You finally decided to act on your dream of becoming a real estate investor– congrats!
Buying an investment property is one of the most financially rewarding things you can do.
There’s just one problem: you need a loan.
You might have heard that investment property loans are different from the kinds of mortgages people take out on their primary residences. While that is true, investment property loans aren’t as daunting as you might think. In this article, we are going to cover everything you need to know about qualifying for one.
Watch our real estate video below to figure out the best mortgage type for your rental property:
What Makes Investment Property Loans Different?
Before we talk about how to qualify for an investment property loan, let’s establish what sets them apart from primary residence mortgages.
Investment Means Risk
The reason investment property financing can be more difficult than taking out a loan on a home you intend to live in is that mortgage lenders tend to view investments as risky. In most cases, an investment property loan is a second mortgage, meaning you are taking on more debt.
But even if you rent an apartment and want to look into investment property financing, lenders will still assess it at the same level of risk. This is because people don’t have the same motivation to pay off a property that they don’t live in. In the event that the investment doesn’t work out, banks fear that a real estate investor would default or stop paying.
A way that new investors often get around this for residential investment property loans is by purchasing an owner occupied investment property. They are able to take out a standard loan for a primary residence, which is much easier because they intend to live in a unit of a multifamily house and rent out the other unit(s).
If the above situation doesn’t appeal to you, however, you’ll have to qualify for a rental property loan. And no, you cannot pretend a rental property is your primary residence when it’s not- this will get you in serious trouble. Your bank will find out, and they have the right to cancel the loan.
Investment Versus Owner Occupied: Key Differences
Some of the key distinctions for investment property loans include a higher minimum down payment on investment property and higher investment property mortgage rates.
Down payments on investment property usually must be 20% or higher, versus a minimum as low as 0-3% for many owner occupied home loans. While there are many programs that help first time and low income home buyers, investors are not cut any slack.
Investment property mortgage rates are also slightly higher for investors. According to Lending Tree, mortgages for investment properties have higher interest rates than those for primary mortgages by 50 to 87.5 percentage points. This can amount to tens of thousands of dollars in interest over the life of a loan.
In addition, there are more stringent rules for investors. That being said, you might be wondering, “Is it hard to get a loan for an investment property?” While the guidelines for qualification are certainly more strict, it’s not impossible.
How Do You Qualify for an Investment Property Loan?
The main aspects of qualifying for investment property loans are:
- Employment history
- Debt to income ratio
- Credit score and credit history
- Sufficient down payment
In order to qualify for investment property loans, you must show proof of verifiable employment. Much like with loans for owner occupied homes, you must show full time, steady income from the same job for a minimum of two years.
This helps mortgage lenders understand that your income is secure. If you work part-time, on tips, or on commissions, even if the income is more than sufficient to cover the expense of the rental property, you should be prepared to show more than two years of employment history. Depending on the bank, they may want to see three or four years at a job if your income isn’t hourly.
Debt to Income Ratio (DTI)
Your debt to income ratio is a large part of the qualification process for investment property loans. DTI is a way lenders can measure the debt you’re taking on against your income and other debts you have. This way, they know if the property is reasonably affordable for you.
DTI = Total Monthly Debts / Gross Monthly Income
Using the formula above, you can determine your DTI. Your total monthly debts include your monthly payments for:
- Credit cards
- Car loans
- Personal loans
- Student loans
- Your current mortgage (if applicable)
- The mortgage you are trying to qualify for
In order to qualify, you must fall below a certain threshold, according to the lender you are using. At a minimum, your DTI should be under 50%. It is most ideal, and you will find yourself with the most options if your DTI is 36% or less.
To make things easier on you, some lenders will allow you to factor a part of your estimated rental income into your gross income. However, you cannot always count on this, and being able to afford a property without rental income is important for your financial security.
To find the rental rate for a property, learn about our rental property calculator.
Credit Score and Credit History
In order to qualify for investment property loans, you must have a clean credit history and a minimum credit score of 620. While this is a minimum for approval, having a credit score of 720 or higher will get you the best interest rates.
If you have bad credit, meaning a credit score lower than a 620, there are several things you can do to increase your score to help you qualify. The top two factors that go into calculating your credit score are revolving utilization and timely payments. Keeping your credit utilization at 30% or less of your available credit, as well as making payments on time each month, will help reverse your bad credit score.
Additionally, having a long enough credit history can be a struggle for young real estate investors. Lenders will want to see at least a few years of good credit habits before approving you for investment property loans.
The last but certainly not least important piece of the puzzle is your ability to make a substantial down payment.
As we discussed earlier, you should be ready to put down 20-25% of the purchase price for investment property loans. You should also have adequate savings beyond the down payment to protect against rent loss and repairs.
Lenders like to see bank statements that show a high level of savings, usually going back several months. This will indicate that you are financially secure and manage your money well, making them more likely to want to lend to you.
Types of Investment Property Loans
Once you’ve determined that you meet the minimum requirements to get qualified for investment property loans, you can start shopping around for the best options.
The most common type of loans for investment property is conventional loans. These are similar to a standard loan you would take out to buy a primary residence. The only difference is that the loan will be classified as an investment loan, meaning the more stringent qualification process we discussed will apply.
However, depending on your investment needs, there are non-conventional loan options for buying an investment property. For example, there are specific loans for commercial property, and investors who are interested in flipping homes can get fix and flip loans.
If you are a homeowner already, you may be able to qualify for a home equity loan, or a HELOC (home equity line of credit) to finance your investment.
There are many options out there, and while each will have slightly different requirements and terms, if you meet most of the requirements listed in this article, you should be able to find a loan type that suits your investment style.
What If I Don’t Qualify?
For real estate investors who don’t meet many of the requirements to qualify for investment property loans, there are still options.
Hard money lenders and private lenders are great for investors who have difficulty getting approved for conventional loans.
No matter which loan type you choose, the road to successful investing starts with having the right real estate investment tools. To start looking for and analyzing the best investment properties for sale in your city and neighborhood of choice, click here.