How much of a house can I afford? Asking this question is a crucial first step when buying a home, especially as a first-time buyer. A good rule of thumb is to use the 28%/36% rule for determining how much house you can afford, which states that you shouldn’t spend more than 28% of your gross monthly income on housing and 36% on total debt, like credit cards, auto loans, and student loans.
For investors, you have to think beyond down payment when determining affordability. You should be able to cover a 25% down payment, closing costs, and repairs. Also, you need to have at least six months of reserves for property maintenance and mortgage payments. Most lenders require this of rental property investors.
This article will explore the “how much of a house can I afford” question in more detail, as it concerns investors. You’ll see how to use Mashvisor’s investment mortgage calculator to determine your monthly mortgage payments, and how investment mortgage rates might change in 2022.
How Much Income Do You Need to Qualify for a Mortgage as an Investor?
We wouldn’t talk about getting a mortgage without qualification – how much do you qualify for? Investment properties require much higher financial requirements. First, your lender is going to require a minimum of 20% down payment. This is because private mortgage insurance (PMI) in the majority of cases does not cover investment properties. The purpose of PMI is to protect the lender in case of mortgage defaults but they only apply to primary residences.
Some lenders might even want you to put down 25% on 2-4 unit apartments with a 620+ credit score. You can get a conventional mortgage at a 15% down payment with a higher credit score for a 1-2 unit apartment. Generally, 25% is a good figure to plan for when seeking to invest in multi-unit properties. One way to sidestep high down payment costs on investment properties is house hacking. This requires that you live in one unit of the property for at least 60 days a year and be an owner-occupant for a full year.
What Costs Do You Need to Prepare for as a Prospective Rental Property Investor?
1. Have at least a 6-month emergency fund. Before doing this, make sure you’ve paid off high-interest debt. Because when you’re paying interest on your credit card at the rate of 17% and earning a 10% annualized return on your rental investment, most of your profits go towards your credit card debt. If you can’t pay off credit card debt, opt for a 0% APR balance transfer. Once you’ve done this, your lender will require you to have at least 6 months’ worth of mortgage payments in an emergency fund. But your emergency fund shouldn’t cover mortgages alone, you should plan for unexpected expenses or negative cash flow at the start.
2. 2%-5% of the property price for closing costs. Expect to pay a relatively higher closing cost when investing in real estate. One of the reasons for this is because property taxes and origination fees are usually higher for investment properties than for primary dwellings. When you close, you’ll have to pay a certain amount of property taxes in advance.
3. Hiring a property management company. It’s a good idea to have your property managed by a company that handles both scheduled and emergency repair work and goes around to the property both on a regular basis and when you’re not there to monitor tenants. Some of these companies also offer rent collection, tenant placement, and evictions for you. This is particularly helpful if you’re buying out of state. You should factor in this cost when preparing to buy a rental property. So how do you calculate if you qualify for a mortgage as an investor?
How Much Income Do You Need for a $350,000 Mortgage? What Lenders Look For
1. Proof of income. Lenders want to see that you have a stable income so every piece of income used to qualify will be thoroughly vetted. A recent W-2 form and recent paycheck stubs (or their electronic equivalents) are usually required by your mortgage lender as proof of income. If you have recently changed jobs, the lender may require a letter from your employer proving your income. You could also use investment income dividends and interests to qualify, but be prepared to submit more documents.
2. Credit score. Investors considering a conventional mortgage need to have a credit score of at least 620. Borrowers with higher credit scores can secure lower interest rates while higher interest rates are used to compensate for additional credit risk. This is known as loan-level pricing. 720 is a good score, while 760 and above is considered excellent.
4. Debt to Income Ratio (DTI). This compares how much you currently pay in debts monthly to how much you earn each month i.e what percentage of your income goes towards debt payments. Lenders generally want a DTI of 36% or less. But some lenders will still work with you if your DTI is below 50%.
Once you have a basic idea of costs and financial requirements to prepare for, it’s time to start searching for properties.
What Makes a Good Property Investment?
