While the home buying market gets most of the attention and coverage from the media and economists, the single-family residential (SFR) rental property market is a booming $4.4 trillion industry making up one-third of the entire US rental market with more than 16 million units.
SFR rentals are mainly owned by local real estate investors although due to the market’s proven resiliency through the COVID-19 pandemic, Wall Street has recently gotten involved.
SFR rentals remain in constant demand as younger generations get married and have children or pets – but don’t want to buy yet or deal with the trials of home ownership, and older generations look to scale down and have less housework to take care of.
If you’re interested in expanding your investment portfolio and earning passive income by including SFR rentals (or even vacation rentals), you should understand how to finance your investment property purchase to maximize your return on investment.
What Is a Rental Property Loan?
A rental property loan is a first-position residential loan secured by a real asset – the SFR property – that is occupied by a tenant. The property must be ready to rent in order to qualify for a rental loan, and the loan can be long-term or short-term, depending on your investment goals. If the rental property needs repairs, you will need another loan to cover rehab or repairs (more on that later).
Ways to Finance a Rental Property
There are multiple ways to finance an investment property, with each lender having its own requirements for borrowers. Having a diverse capital structure is usually beneficial, and going with the “wrong” kind of loan may impact the success of your investment, so it’s best to understand your funding options.
Hard Money Loans
A hard money loan, aka bridge loan, is a short-term loan secured by a real asset – the investment property. Because a hard money lender is mainly focused on the value and profitability of the property being used as collateral, they are more flexible with the credit score, the employment history, and other requirements that if fair, poor, or lacking would be deal-breakers for a conventional lender, such as a bank. Because of this, hard money lenders are generally able to get capital to borrowers quicker than a typical lender.
Bank or Conventional Loans
If you already own a home that’s also your primary residence, you’re probably familiar with conventional financing from a bank. Conventional mortgages conform to guidelines set by Fannie Mae or Freddie Mac. These guidelines are more rigid than those from a lender offering non-conforming loans (such as a hard money lender) and may take more time to close, but the rates will generally be lower.
Private Money Loans
Private money loans are loans from one person to another, such as from your rich uncle. Many private money loans are from the real estate investors friends and family. If that’s not an option for your financing, real estate networking events such as from a local REIA or networking websites such as Property Nirvana, are a great place to connect with private lenders looking for an opportunity.
If you already own a home, you can also draw on your home equity through a cash-out refinance, home equity loan, or home equity line of credit (HELOC) to finance your rental investment property. You can usually borrow up to 80% of your current home’s value to use toward the purchase or renovation and repairs of an investment property.
What to Expect When Financing a Rental Property Loan
Again, if you’ve gone through the mortgage process for your primary residence, the process to get a rental property loan is somewhat similar:
- Research lenders, including the options above.
- Fill out an application with the lender(s) – it may be more extensive than your mortgage application.
- Expect the lender to request a credit report as well as other checks, such as validating income.
- The lender will then order an appraisal on the property and open title.
How to Qualify for an Investment Property Loan
In order to qualify for a loan on an investment property, any lender is going to make sure the borrower’s financial situation – and the investment property – are within their lending requirements.
As we stated up top: Make sure the proper is ready to be rented. Rental property loans do not include construction, which is a separate loan (usually from a hard money lender, which often offer both types of loans). Your lender will check to ensure the property doesn’t need extensive repairs or have any violations that need to be resolved.
Get your finances in order. You will probably need 6-12 months of liquid cash reserves, as well as be able to provide proof of income, credit in good standing, etc. Cash reserves also ensure you will be able to make your monthly loan payments if you lose a tenant or fall on hard times.
Plan for at least a 20% down payment. That’s the standard. If you have excellent credit, your lender may only require a 15% down payment, but fair or poor credit scores or little credit history may require a down payment as high as 35%.
Boost your credit score. Before you apply, make sure you know what your credit score is and work to improve it by paying down or off debts. Or if your credit history is short, consider new lines of credit (that you do not run up). And once you apply for your rental property loan, leave your credit alone.
Prove you’ve got the finances to purchase the property. You’ll need (at least):
- Pay stubs/proof of income
- Tax returns
- Credit report
- Bank statements
- Operating income for other investment properties
Comparing Rental Property Loans and Conventional Home Loans
|Rental Property Loan||Conventional Home Loan|
|Down Payment||Expect 20%, but will depend on credit score||As low as 5%|
|Interest Rates||8.18% or more*||7.18%^|
|Cash Reserves||Possibly equal to down payment, closing costs, up to 12 months of principal, interest, taxes, etc.||A few months of housing payments, depending on credit score, etc.|
|Documentation||Proof of employment/income, tax returns, bank statements, and other documentation if you have more than one investment property.||Proof of employment/income, tax returns, bank statements, etc.|
*Rental property loans are typically 100 to 400 basis points (one basis point = one-hundredth of a percent) higher than conventional home loans.
^Average mortgage rate as of June 14, 2022.
Rental Property Loans in Closing
After reading this guide to rental property loans, you should be in a good place to understand your financing options and what will be expected of you as you search for your investment rental property.
Investing in real estate, whether passively or actively, can be a great way to generate income and create wealth, as well as give back to communities. Of course, this means investing with a plan and strategy to meet your investment goals – including speaking with a financial advisor.
This guest post has been contributed by our friends at Fund That Flip.