What are your residential mortgage options when buying a rental?

Written on July 18, 2018 by

Recently, I went down a residential mortgage rabbit hole.

I’ve been considering buying a vacation rental. With dreams of beachfront cottages and wooded cabins, I went online to research financing options. There were so many. True to myself, I obsessively researched it until the idea of a vacation rental gave me chills.

The amount of money we would have needed for a loan was too low for a traditional mortgage. I wasn’t aware that mortgages had minimums. I also wasn’t aware of the myriad of other stipulations with investment mortgages.

Securing financing for an investment property is more difficult than for your primary home. You need to prove that you can not only afford your mortgage but, if the property isn’t rented, you can afford the second mortgage as well. In addition, the down payment needs to be higher than with your home at a minimum of 20%. No small feat.

Here are the seven mortgage options for investment properties.

7 investment property mortgage options

1. Hard money loans

Hard money loans can be approved quickly and without too many hoops to jump, but they come at a risk. They are funded by investors who provide the loan based on the property and collateral. Hard money lenders generally lend with collateral to back up the landlord’s ability to pay. The loans are short-term (less than five years) and have high interest rates.

Pros: These loans can be funded quickly with fewer requirements than traditional loans. They are used mostly for fix-and-flip investors who will have the property for less than a year, sell it, and pay it off.

Cons: Hard money loans are expensive with high interest rates and origination fees. If your flip doesn’t work out as planned, a hard money loan could get very expensive and you risk losing your collateral.

Related: Top 10 reasons real estate investors use hard money loans

2. Conventional loans

Conventional loans are slightly less risky than other options; however, you need to be financially secure to be approved for an investment property. Loan requirements are more strict than with a primary home, and more money is needed up-front.

Pros: A conventional loan will have a better interest rate than a hard money loan. You can have a 30-year loan, so if you plan on keeping the property as a long-term rental, you have time to pay it off. Last, it’s backed by a bank, making the loan more secure.

Cons: The loan requirements are difficult to meet. Mortgage insurance is not available for second homes or investment properties, so a minimum of 20% needs to be put down on the property. In addition, if you need rental income to meet the debt-to-income ratio, you will have needed two years or more of property management experience (with a Freddie Mac backed loan). Last, the interest rate is higher on a second home.

Related: Pros and cons of making extra payments on your mortgage

3. HELOC

A HELOC—home equity line of credit—is when an investor takes equity out of their primary residence as a line of credit to purchase another property. You can use this line of credit for five to 10 years, depending on your lender, and you have 10 to 20 years to pay it off.

Pros: Using a HELOC loan for buying an investment property has a quick approval process, and you have a long period to pay it back.

Cons: The issue with HELOCs is that you are taking equity from your primary residence to buy an investment, and that is always a risk. The interest rate can vary, just like with a credit card, so payments will not be the same every year. If you are a Dave Ramsey fan, you know that he would say using a HELOC to buy an investment property is “dumb.” If you do not pay close attention to your finances, using a HELOC can be risky and your debt can get out of control.

Related:  6 ways to buy your first investment property for $1,000 or less

4. FHA loan

Many first time homebuyers know FHA loans well. They are federally backed loans that require only a 3.5% interest rate and a less restrictive approval process. For example, you can use a gift as a down payment. However, they come with extra stipulations, such as not using the home as a rental property.  So, why is it on this list?

Pros: FHA loans have low-interest rates, have extra funding available for renovations, and are less restrictive on the down payment.

Cons: You need to occupy the residence. That’s a big con. An FHA loan cannot be used for an investment property. However, it can be used for multi-unit properties. You can use an FHA loan to finance a three-flat, live in one unit, and rent the other two. That’s exactly how I financed my investment property.

5. VA loan

Veteran loans started in 1944 with the G.I. Bill of Rights. A VA loan is a home loan with no down payment. VA loans are available to vets whose service met a certain requirement. Like, FHA loans, VA loans cannot directly be used for investment properties, but there is a way around that.

Pros: VA loans can be used on properties with up to four units. If you want to use a VA loan to finance a rental property, you must occupy one of the units. The benefits of VA loans are no down payment, no PMI, eased debt-to-income requirements, and they are flexible.

Cons: There is a VA funding fee that is used to continue funding the VA loan program. You cannot buy a rental property that you do not occupy. It is difficult to qualify.

6. Cash-out refinance

A cash-out refinance is when you leverage the equity of a property you already own to purchase another. Let’s say your primary residence has $100,000 of equity in it. As long as you leave 20% equity in the property, you can refinance and take the cash out to invest in another property.

Pros: If your property has the equity, it is a quick process to get approved. You pay the interest rate of your primary residence, avoiding the high interest that comes with an investment property.

Cons: You start your mortgage over again. You might end up with a higher interest rate on your primary home than before. Without enough cash in your reserves, you might not be able to qualify for a refinance.

7. Seller financing

Seller financing, also known as private money mortgage, is financing supplied by the seller of the property. The financing can be for the down payment, whole mortgage, or both. Seller financing is popular among property investors and can benefit both the buyer and seller. Sellers can finance in two ways.

1) The buyer signs a contract to pay off the loan over a certain period of time, and the seller provides a deed of trust that lets them foreclose on the buyer if the buyer fails to pay, but also gives the buyer the right to sell. 2) The second option is a land contract where the seller keeps the deed until the loan is paid off. This option is less popular than the first because the buyer does not have the right to sell or refinance until the loan is paid off.

Pros: The approval process is fast. The closing fees are low. Down payment is flexible. The seller has pros as well. A motivated seller can finance the sale of their property. They have fewer tax implications. The promissory note can be sold to another investor if they need cash. The property can be sold “as-is” easier.

Cons: The seller needs to have the mortgage free and clear for a seller financing option to work. The interest rate is usually higher than with a standard loan. The seller needs to be willing to take the risk of holding a loan. Not all sellers will want to be responsible for financing.

Related: How to do a seller-financing deal

Conclusion

There are many ways to finance an investment property, but they each option has its quirks. When making an investment, look at all your options for financing. Making the wrong decision can cause you to go broke, but making the right decision can make you rich.

After my trip down the rabbit hole, I have an idea of which route is best for me. What’s right for your investment strategy?

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