likely be the greatest expense you have as a landlord, and your goal should be to get a mortgage that is as easy to manage combined with your other operating expenses.
While a rental property loan can help you realize your ambition to earn passive income, there there are many points to consider before you apply for one. Luckily, there are several types of rental property loans to explore.
In this article, we will cover what types of loans you can apply for to purchase a rental property. This information will help you build a strong foundation for your real estate portfolio, as well as avoid some of the common mistakes new landlords make when securing loans for their first properties.
What is a rental property loan?
In order to buy a rental property, you will likely need to apply for a loan to cover the cost. Unless you can pay for a property in full, you will pay for it using a loan.
A rental property loan is a type of mortgage that lets you pay off your property over a period of time, usually 30 years.
Because a rental property is a major investment, they tend to have higher requirements than residential mortgages for private residences.
A rental property can be a mobile home, vacation home, single house, duplex, apartment or apartment, condominium, or another similar venue. In real estate terms, rental properties managed by landlords are called dwellings.
The loan you use to secure your property will become your own personal debt; you will use a portion of the income you generate from rent to make periodic payments on your mortgage.
Parts of a Rental Property Loan
Rental property loans consist of two core elements:
- Principal amount. The principal amount is the base value of your loan, which equates to the property’s sale price minus your down payment, which is the amount of money you must pay upfront to secure the loan.
- Interest. Mortgage lenders generate their own revenue by adding money on top of a principal loan amount. Interest is essentially the additional costs you pay to have a loan.
You will also have to pay for taxes and insurance, and the costs of these vary depending on many factors, including the property size and the state it is in. Mortgage lenders also set insurance limits, so you will have to secure the right level of coverage before you are eligible to receive a loan.
Related Reading: How to Buy a Rental Property
Types of Loans for Buying a Rental Property
In this post, we will explore four types of rental property loans you may apply for to finance your first rental property. It is helpful to know what major types of home loans there are, so you can find a lender that provides the most agreeable rates and terms for your property.
A standard rental property loan that anyone can apply for is called a conventional loan. These loans are issued through banks or credit unions, who work through various mortgage lenders. If you have a good credit score and enough money for an adequate down payment, you will likely find that the interest rates are the lowest in conventional mortgages.
The greater your financial stability, the easier it is to acquire a conventional mortgage with favorable terms and low interest rates. Down payments can be 25% or less in most cases, making them easier to acquire than some other types of mortgages.
All conventional rental property loans must meet guidelines laid out by Fannie Mae or Freddie Mac, organizations created by the U.S. Congress to stabilize the housing market.
You may benefit from this type of loan if:
- You can afford to make a down payment worth up to 25% of the property’s cost.
- You have a minimum credit score of 620.
- You can show at least six months’ worth of mortgage payments in cash reserves.
Rental property loans through the Federal Housing Administration (FHA) tend to have lower interest rates and requirements than conventional loans. However, to qualify for an FHA rental property loan, you will need to purchase a multifamily property, and use one of the dwellings as your primary residence for at least one year.
The good news is that FHA mortgages for rentals are highly flexible; you can apply for them for properties you wish to build, renovate, or purchase brand new.
If you are a veteran, active duty member, or eligible spouse of either, you can apply for a mortgage through the U.S. Department of Veterans Affairs. VA loans are some of the most versatile types of rental property loans available; they have no minimum requirements for down payments or a credit score.
You can apply for two- to four-unit properties, and possibly a single-family home. Borrowers must live on the property full-time.
VA loans can help landlords expand their investment portfolio, and grow their wealth steadily as they acquire more real estate. You can apply for a VA direct loan, which is lent by the Veterans Administration itself, or a VA-backed loan, which is issued by a conventional mortgage lender and partially guaranteed by the VA.
In seller financing, the seller directly loans money to the buyer to purchase the property. The buyer then makes payments to the seller; the seller could also continue to collect rent, and deduct a portion of it to apply toward the loan.
Because the owner is the lender in seller financing, it can be much easier to get approved for, and have far fewer stipulations, than any other type of mortgage. Also, seller-financed homes have much shorter mortgage terms overall, usually around five years.
