In most cases, investors who want to invest in Airbnb rentals may not have sufficient capital. This is where short term rental loans come in.
Short term rentals became increasingly popular among potential real estate investors in the past few years. While the pandemic almost brought the industry to its knees, there are so many advantages that investors couldn’t resist.
Table of Contents
- #1: The Economic Climate
- #2: Investment Budget
- #3: Debt-to-Income Ratio
- #4: Financing Options
- How to Find the Best Short Term Rental Investment
- Key Takeaways
- Frequently Asked Questions
For starters, short term rental properties offer investors a higher potential monthly rental income. Short term rental guests pay you a nightly rate for every day they spend on your property. The more nights your property is booked, the more your rental income increases. On the other hand, for long term rental properties, tenants pay landlords monthly or yearly,
Another major reason why investors are showing a strong affinity toward short term rentals is the amount of flexibility they give investors. For example, you’re free to choose how much you wish to receive every night. You can also block some nights off to use the property yourself.
While the above advantages are strong enough to convince an investor to consider short term rentals, there’s a single problem; not every investor can afford to invest in such properties. Such investors consider short term loans.
In today’s blog, we’re going to look at everything you need to know about financing a vacation home rental.
What are the things you need to consider?
1. The Economic Climate
The US housing market went through many dramatic turns of events at the height of the COVID-19 pandemic. The 30-year mortgage interest rate dropped to a record low of 2.6% in December 2020. It only began climbing in 2022, and not many experts could predict the future.
Many homebuyers and aspiring short term rental hosts went from being hopeful to sitting on the sidelines if mortgage rates are an indicator of the risk associated with new investment.
However, the US real estate market history shows that rising mortgage rates lead to a decline in home prices.
As an aspiring short term rental host looking to finance their vacation rental investment, you must ask yourself whether you’re more comfortable with a higher mortgage rate or a lower property price.
Remember, no two markets are the same. Market trends may also differ across various locations.
As such, some financing methods (which we’ll be looking at in a few minutes) may be more or less attractive, depending on the prevailing economic conditions. There’s no one-size-fits-all financing option. What works for you may not work for another investor. Where one investor sees an opportunity, another sees risk.
One of the best ways to decide what works for you is to use predictive data and analytics. You can hold back your rental investment until mortgage rates come down. But sometimes, the rates might stay steady or continue to rise.
Related: 3 Interesting Real Estate Market Trends to Expect in 2023
2. Investment Budget
Now, it’s time to consider how much you can afford and how much you’re willing to pay for the property before taking out a short term rental loan. The amount you can borrow is intertwined with the amount you’re willing to pay.
Remember, the amount you can borrow also depends on a number of factors, such as your credit score and qualifying monthly income.
As such, it’s important that you’re realistic when creating your budget. Don’t be too ambitious; otherwise, you’ll end up with a property you can’t afford and mortgages whose payments you struggle to pay.
You need to ask yourself a few important questions to guide you. How much money do you have in your savings? How much money do you expect to make in the coming years? How much can you afford from your pocket before the property is ready to host guests?
If you plan to take out a conventional mortgage, know that you’ll need to prepare at least 20% of the property’s selling price to use as a down payment. While you can also consider other alternative methods of financing, keep in mind that they may come with additional costs and higher interest rates.
If you can afford a larger downpayment (more than 20%), you can access a lower interest rate.
On top of the down payment, you also need to factor in the closing costs (about 2%-6% of the financing amount), first-year property insurance and tax, and repairs.
Unlike long term rentals, short term rentals need furnishing. You want your guests to feel at home. The property should be cozy enough to convince your guests that booking your property is better than staying in a hotel room. In the US housing market, furnishing costs may range between $2,000 and $20,000, depending on the state of the property.
If the property selling price is $350,000, you can expect your initial investment to add up to $100,000. It is quite a large amount for someone who’s just getting started.
One of the common pitfalls, especially with beginner investors, is leaving their cash reserves dry. Never fall for it. Anything can happen. You don’t want to be in dire need of cash and not be in a position to access some.
For example, you can discover an unforeseen repair that needs a significant amount as you prepare for tenancy. You might also face a lower-than-expected occupancy rate in the first few months, therefore paying for property expenses out of your own pocket.
The key to wise budgeting is staying realistic, planning ahead, and making sure that you’re in a position to take care of your property and keep it in good condition.
3. Debt-to-Income Ratio
It’s similarly important to consider your debt-to-income (DTI) ratio before taking out a short term rental loan. Simply, the DTI ratio is a metric used to compare how much you owe every month to how much you earn. It is how much you pay from your monthly income to your debts.
