The demand for rental properties continues to outpace availability. Therefore, buying an investment property could be a great way to earn some extra monthly income. However, one of the most challenging aspects of buying an investment property is acquiring investment property financing. Getting a mortgage for investment property is quite different from getting a home loan for your primary residence. Even though the process of getting a mortgage loan is not complicated, there are a lot of moving parts. There are certain requirements and rules you need to know before you begin the mortgage loan process.
Many beginners usually fear being rejected, which holds them back from getting started in real estate investing. However, knowing what to expect will give you the courage to make solid decisions that will enable you to get approved for a mortgage. Here’s a step-by-step guide of how to get a mortgage for investment property.
1. Get Your Credit in Check
Even before you set off to look for an investment property or mortgage lender, make sure you are financially prepared to own an investment property. You should thoroughly assess your finances and get everything in tiptop shape. There are a number of things that mortgage lenders look at closely before determining your eligibility for a mortgage loan. Lenders set these qualification guidelines to be sure that you can repay your mortgage. As you prepare yourself, it’s important to note that higher standards are usually expected when applying for a residential rental property loan than for a primary residence loan.
The following are the things you need to consider:
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Credit Score
The first thing that lenders use to assess your financial situation is the credit score. Credit score is a three-digit number that lets the mortgage lenders know if you can pay off the loan. Lower credit scores indicate a higher risk for them, hence lowering your chances of getting approved for a loan. Your credit score will also influence the mortgage rate for investment property. If you get approved with a lower credit score, the interest rates will typically be higher while the amortization schedule will often be shorter.
The credit score needed usually varies with different mortgage lenders. However, most investment property loans will require a minimum credit score of 620. If you have a low credit score, you need to improve it first before looking at a mortgage for investment property. You can do so in the following ways:
- Review your credit report for accuracy and dispute any negative information that you find to be inaccurate.
- For months to come, make sure you pay your bills on time.
- Use less of the total credit available to you to lower your credit utilization ratio.
Related: How Can You Improve Your Credit Score for Financing Investment Properties?
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Debt-to-Income Ratio
Debt-to-income ratio (DTI) is also important to mortgage lenders assessing your eligibility for a mortgage loan. It refers to the percentage of your income that is used for debt payment. This includes student loans, car loans, credit card debt, etc. Mortgage lenders usually want a borrower to have a low debt-to-income ratio. If your DTI is higher than 36%, you need to work on it first before applying for a loan. Improve your DTI by doing the following:
- Pay off as much of your debt as you can.
- Avoid taking any more debt or credit cards.
Related: Debt-to-Income Ratio for a Mortgage: What Real Estate Investors Should Know
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Cash Reserve
Before you apply for a mortgage for investment property, make sure you save enough money for a down payment and closing costs. Mortgage lenders will require you to have substantial cash reserves. You are also likely to be offered a better interest rate when you put more money into the deal. You’ll typically need to put at least a 20% down payment for investment property to qualify for a mortgage. The exact amount you need to save will depend on the mortgage type and the price point of the prospective investment property.
2. Choose the Right Mortgage Type
Once you have assessed your finances and improved your credit where possible, you can now research and select the best mortgage type and mortgage lender for you. There is a range of mortgage options available when buying real estate. Here are the most common mortgage types:
- Conventional mortgage (non-government)
- Federal Housing Administration (FHA loans)
- Veterans Administration (VA loans)
However, when getting a rental property mortgage, the options available change. Government-backed loans like FHA loans and VA loans typically require the property being bought to be a primary residence. Therefore, a conventional mortgage is usually the best mortgage for investment property. However, you could still work around using a government-backed loan by buying a multi family home, living in one unit, and renting out the rest. The advantage of these loans is that they require lower credit scores and down payments than most traditional mortgage loans.
3. Find the Right Mortgage Lender
Just like you want to get an investment property that best suits your financial goals, you’ll want to find a mortgage lender that best suits you. Depending on their requirements, some mortgage lenders will also reject you. To find the best mortgage lenders for investment property that will qualify you, you’ll need to shop around. Do your research and compare different lenders to find those with the best mortgage rates. Also ask about their mortgage down payment requirements, fees, and other terms. A good mortgage lender to work with should also be experienced with investment property loans. Consider working with a broker who can help you find a good lender. Moreover, you can ask for referrals from family and friends.
4. Get Pre-Approved
Once you pick the right mortgage lender, you can go ahead and get pre-approved. Pre-approval is the process of determining whether you meet the guidelines of a particular mortgage lender for you to be given a mortgage for investment property. Even before finding a real estate deal, you need to get pre-approval from the bank by providing your financial paperwork to prove your income, your assets and liabilities, and your source of down payment. The bank will probably ask for your pay stubs, bank statements, tax returns, etc. They will also check your credit report, which shows your credit history and credit score. All these documents will determine your credit-worthiness.