At the end of the loan term, the buyer pays off the remaining principal and interest in a balloon payment; balloon payments are lump sums of cash that are paid to a lender at the end of a loan. The last payment is designed to be larger than all the others before it.
While they may not involve a bank or other lending agency, seller-financed loans still require a down payment. Most seller financing down payments run between 8% to 25%.
How to Apply for a Loan to Purchase a Rental Property
The application method for your rental property loan will depend on what type of loan you decide on.
The first step for a loan issued through a lending agency is pre-approval. During this process, you submit information and financial records to a lender. In turn, they tell you how much money you could be approved for, and what your interest rates might be.
It is beneficial to speak with at least three to five lenders before you make a final decision; however, keep in mind your credit report will be pulled each time you apply. Multiple pulls on your credit can lower your score, so only apply to lenders that you are serious about borrowing from.
Mortgage applications always require a credit check, except VA loans. They include a more comprehensive financial review, and you must meet the eligibility requirements outlined on their website.
When you are ready to apply for an actual mortgage, you will need to submit the following information to a bank or credit union lender:
- Employment details
- Two years of W-2s or profit and loss statements
- A list of all other types of continuous income
- A rundown of your current debts, such as property, car loans, student loans, and child support
- Information about the property you want to purchase, including the address, anticipated price, the type of home, real estate taxes, Homeowners Association (HOA) dues, and the expected closing date of the sale
- Your complete credit history, which includes any liens, bankruptcies, collections, or foreclosures
Why You May Be Denied a Rental Property Loan
The primary reasons applicants are denied a mortgage are a low credit score, insufficient finances, or high debt. The lender will let you know why your application was not approved, so you can take steps to improve your application in the future.
Most lenders will allow you to reapply in the future, but there is often a 30-day waiting period. This is beneficial because it helps prevent too many successive pulls on your credit. Remember, every time you apply for a mortgage, your credit score can be lowered.
If you apply for multiple loans at once, you could actually lower your score and risk being approved altogether. So, time your applications wisely, and start with your preferred lender first.
Other Rental Property Financing Options
One of the most common ways to purchase property is with cash. Why? Because you don't have to worry about mortgage payments, interest rates, qualifying for a loan, or any closing costs. You buy it in cash, and that's it.
Related Reading: How Much Can I Rent My House For?
Through an IRA
You'll need to create a self-directed IRA account to buy a rental property through an IRA.
Once you have your account, you can invest in real estate in your account. You'll be able to purchase single-family homes, multi-family properties, or commercial buildings like retail stores, but nothing out of real estate investment. You can also set up an LLC that owns the rental property and use this as your vehicle for purchasing real estate investments using your IRA account.
This is one of the most beneficial ways to start investing in real estate because it gives you access to potentially lucrative tax deductions while protecting you against loss if the market turns south during any given year.
If you don't have the money to buy a house and you're not interested in renting out your own home, then you might be interested in buying a rental property through wholesaling.
Wholesale is a process by which an investor finds buyers for other people's properties to make money off the transaction.
The first step in wholesaling is finding someone with an available property that isn't selling for some reason, maybe the price is too high, or it needs work. Once you find such a property, you arrange to buy it from the owner at an agreed-upon price. Then you turn around and sell it on behalf of your client to another investor or landlord who might be willing to pay more than what you paid for it and then pocket the extra cash for yourself.
You won't need any special license or training. However, it's important to remember that when you're wholesaling real estate, you will represent the seller in their negotiations with potential buyers, so make sure you know what you're doing.
Use a lease option to purchase
A lease option is a contract between the owner and the buyer that gives you, as a buyer, the right to buy the property at some point in the future.
You'll need to make sure that your lease option contract includes all of these key points:
· A specific purchase price for when you decide to buy it.
· The time until your option expires (usually one or two years).
· Whether there's a penalty for canceling at any time before closing on the sale date (no penalties are common).
There are several methods for receiving a loan to finance your rental property. The most important thing to do before you buy any property is to thoroughly research your financing options, and plan your budget accordingly.
Preparation will give your budget structure, making it easier to manage your future building and pay off your loan on time.
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