The debt-to-income ratio is calculated by dividing the total monthly debt payments by your monthly gross revenue.
Many lenders consider this ratio is a qualifying factor for a short term rental property loan or when you’re investing in a secondary home. Some require a DTI ratio of at least 35%, while others go as high as 43%. The DTI ratio requirement varies depending on the size of your downpayment and personal credit score.
A high DTI ratio means that you may not be in a good position to take on more debt, while a lower DTI ratio shows that you can take more debt and still pay them on time. It means that your borrowing power is limited to the amount of money you make.
As a newbie investor, you may not have a good DTI ratio, especially if you haven’t borrowed much before. However, there are a few steps you can take to improve the ratio and become more attractive to lenders:
- Reduce any unnecessary monthly expenses that are reported to credit bureaus
- Minimize revolving debt (across personal loans and credit cards)
- Don’t open any new credit accounts
- Consolidate your existing loans
- Look for ways to refinance your existing loans at favorable rates
4. Financing Options
Now we’ve come to the fun part. There are several methods to access a short term rental loan. Some of the methods are quite conventional, while others are modern.
Let’s break down some of the best bets:
If you’re buying your first short term rental property, the most suitable method of financing for you is conventional or traditional loans. Traditional banks and lenders are quite straightforward and offer some of the most competitive interest rates in the market.
On the downside, however, they also impose some of the strictest lending requirements. Besides, it’s not the best option for short term rental investors looking to grow their investment portfolio.
Because traditional loan lenders will need you to jump through more hoops than you did when getting your first mortgage. While requirements vary from one mortgage provider to another, many will look for a strong revenue history, a good DTI ratio of below 45%, and a credit score of at least 640.
Some traditional lenders are willing to relax the said requirements if you put in a higher down payment.
To qualify for a mortgage for a second home, the US Internal Revenue Service requires you to live on the property for at least 14 days a year and 10% of the nights you rent it out. If you can’t meet the said requirements, the property is considered an investment, which comes with stricter loan terms.
Be sure to check every detail of the loan term since some lenders will restrict you from renting out your second home. Additionally, the closing process is sometimes lengthy.
On the brighter side, though, conventional lenders may not require you to use your primary residence as collateral.
Home Equity Line of Credit (HELOC)
A home equity line of credit (HELOC) is a second mortgage that gives you access to a revolving credit line based on the value of your home. The lender agrees to lend you a maximum amount for an agreed period, and your primary home acts as the security.
Short term rental investors take out HELOC loans to sort out large expenses or consolidate high-interest rate loans on other debts. Like credit cards, you can access the funds whenever you choose.
Your equity in the property increases as you make mortgage payments and increase the value of the property through upgrades or renovations. Your equity also goes up through property appreciation.
The amount you can access through a HELOC is mainly determined by the amount of equity you hold in a home. But just like other loans for short term rentals, it’s also affected by other factors, such as your credit history, income, other debts, and primary characteristics.
For example, let’s say you own a home valued at $400,000, and you still owe $250,000 on it. In this case, your equity in the property is $150,000. Lenders will typically set your maximum HELOC line of credit to 80% or 90% of your home value minus debt owed on the original mortgage. As such, you can get between $120,000 and $135,000 in a revolving line of credit.
It’s like a huge credit card. The draw period lasts 10 years when you can continually borrow against your line of credit, hold a balance, and make monthly payments on the interest only. After the 10-year draw period, the balance locks into a 20-year repayment period.
HELOC Pros and Cons
The main benefit of HELOC loans is that they come with lower associated costs and lower interest rates compared to other alternative methods of financing. You can also opt to only pay the interest during the draw period.
Unlike other property loans that you can only use to purchase a property, a HELOC line of credit allows you to use the money as you wish.
On the downside, HELOC loans may only make financial sense if you own considerable equity in your home. We already saw how your HELOC line of credit maximum amount is calculated. If you hold little equity, the maximum amount may be insignificant.
HELOC loans may also not be a good option for investors with a bad credit history. The interest rates are variable and may increase in the future.
Home Equity Loan
Home equity loans are often confused with HELOC loans, but they’re quite different. Unlike HELOC loans, which give you access to a line of credit that you can draw over a 10-year period, a home equity loan is provided in a lump sum.
Instead of variable interest rates, you repay a home equity loan in set fixed installments, with terms going from 5 to 30 years.
The only similarity between the two is that the maximum loan amount for home equity loans is also 80% to 90% of the equity held in the borrower’s home.