However, it’s important to note that the pre-approval is not a guarantee that a real estate investor will be given a mortgage or the loan amount. This is because they are yet to get the property details. You also have to be careful not to affect your approval by altering your cash flow in the near future with new debts, losing your job, changing employers, etc. Try to keep your financial picture quite stable until you have made an offer on a property.
While pre-approval definitely doesn’t guarantee that you’ll get a mortgage from the lender, you’ll want to get pre-approved because of the following reasons:
- A mortgage pre-approval shows that you are qualified to borrow from the lender. It also shows the loan amount for which you qualify. Therefore, you will be able to focus exclusively on investment properties in your price range.
- It shows real estate agents that you are serious about the purchase. When you approach a real estate agent, most of them will first want to know if you are eligible for a loan.
- It also shows the seller that you can make a solid offer up to a particular price. This signals to the property seller that you are ready and able to buy and, thus, a serious buyer. With a pre-approval, your offer will have more gravity if you intend to negotiate the deal. If you are in a hot real estate market with multiple offers, sellers will likely go for one who is pre-approved since your financing is less likely to fall through.
Although the pre-approval process typically doesn’t take that long to complete, it’s important to start the process early enough before you start making offers on investment properties. You don’t want to start the process of getting one while simultaneously dealing with crucial offer negotiations. Once you are pre-approved, you will get a pre-approval letter that outlines the mortgage type, the amount you can receive, etc. You’re now ready to hit the real estate market!
It’s important to note that you won’t have to stick with the same bank when you are ready to apply for the mortgage for investment property. However, doing so will make the process quicker since you have already done some paperwork.
5. House Shopping
An approval letter shows that you are credit-worthy and qualify for a mortgage loan. However, as stated earlier, it is not a guarantee that you will get the mortgage. You also need to find an investment property that the mortgage lenders will love. At this stage, it would be a good idea to work with an experienced buyer’s agent. The agent should have a good understanding of the local housing market.
You are more likely to be approved for a mortgage for investment property if the property can potentially bring in a good return on investment. Will the rental income be enough to pay off the mortgage payments and other monthly expenses? Will the property have a good cap rate and cash on cash return for the investment strategy you choose? To find an investment property that mortgage lenders can’t reject, be sure to use Mashvisor’s rental property calculator. This tool evaluates the performance of an investment property by providing important real estate metrics like cash on cash return, cap rate, and cash flow.
When you find a profitable investment property, make an offer. If the terms of the deal are approved by both parties, a purchase agreement will be signed. This becomes a binding offer. At this point, you can move forward to finalize your mortgage for investment property.
6. Mortgage Approval
After making an offer on a property, it’s time to start the second half of your approval equation. To complete the approval process, you will be required to submit the property information (usually the P&S agreement) together with the mortgage loan application. The lender will send an appraiser to conduct a home appraisal on the property. This is to ensure that it is in good condition and that they are not loaning you more than they should (the fair market value of the property). There will also be a title search to verify the home’s title as well as any other state-required inspections. Moreover, if it’s been long since you got pre-approved, the lender may need to see your updated financial documents. This will help them to re-verify your financial information like credit score and debt-to-income ratio in case it has changed.
When all the information is collected, it will be given to the lender’s underwriter. The underwriter will review all the property information and decide whether to approve or deny the loan. If you meet all the requirements and the mortgage for investment property is approved, the bank will let you know. The lender will give you a Closing Disclosure and set the closing date. The Closing Disclosure gives the details of the mortgage loan. It includes the interest rate, loan terms, down payment, monthly payments, and closing costs. Congratulations! You are now clear to close on the home.
7. Closing
At the closing table, you and the seller will review and sign all of the relevant documents. You will be making a significant commitment at this stage. Therefore, make sure you read and understand every document before signing. Be sure to ask any questions you may have about the terms of the loan. You will pay your down payment and closing costs. The mortgage lender will then disburse the funds needed to make the purchase. After you’ve signed everything, you will be officially the owner of an investment property.
The Bottom Line
The most dreaded part of the process of buying an investment property is securing a mortgage loan. With all the paperwork, people, and time involved, financing real estate investments can seem to be a very challenging endeavor for beginners. However, by understanding the different aspects of getting a mortgage for investment property, you will be one step closer to getting approved and attaining your investment goals. Hopefully, you now feel a little more educated about the steps you will need to take and are more confident about doing it yourself.