If you use debt to finance your property investment, it becomes more important to put your best foot forward by doing enough due diligence. Missing a slight detail could be the difference between positive and negative cash flow. A good property investment would be a good property at a good price in a good neighborhood. How do you find the right kind of property? Here are some things to look for as an investor (some lenders might want to see these too):
1. The 1 Percent Rule
In some markets, you could use the more stringent 2 percent rule. Generally, the 1 percent rule states that the rental income should be at least 1 percent of the purchase price. Conversely, this means you don’t buy a property whose purchase price is greater than 100 times the expected rent. It’s a good rule of thumb for many investors. However, the problem is; how do you estimate rent as a new investor? In cases where the property is already rented, it’s easy to calculate rental income. But in the converse scenario, there are three ways to estimate rental income:
- Order a real estate rent appraisal.
- Use Mashvisor’s rental estimate (you’ll be able to use this with Mashvisor’s property marketplace)
- Check out rent prices for similar properties in your neighborhood.
This property in the Mashvisor property marketplace has an asking price of $575,000. It rents for $3,226 via the traditional rental approach but nets $7,027 via Airbnb.
Based on the 1% rule, the property should rent for $5,750 to deliver a good ROI. Hence, listing on Airbnb would be a better investment approach here.
2. Occupancy Rate & Vacancy Rate
Occupancy rate is the percentage of occupied units compared to total units in space. Beyond the individual property metrics, occupancy rate measures how profitable your location is. Occupancy rate can be a test of market hotness or coldness. Areas with high occupancy rates signify high demand because people are moving there while a high vacancy rate in an area is a red flag. To get a good idea of the desirability of a place, look at how vacancy rates/occupancy rates have changed in recent times.
Related: A Property Manager’s Guide to Boosting Occupancy Rate
3. Cap Rate
Cap rate measures the potential return an investor should expect within a year. It’s measured by using the formula:
Net operating income/fair market value.
Note that purchase price isn’t used because using purchase price would make it impossible to get cap rates on old buildings and inherited properties. Net operating income is the income derived from the property in a year minus property expenses. For example, if the current fair market price of a property is $575,000. If rent is $3,226, and the property costs $1,379 to maintain, the net monthly income is $1,847. When you multiply this by 12, you get the net operating income. Ensure you subtract the cost of vacancies when calculating your net operating income.
For our sample property, NOI is 22,164. Cap rate is NOI divided by current market value, expressed as a percentage. That is 4%. The lower the cap rate (less than 5%), the lower the risk profile, and the higher the cap rate (greater than 7%) the riskier the investment.
Based on Mashvisor’s automated analysis, as shown, we can conclude that this property presents lower risk and lower profitability as a traditional rental compared to an Airbnb rental.
4. Cash on Cash Return
Cash on cash measures the cash yield of the property. In cases where you’re financing your property investment with debt, cash on cash return becomes a more relevant metric. Switching on the mortgage tab in the Mashvisor property page presents a different value for cash on cash return.
In this case, operating expenses do not just cover mortgage and property expenses but also monthly mortgage payments. Note that cash on cash return focuses solely on cash inflow and outflow, and doesn’t factor in property taxes. Cash on cash return is annual pre-tax cash flow divided by the total cost of purchase.
Annual pre-tax cash flow is annual cash flow minus yearly expenses (mortgage, operations, and vacancies). The total cost of purchase is the cost of the down payment plus other costs incurred while buying the property. For our example property, cash on cash return for traditional investing is $1032 divided by (down payment + startup costs) i.e $151,750. Cash on cash return for a traditional rental strategy on this property is pretty low (using a 30 year fixed rate mortgage and a 25% down payment) at 1.23%. On the other hand, cash on cash return is more than double for an AirBnB strategy at 18.06%.
When mortgage terms change to a 15 year fixed rate, the cash on cash rate changes drastically.
With Mashvisor you can see all these in real-time. You would be able to make decisions quickly.
5. Net Income Multiplier
The inverse of the CAP rate provides a metric to judge how much you’ll spend for each dollar of profit. i.e
NIM = Property value/NOI
The lower your NIM, the better. This is because your cash input should be low compared to cash output for a highly profitable property investment. However, based on research, low risk, high demand properties with comparatively lower profit potential would have high NIMs and low cap rates. For risky markets with higher vacancy rates and excess supply, NIMs should be lower and cap rates higher.
6. Expense Ratio and Debt Coverage Ratio
When comparing similar properties, you should take note of the expense ratio and the debt coverage ratio. The expense ratio (ER) shows what percentage of your rent earnings go towards operational expenses. In many cases, luxury real estate with high maintenance costs wouldn’t make a good property investment. On the other hand, properties that need a lot of fixes might also turn out to be money pits.
