Being a landlord comes with some great perks. It’s actually one of the best ways to generate steady cash flow, build wealth, and attain financial freedom. However, buying a rental property is not a walk in the park. If you don’t have deep pockets, you may need to consider investment property loans to finance your investments. The problem is that securing an investment property loan is usually tougher than taking out a mortgage to purchase a primary residence. Apart from having more stringent requirements, the interest rate on investment property loans is typically higher. This is a well-known fact. And, obviously, higher rates make investment property loans more expensive.
Related: Buy a Rental Property Using a Mortgage or Cash?
But how much higher is the interest rate on investment property? Well, technically, this will depend on a number of factors including investment property type, your down payment, and your creditworthiness. On the whole, the interest rate on investment property loans is higher than the mortgage rate on primary residences by at least 0.50% to 0.80%.
But what exactly is the reason behind the higher rates? Why do real estate investors need to pay more than those buying their primary residence?
Related: All You Need to Know About a Mortgage for Rental Property
Why Is the Interest Rate on Investment Property Higher?
Generally speaking, rental property mortgage rates are higher than mortgage rates on primary residences because investment property loans are riskier for lenders. The higher mortgage rates provide them with some extra protection if things don’t work out. The rate you’ll pay for your loan, by and large, will depend on the amount of risk the lender will be taking.
Let’s look into it in a little more detail. Why do lenders consider rental properties riskier investments? Here’s why:
You Are Less Attached to a Property You Don’t Live In
The main reason why the interest rate on investment property loans is higher is that you are less attached to a home that is not your primary residence.
Lenders know that if you don’t plan to live in a property and only think of it as a business, you are less likely to see repayment of the mortgage loan as a priority when your finances get tight. You simply don’t have as much of a personal stake in the property as you would if it were your primary residence. After all, the worst that can happen is you lose the rental property. Hence, you are more likely to default on an investment property mortgage. A higher interest rate on investment property loans is a measure by lenders to protect themselves against this risk. Moreover, the qualifying requirements will be higher.
If the property were your primary residence, you’d probably do everything within your means to keep up with your mortgage payments and avoid the more adverse effects of losing your home. Definitely, the physical safety and security of you and your family are of the utmost importance to you.
It’s for this reason that you can get a better deal if you use an FHA loan to purchase a multifamily rental property, live in one of the units, and rent out the rest. Apart from having lower interest rates, FHA loans require a lower minimum down payment (3.5%) and credit score compared to conventional mortgages.
Related: Can You Use FHA Loan for Investment Property Financing?
Your Income Relies on the Rental Property
Lenders will also be more cautious and charge a higher interest rate on investment property loans because your income primarily relies on the rental property. And since the future profitability of the property can’t be guaranteed, this presents additional risk to the lender.
If the rental property sits vacant for a while, you will be unable to generate rental income and keep up with your monthly mortgage payments. Charging a higher interest rate on investment property loans helps lenders to cushion against possible loss in case you default.
Ways to Lower Interest Rate on Investment Property Loans
As a real estate investor, you always want to get the lowest mortgage rates possible. This will help reduce your mortgage costs and improve your return on investment. Remember, even a slight difference in the mortgage rate can mean paying or not paying thousands of dollars over the life of your loan. While its difficult to escape the higher interest rate on investment property, there are measures you can take to minimize it.
Investment property mortgage rates vary widely depending on a number of factors. You need to understand these factors and how you can manipulate them to get the best mortgage rates.
Here are some key tips on how to lower your interest rate on investment property loans:
1. Make a Sizable Down Payment
One of the best ways to lower your interest rate on investment property loans is to make a sizable down payment. Larger down payments provide lenders with more security against the risk that comes with financing real estate investments. For investment property loans, you’ll typically be required to place a minimum down payment of 20%. If you put down more than that, you are likely to qualify for a better interest rate
Moreover, mortgage lenders know that having more skin in the game will be a great incentive for you to repay the loan. Since you have invested more of your money, you’ll have more to lose if the investment goes south.
2. Improve Your Credit Score
Another way lenders protect themselves when financing real estate investments is by checking your credit score. Your credit score will show them the risk of doing business with you. A higher credit score shows that you are a trustworthy borrower and will attract a lower mortgage rate. The better your credit score is, the lower the interest rates you’ll get.
Before you apply for an investment loan, be sure to review your credit report. If you have a poor credit score, take the necessary steps to improve it. For instance, pay down some of your pending debt. To secure the best interest rates on investment property, aim for a credit score of at least 720.
Related: How Can You Improve Your Credit Score for Financing Investment Properties?
3. Have More Cash Reserves
If you want to secure a decent interest rate on investment property loans, be sure to also have enough cash reserves or liquid assets. If all your money is tied up in illiquid assets, it means that you’ll have fewer options if your finances get tight. This presents an extra risk to lenders and forces them to charge higher rates.
You are usually required to have at least six months’ worth of cash reserves to cover estimated mortgage payments and other expenses. The more cash reserves you have, the better. It demonstrates to the lender that you can still keep up with your mortgage payments even if your rental sits vacant for some months. You don’t have to rely on rental income.
4. Shop Around for the Best Mortgage Rates
The interest rate on investment property loans will vary from lender to lender. Therefore, to find the best deal, you should compare quotes from different lenders. This can save you thousands of dollars over the life of your mortgage. Remember, mortgage rates are dynamic and can fluctuate daily. Therefore, the best way to know the current interest rate on investment property is to talk to the lenders.
Apart from mortgage rates, you should factor in the overall cost of the mortgage. This includes the closing costs, size of monthly payments, loan terms, etc. This is a process that needs a lot of research and analysis.
Related: Investment Property Loan Providers: What Are Your Best Options?
Using Mashvisor to Analyze Investment Property Loans
One of the best ways to ensure that you are choosing the best investment property loan and rate is to use real estate investment software like Mashvisor. Mashvisor’s investment property calculator can help you determine how different mortgage rates and loans affect your ROI (cash on cash return).
First, you select the financing method you intend to use (mortgage or cash). If you are using a mortgage, you will then be required to enter the following information regarding the loan you are analyzing:
- Interest rate
- Down payment
- The loan amount
- Loan term
- Loan type
The calculator will then automatically calculate the expected cash on cash return for the rental property. You can play around with the figures to figure out which loan will help maximize the ROI of your rental property. With this tool, you can analyze the mortgage options for both Airbnb and traditional investment properties for sale in a matter of minutes.
The Bottom Line
While mortgage rates are extremely hard to predict, one thing that is for certain is that interest rate on investment property loans is higher than that of owner-occupied mortgages. Nevertheless, it’s a challenge that real estate investors can deal with. Like any other business, you’ll have to incur some costs. As a real estate investor, the key is to find a mortgage loan that will help you maximize your return on investment.