Since both home equity and HELOC loans come with higher interest rates compared to conventional loans, they make more sense if you hold significant equity in your property.
One reason why you may consider home equity loans instead of a HELOC line of credit is that fixed installments are easier to manage. They’re also less complicated than HELOC loans if you’re looking for a one-time property purchase.
Cash-out refinance is another financing method that allows you to leverage your home equity. It’s quite similar to a home equity loan, just that you’re not taking a second loan. Rather, you’re refinancing with a new mortgage for a higher loan amount. The new loan pays off your original mortgage completely and leaves you with a surplus to use as you wish.
For example, let’s say you took out a $300,000 mortgage on a property worth $500,000. The maximum loan amount for a cash-out refinance is 80% of the property’s appraised value. In this case, you can take out $400,000, settle the $300,000 mortgage, and remain with $100,000.
You’re cashing out your equity in your primary property to refinance your investment property.
You can choose whether you want the loan for short term rental property to be charged with a variable or fixed interest rate, with a term of 15-30 years.
The interest rates associated with a cash-out refinance are usually lower than those of HELOC and home equity loans. There’s also the potential to get a lower interest rate than with your original mortgage.
The downside is that the closing process is quite lengthy. Higher mortgage payments also increase your chances of defaulting and getting foreclosed.
Private loans are popular with many investors for their flexibility compared to conventional loans. If you don’t meet conventional mortgage requirements, either due to bad credit or a low downpayment, private loans may be your only option.
Short term rental property loans from private lenders are quite similar to conventional mortgages. You can choose a fixed or variable interest rate with up to a 30-year repayment period.
The main difference is in the criteria private lenders use to approve a private loan. While creditworthiness is also a determining factor, private lenders are more interested in investment property.
It means that you aren’t limited by your income. The loans are also easier to scale, and the closing times are faster. As long as the cash flow from your short term rental property can cover the loan repayments, private lenders will approve your loan.
With the relaxed requirements, private lenders take on more risk. The higher risk is compensated by higher borrowing rates, which usually start at 4%.
Related: 7 Best Loans for Investment Property in 2023
How to Find the Best Short Term Rental Investment
We’ve already seen how you can choose the best short term rental loan option. At this point, you already have a few options in mind. You’ve probably already reached out to a few financing providers.
Once you’ve secured financing for a short term rental, how do you actually ensure you invest it the right way?
Let’s take a look at how you can ensure you invest in the best short term rental.
Find a Suitable Location
Location is one of the most important factors for any real estate investment. It determines how much return on investment you can expect from your property. It also influences how much property expenses you can expect to pay.
As such, your first step when investing in any real estate property should be finding a suitable location.
With short term rentals, your best bet is with tourist cities. They are places located near national and water parks, beaches, hiking trails, lakes, forests, and other attractions that appeal to visitors.
Such locations assure you of a consistent flow of visitors throughout the year which translates to a good occupancy rate. College towns and business hubs also make excellent locations for vacation rentals.
While the occupancy rate can be promising, you also want to focus on the average property price. If the price to buy and maintain a property is high, it will eat into your profits.
As you can see, it is something you don’t want to gamble with. You need to use the right tool for this function. This is where Mashvisor’s Market Finder comes in.
The Market Finder is a market analysis tool that gives you an aerial perspective of the US housing market to determine the most suitable locations for your short term rental investment. It also lets you see the best investment opportunities in and out of your state.
With the Market Finder feature, you can zoom in and out of your preferred city or neighborhood so that you can see what the area can offer. It also grants you access to a wide array of tools to make your search for a lucrative location and property more efficient.
For example, it comes with a heatmap to help you analyze how a neighborhood in a certain city performs for both short term and long term rentals. With the said tool, you can see which areas to invest in and which ones to avoid.
You can also customize your search using Mashvisor’s filters to further analyze an area’s profit potential. The filters include:
- Mashmeter Score
- School Rankings
- Crime and Safety
- Property Type
- Home Value
- Monthly Rental Income
- Cap Rate
Find a Lucrative Short Term Rental
Once you’ve found a few potential investment locations, it now becomes easier to find profitable short term rentals. In any particular market, there can be hundreds of properties listed for sale. But to succeed in the short term rental business, you must narrow down your search. Find a location that matches your budget, expected rental income, and expected return on investment.
Traditionally, real estate investors would drive around neighborhoods looking for “for sale” signs and knocking on doors. However, the process is too tedious. You can also decide to hire a real estate agent to help you with your property search.