Expense ratio = Total operating expense (minus yearly depreciation)/gross revenue.
You should aim for an expense ratio below 60%. The lower the better.
The debt coverage ratio focuses on the relationship between your rental income and your mortgage. That is, how much of your total rental income goes towards mortgage payments? Debt coverage or debt service coverage ratio (DSCR) is calculated as Net operating income divided by debt obligations. Lenders prefer borrowers who have a DSCR of at least 1.15.
7. Expected Internal Rate of Return
To take your property analysis to the next level, you might want to calculate the historic rate of return. This is measured by the IRR (Internal Rate of Return). It measures the average return from a property based on past and current performance. IRR takes time (and inflation) into account when measuring potential return hence commercial property investors consider it a helpful metric for determining profitability. Once you know the respective cash flows, you can calculate the IRR using a formula in Microsoft Excel.
Top Investment Loan Options in 2021
Now that you know what to prepare for and what kind of property to look for, you need to know your loan options as an investor. What types of mortgages can you get approved for as an investor? Choosing the wrong type of loan will impact your profitability as an investor for a long time. Here are some of the best investment loans for real estate in 2021
Conventional Financing
Conventional loans are usually compliant with Fannie Mae or Freddie Mac lending standards and they have a certain lending limit, usually between $548,250 and $822,375. Some lenders offer jumbo loans for higher-priced properties. As an investor, you should expect to pay between 0.50% – 0.75% more for conventional financing. Also, with conventional financing, the lender isn’t as interested in your assets or investing experience as much as your ability to repay the loan.
This means your personal credit, income, employment history will be placed on the pedestal. Your DTI ratio comes into play i.e how much debt do you currently have? And how much debt are you qualified to take on? As mentioned before, lenders prefer debt to income lower than 36. Here are three of the best conventional mortgage lenders for investors in 2021, according to Nerdwallet.
- Rocket Mortgage by Quicken Loans. Based in Detroit, Quicken Loans is America’s largest mortgage lender. By July 31, Quicken loans will officially become Rocket Mortgage, which started as an arm of quicken loans offering online mortgage applications and approvals. As of 2011, Quicken Loans had released its first mobile app to allow its clients to e-sign their mortgage documents. It was the first home lender to have a mobile app. They offer a variety of mortgage types – fixed-rate mortgage, adjustable-rate, FHA, VA, USDA, and Jumbo. As an investor, you should plan on putting 15-20% down but homeowners with PMI can pay 3% in down payment. As of July 2021, the 30 years fixed-rate mortgage for Quicken loans has a rate of 2.99% and a 3.2% APR while a 15-year mortgage comes at 2.5% and an APR of 2.9%.
- CitiBank. Citibank has a wide range of mortgage products for investors. Aside from an opportunity to benefit from its low down payment program, Citibank customers benefit from relationship pricing. This means that they get rate discounts and credits on closing costs if they set up automatic monthly mortgage payments through their Citibank account. Investors can get 15/30 year fixed mortgages, 7/1 and 10/1 adjustable-rate mortgages as well as jumbo loans. There are also government-backed loans available. You can start a Citibank mortgage application online or over the phone. As of today, July 8, 2021, the rate for a 30-year mortgage at Citi is 2.9% and APR is 3.1% while a 15 year fixed mortgage carries 2.4% and APR of 2.6%.
- New American Funding. One of America’s top 20 lenders. New American funding is family-owned but has grown to almost 200 branches in all 49 states and the DC. NAF offers fixed-rate mortgages, ARMs, home equity loans (HELOCs), cash-out refinance, jumbo loans, reverse mortgages, and government-backed loans such as FHA, USDA, and VA loans. While documents can be uploaded online, the bulk of financial assessment is done manually. Mortgage approval can take up to 35 days. The current rate for a 30 year fixed rate mortgage is 2.75% at a 2.86% APR. For a 15 year fixed mortgage, the rate is 2.25% at 2.46% APR.
Asset-based Financing
When you can’t qualify for conventional financing, asset-based lending is your next best option. However, you might be paying 2%+ in interest rates. Asset-based lenders use tangible assets when determining your creditworthiness. In this case, the lender is interested in the profitability of the investment and the ratio of potential income to debt i.e your debt service coverage ratio (DSCR).
