As you continue to expand your real estate portfolio, it can be tough to find funding for your next property.
Without question, “How do I pay for my next rental?” is the single most asked question we’ve received since the housing bubble burst in 2008.
If you are trying to purchase your first rental property, CONGRATULATIONS and welcome to the club! If this is you, I would suggest reading 5 Considerations Before Buying a Rental Property, before you continue here.
Cash is King, but Lenders are Vital
The best way to buy a property is with C-A-S-H. But since most of us are not Uncle Pennybags, we need the help of money lenders to make our dream a reality.
Given that the properties are typically single family residential in nature, our first inclination is that all lenders can finance the homes and it should be a straightforward process.
This assumption is not true.
One of the issues is that many of the homes in which future landlords want to buy, are in some need of major repair. Properties that are in very poor condition will not qualify for some types of financing.
These necessary improvements are many times “deal stoppers” for a lender to provide financing. The main reason is that the renovations often create too high of a Loan-To-Value (LTV) ratio and prevents immediate habitability by tenants.
But never fear, there are multiple ways to finance your next rental property. Let’s start with the most popular…
1. Conventional Financing
Conventional Financing is when a lender uses the property you hope to purchase as security for the loan.
With conventional loans, you will secure a low monthly payment for the next 15-30 years. However, most lenders require you to put a 20%-30% down payment.
In many parts of the country, this will mean that you will still need to come up with $50K-$200K to pay for the down payment. The steep down payment requirement will sometimes have folks scrambling for other financing sources.
Further, gift funds are not allowed and you are not able to count “potential” rental income into your Debt-to-Income (DTI) calculation. Conventional financing often requires the borrower to afford the mortgage for both their primary residence and the new investment without the help of future rental income.
If conventional financing is not possible, there are alternative types of loans which maybe more appropriate to help you finance an investment property.
2. HELOC or Home Equity Loan
A HELOC or Home Equity Loan is applicable when the lender uses an existing property that you own as security for the loan. This loan is typically in addition to the primary loan that is already in place.
Most Lenders will allow you to borrow up to 90% of the value of the home on a primary residence and 80% on a second home (vacation). Some folks have an issue with borrowing against their primary residence but if you view your personal real estate and investment property portfolio as assets and liabilities that increase your net worth, this can help you get past the issue.
A HELOC (or Home Equity Line of Credit) works like a credit card. The lender will give you a line amount and you can charge or borrow funds from the line. You are billed monthly and the minimum payment is typically interest only.
A Home Equity loan works differently. The lender will give you all of the funds upfront, and you are required to make a fixed payment each month that typically contains principal and Interest. These loans are often amortized over a 15 or 20 year period. Home Equity Loans are “mini-versions” of a conventional mortgage.
3. Cash-out Refinance
…on a primary home or second home:
A Cash-Out refinance is used when the lender uses an existing property (primary or secondary home) that you own as security for the loan.
This process is identical to applying for a regular mortgage so it takes about 30-45 days to complete. Typically you can borrow up to 80% of the value of your home with no issue. A cash-out refinance pays off any existing debt on the property, then creates a new mortgage, and gives you the difference as a “cash-out”.
Again, you must be comfortable in using the equity out of your personal properties, which has been difficult due to the lack of equity after the housing collapse in 2008. Michigan, one of the hardest hit states in the US, has some very strict cash out refinance guidelines.
…on an investment property you already own:
If the home was not purchased within the prior 6 months, the max cash-out rule is 75% LTV for a 1 unit property and 70% for a 2-4 unit property. If you have 4 or more properties financed, then the maximum LTV cash-out limit is 65%.
…what about the delayed financing exception?
A cash-out refinance is allowed immediately (no waiting period) if there was no financing for the purchase transaction and the following are guidelines are met:
- The new mortgage can’t be for more than the initial investment that was used to purchase
- Purchase was an Arm’s Length transaction
- Provide the Settlement Statement which shows no financing
- Title search must show NO liens on the property
- You need to be able to source the funds for the purchase via loan documents, bank statements, etc.
- Loans used as a source of the down payment must be paid back on the new settlement statement
4. Private Funding
There are people out there that provide private financing with a secured interest in the home, very similar to mortgage lending, that can be a great source to expand your portfolio. This process is generally faster than conventional mortgage financing process.
Be prepared to pay a higher interest rate, but don’t let that deter you from considering the option. If the property is a good investment (rental income has positive cash flow and possibility of appreciation) the private funding may only be needed for a short-term until conventional financing is available.
If you think private funding is right for you, check out these two articles:
- Private Money Lenders: Who They Are & How to Find Them
- How to Build Your List of Local Private Money Lenders
BiggerPockets has a small, but useful directory of private lenders. It’s a great place to start if you’re looking private funding.
Regardless of the method you use to finance your purchase in the beginning, you will eventually want to refinance the property into a traditional / conventional 15/20/ or 30 year mortgage.
I typically do this after I fix the property up, but before I find tenants. If that’s not possible because of the lack of LTV, I usually wait a few years, and try again. Doing so, will allow you to have a fixed monthly payment in which you can plan for in your rental calculations.