But technology has made all these easier. You can now access lucrative short term rental listings in your desired neighborhood with the click of a button. How? The answer lies in Mashvisor’s Property Search feature.
Also known as the Property Finder, the tool helps you access high-return short term rental properties based on your search criteria. You can customize the search criteria using the following filters:
- Property type
- Ideal rental strategy
- The number of bedrooms and bathrooms
Once you’ve set up your search criteria, the tool will dig through the market and show you listings that fit your requirements. The listings are ranked by order of performance. Those with high returns are ranked first.
Related: How Is Mashvisor’s Property Finder Helping Real Estate Investors?
Conduct a Property Analysis
By now, you have a few potential properties to invest in. But you’re not yet done. You need to really get down to the details. Analyze each of the properties individually to see whether they’re indeed worth your time and money. It requires an in-depth short term rental property analysis.
Carrying out this process manually can be a painstakingly long process that wastes much of your time. The best way to do it is to use the rental property calculator.
Our rental property calculator helps you conduct an in-depth property analysis. In addition, it provides you with a comprehensive report containing all crucial metrics to help you determine a property’s profitability.
The metrics are pre-calculated based on real estate comps and the local market data. The metrics are:
- Rental income
- Rental expenses
- Cap rate
- Cash on cash return
- Cash flow
- Occupancy rate
Our calculator is interactive. You can adjust any of the figures provided to see how they would affect your returns.
With our tool, you don’t need to worry about data accuracy and reliability since we pull the data from reliable sources, such as Airbnb. The data is validated using feedback from actual short term rental hosts.
The best thing about the tool is that it provides crucial metrics for both long term and short term rental strategies. It allows you to carry out a quick side-by-side comparison and choose a strategy that matches your income expectations.
Sign up on our platform today and start your 7-day free trial.
Short term rentals are a good real estate investment option for people looking to build a consistent flow of monthly income. Such properties come with the potential to give you a higher rental income compared to long term rentals. Besides, you enjoy the flexibility to set your nightly rate and use your property whenever you want to.
But sometimes, real estate investors aren’t liquid enough to invest in the said properties. This is where short term rental loans come into the picture.
Before taking out a short term loan, first, gauge the economic situation to establish whether you should wait for mortgage rates and property prices to fall. Once you’ve done that, come up with a realistic budget that accounts for both your income and expenses. It will help you avoid buying a property that you can’t afford and leave you with unpaid debts.
Afterward, get to know your financing options when obtaining a loan specifically for short term rentals. Your options include conventional loans, HELOC loans, home equity loans, cash-out refinance, and private loans.
Most importantly, ensure you use the right tools to invest in a property with the highest potential. Mashvisor offers the best tools in the market to help you establish which locations and properties will help you achieve your financial and investment goals.
Our tools give you access to the most important metrics you need to make informed business decisions. They also stand out from all others in the market due to their reliability and accuracy.
Book your free demo today and see how our tools can help you make smart decisions.
Frequently Asked Questions
Please find below our responses to some of your frequently asked questions:
Can You Get a Loan for Short Term Rental?
Yes, you can access a loan to finance your short term rental investment. Some vacation rental financing options include conventional loans, HELOC loans, home equity loans, cash-out refinance, and private loans.
What Is a Vacation Rental Loan?
A vacation rental loan is a mortgage granted by a bank or lender with the sole purpose of helping you to purchase a vacation rental property. In some ways, the loans are similar to conventional mortgages.
Just like traditional mortgages, you’re expected to pay the money back with interest. The interest rate can be fixed or variable, depending on the financing option you go for. The term can go for up to a 30-year repayment period.
How Do I Fund My Short Term Rental Business?
The best way to fund your short term rental business is through personal savings or loans from family and friends. However, you can still get a loan from conventional lenders, such as banks, to invest in short term rentals.
If the above options aren’t possible, perhaps due to a low downpayment or poor credit score, you can also access a short term rental property loan from personal lenders. However, be prepared to pay a higher interest rate for personal loans.
Other less popular but effective ways to fund your short term rental business are crowdfunding and through angel investors.
Can an LLC Get a DSCR Loan?
Yes, an LLC can access a DSCR loan. They’re eligible since they have the same status as individual borrowers when applying for a loan. While the requirements and eligibility criteria for LLCs may differ a bit from individual borrowers, lenders tend to consider them in the same manner.
For an LLC to qualify for a DSCR loan short term rental, it must demonstrate that it generates enough rental income to make mortgage payments. It must provide proof of rental income and property expenses to qualify.