However, as an individual, you still have to meet the lender’s financial requirements. But your loan approval wouldn’t depend on your DTI or income statements but your DSCR. A big advantage of asset-based loans is that they can be made to an LLC, rather than to an individual since much doesn’t depend on your individual finances. For conventional asset-based lending, you pay back the advance, plus interest, over a set period of time. If, however, it’s an asset-based line of credit, you will be able to borrow as much as you need and only pay interest on the amount you use. However, the lender has the right to claim the asset and sell it to cover losses when you default.
HELOC (Home equity line of credit)
Your home equity can be a great financial tool. You can tap into home equity through a second mortgage in the form of a lump sum home equity mortgage or a home equity line of credit. The HELOC offers a revolving line of credit (similar to a credit card) which is a great idea for fix and flip investors or investors who need to make a number of costly repairs. Since these loans are secured against the value of your current home, lenders offer lower rates for them. However, just like taking out a mortgage, you’re placing a lien on your home. This means that lenders have another avenue to lay claim to your property if you stop making payment.
FHA 203k Rehab Loan
For house hackers, an FHA 203k loan helps combine your mortgage loan and renovation loan into a lump sum payment. The advantage here is that these loans are insured by the government, hence they require lesser down payment compared to conventional investment loans. Investors who take out FHA 203k loans are usually fix-and-flip investors who anticipate spending considerable money on repairs. But anyone can apply, as long as you plan to live in the property for at least one year. With an FHA 203(k) loan, project work must be completed within a maximum of six months. And work must begin within 30 days of the loan closing. You can also get a streamlined FHA 203k loan, capped at $35,000 for home repairs.
SBA 504 Loan
Typically issued to incorporated businesses, this type of loan involves partnerships between banks and non-profit development companies. The loans are usually capped at $5 million, with a 10% down payment from the business owner, 40% financing from a not-for-profit development company, and 50% financing from banks. One major advantage of this type of loan is that rates are usually low when compared to standard rates and they are fixed for the loan term, which is usually 10, 20, or 25 years. Note that, for new businesses (2 years or less), the portion the business contributes would be higher than 10%.
Hard Money Loans
Hard money lenders are usually the last resort because they come at higher rates and have shorter loan terms. But they are also the quickest way to close on your property purchase as they have fewer qualification criteria. All the same, make sure to read the fine print and terms of the loan.
Related: Hard Money Loans for Real Estate Property: The Pros and Cons
How to Use Mashvisor’s Mortgage Calculator
Costs can present curveballs when you’re planning to buy a property either for residential purposes or as an investment. But while there are many mortgage calculators for home buyers, there aren’t many for investors. Moreover, figuring out monthly mortgage payments per month is only one piece of the puzzle, but you want to have a full picture of all the costs associated with your investment.
Mashvisor’s mortgage calculator, created specifically for investors, helps you with a ballpark estimate of your costs. Mashvisor’s calculator will present your cap rate and cash on cash rates in real-time, depending on your desired investment strategy and loan amount. Note that a mortgage calculator, just like any other calculator, relies on your input to help you make profitable decisions. Hence, make sure you do sufficient research and due diligence on your part. Factor in property taxes, insurance, HOA dues in the expenses section.
Mashvisor provides property analytics tools for both short-term and long-term rental investors. Mashvisor’s mortgage calculator is a part of the full-view rental calculator which presents you with data on the profitability of your desired investment on one page. The property page is usually similar to a normal property listing page with a high number of good images and a property description.
Moving from this page, you can customize any of the input based on your existing research or requirements to see how it impacts your profitability. For example, if you’ll be taking out a mortgage, click on the mortgage calculator tab to switch it on.
This will factor in the impact of your mortgage expenses on the profitability of your investment. In the valuation section, you can choose to analyze using the property price as listed on Mashvisor or the price on Redfin (if the property is listed there). You can also select a custom price, for example, in the case of reduced price.
Next, shift the down payment slider either to the left or right. You can choose to show your down payment in dollar amounts or as a percentage. This is interesting because it shows you how your cash on cash return and cash flow varies with your down payment amount.
For example, with a 15% down payment and a 2.75% interest rate on a 30 year fixed mortgage, the property becomes slightly cash flow negative when it’s used as a traditional rental.
On the other hand, using the same mortgage terms, the cash on cash return on an AirBnB strategy is 26.9%, i.e very profitable.
At 30% down payment, using the same terms, the property becomes cash flow positive, yet marginally, in comparison with the Airbnb strategy. Airbnb cash on cash reduces to 16%, but cash flow increases (since mortgage fees reduce).
You can customize the result based on the term and type of mortgage. Although rates are based on data from a number of accurate sources, talk to a lender to figure out an accurate rate to expect as an investor. Input this rate in the calculator to see how your rate affects your profitability
- Fixed-rate mortgage: Mortgages with a fixed interest rate remain the same for the entire term of the loan. Therefore, you will make the same monthly principal and interest payments over the term of the loan.
- Adjustable mortgage: According to Freddie Mac, “The initial interest rate on an ARM is set below the market rate on a comparable fixed-rate loan, and then the rate rises as time goes on. If the ARM is held long enough, the interest rate will surpass the going rate for fixed-rate loans”.
- Interest-only mortgage: This type of mortgage requires the mortgagor (the borrower) to pay only the interest on it for a specified amount of time. The principal can either be repaid in a lump sum at a particular date or through periodic payments.
15 Year vs 30-Year Mortgages for Investors
For 15 year fixed-rate mortgages, you’ll pay more per month but score a lower interest rate over the term of your loan while the converse is the case for 30 years fixed mortgage. So, should you go for a 15 year fixed rate mortgage or a 30 year fixed mortgage? Based on Mashvisor’s calculator, a 30 year fixed mortgage might be the best option if you want positive cash flow from the onset. But if you can settle for reduced cash flow or even negative cash flow for a long time, then opt for 15-year mortgages as you’d save considerably on interest.
In our current example, for a 30 year fixed mortgage at a 30% down payment, you pay $1,643 monthly or $19,716 annually over the term of the mortgage.
On the other hand, for a 15-year mortgage, you pay $2,652 monthly or $31,824 annually. The 15-year mortgage provides $114,120 savings on interest rates.
Yet, the downside of the 15-year term is that your mortgage eats up your rental income. So with a 30% down payment at a rate of 2.75%, a 30-year mortgage provides a $273 monthly cash flow for a traditional rental. But you bear a loss with 15 year fixed mortgages. Using the same terms, for a traditional rental, you lose $736 per month with a 15-year fixed-rate mortgage. If you wait it out until you pay off your mortgage, your cash flow rises back up. But you have to account for depreciation and market strength. This is why many real estate investors opt for 30-year fixed-rate mortgages.
What About Adjustable Rate Mortgages?
For a set period of time, generally, five or seven years, depending on your lender’s amortization schedule, an adjustable-rate mortgage offers a low introductory interest rate. During that first period, the rate and the principal and interest payments are fixed, but after that, the rate adjusts according to the terms of the loan and the index to which it is linked. Enter your ARM rate in the loan ARM rate box to see data on cash flow and cash on cash return.
Most investors do not opt for adjustable-rate mortgages because they’re unpredictable and offer lower cash flow.
Related: Adjustable-Rate Mortgage vs Fixed-Rate: Which Is Better for a Real Estate Investor?
Investment Property Mortgage Rates in 2022: What Should you Expect?
Now that you know how to use Mashvisor’s mortgage loan calculator. And you know that mortgage rates can affect your profitability as an investor, you’ll probably be wondering if the current trend of rising mortgages will persist in 2022? One thing analysts are predicting about mortgage rates in 2022 is that rates will continue to rise. Not such good news, especially for investors who pay more in interest rates than homeowners. Freddie Mac estimates put mortgage rates for the first quarter of 2022 at 3.5% while the Mortgage Bankers Association (MBA) presents a more grim outlook for mortgage rates, estimating rates to cross the 4% mark.
Yet one thing we know for sure is that it’s hard to make predictions on mortgages as rates have taken unexpected turns over the years. But with an improving job market and rising inflation, mortgage rates are expected to rise in 2022, however, at laggard paces.
Based on a FoxBusiness article, “As recently as the end of 2020, 12 of the Fed’s 18 voting members said that interest rates would need to remain at their current levels until at least 2024. Currently, the majority of Fed members are now predicting at least two rate hikes in 2023. At a recent virtual event hosted recently by The Atlantic, Treasury Secretary and former Federal Reserve Chair Janet Yellen said interest rates may need to rise to slow the rate of inflation and keep the economy from overheating”. Read more about the 2022 real estate market here.
Now that you know how to use Mashvisor’s mortgage calculator, your property investments do not have to be a gamble. Start searching out property investments that are sure to generate good cash flow.
