There are a number of reasons why owning a rental property is a smart investment. Real estate tends to appreciate in value over time. This provides buyers with the ability to increase their return on investment (ROI) through future resale value. Investment properties also provide a steady stream of revenue through rental income.
Once you’ve decided to purchase a rental property, one of the first factors you’ll need to consider is financing. Where will you get the funds to purchase your rental property? Also, what terms will be attached to those funds? Before moving forward with any purchases, make sure you know the answers to these questions.
Let’s explore more about loans for your next real estate investment together.
Before describing loans, it is important to understand how interest is calculated.
Interest is what a lender charges to lend you money, usually expressed as the annual percentage rate (APR). The APR is a percentage of the principal (the initial amount you borrowed). Therefore, if you borrow $100,000 with an interest rate of 3%, you will owe $3,000 per year in interest. For this reason, it is crucial to understand how much you’ll pay in interest when determining your investment rental property’s true ROI.
Interest rates are determined by a number of factors, including the length and size of a loan, level of risk, inflation, market conditions, the Federal Reserve, and even international forces.
Because lenders consider investment properties to be riskier than primary residencies, interest rates on investment property loans are typically 0.50% to 0.75% higher than the rate on a primary mortgage.
A loan’s interest rate can either be fixed, meaning it will remain the same throughout the life of the loan, or variable (also known as adjustable), which means it can fluctuate. To get an idea of what banks are currently charging, you can check the prime rate, which is the interest rate that banks charge their most creditworthy customers.
The following are types of loans for real estate investors. Some are suitable for rental loans and others for shorter term investments.
Conventional bank loans
If you are already a homeowner, then you are likely familiar with conventional mortgages. These loans are not backed by the government and are issued through a private lender such as a bank, credit union, or mortgage company. There are two types of conventional loans, however, that are secured by government-sponsored enterprises—the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac).
For a primary residence, a conventional mortgage lender will require around 20% of the home’s purchase price for a down payment, but with investment properties the lender may require up to 30%. If the borrower can make a sizable down payment, this can help lower their interest rate.
Another popular type of mortgage is the 5/1 adjustable-rate mortgage (ARM), which allows borrowers to pay a fixed interest rate for the first five years before starting to adjust the rate. These are a good option for individuals who are looking to quickly sell a property after they purchase it.
Since conventional loans are not federally secured, they typically have stricter lending requirements. Borrowers will need to fill out a mortgage application and sometimes pay an application fee.Then, the lender will perform an extensive check on their background, credit history, and current credit score. This information will determine their eligibility for a mortgage and their interest rate.
Potential borrowers must also be able to show proof of income, assets and employment verification. These documents collectively prove to the lender that the borrower can afford their existing mortgage and monthly loan payments, as well as upfront costs associated with purchasing a home. Lenders usually expect borrowers to have at least six months of cash reserves to cover their mortgage obligations. It is important to note that future rental income is not factored into the debt-to-income calculations.
Hard money loans are secured by real property and are issued by individuals or companies, not banks. These types of loans are sometimes referred to as short-term bridge loans or “loans of last resort”; however, don’t let this name fool you. Under the right conditions, these loans can be great for house-flippers.
These loans are also more flexible in their terms because they are issued by individuals, and borrowers may be able to negotiate fees and repayment schedules. Hard money loans are usually much faster to attain and can be issued within weeks, compared to a conventional mortgage, which can take months to get approved. A fast turnaround can be crucial if you’re looking to quickly close on an investment property.
Typically, hard money loans are issued to house flippers because they expect to quickly renovate and sell a fixer-upper. When calculating a fixer-upper’s ROI, it’s imperative to determine whether you’ll still turn a profit after renovation fees and loan interest.
Although the duration of a hard money loan is usually too short for rental loans, hard money lenders may offer longer term rental loans for longer term investment purposes.
The third most common type of investment loans are home equity loans and home equity lines of credit (HELOC), aka a “second mortgage.” These loans use the equity in your home (the difference between your home’s value and your mortgage balance) as collateral and are underwritten by banks.
The interest rates on home equity loans and HELOCs are extremely competitive. Since they have lower interest rates than credit cards and other loans, they are often used for remodeling projects (i.e., kitchen renovations). However, when using the equity in your home as collateral, you are exposing yourself to great risk. Lenders will place a second lien on your home, meaning if you fail to make payments you can lose your investment property and your first home.
A home equity loan is a lump sum of cash and good for one-time expenses such as kitchen remodeling. But note, most lenders won’t extend a home equity loan for less than $25,000.
Additionally, at closing, some home equity lenders require the borrower to pay “points,” or prepaid interest.
On the other hand, HELOCs are more like credit cards, in that they are revolving source funds.
They tend to have variable interest rates (currently, the average rate is 4.55%) and few closing costs.
Most HELOCs have two phases — the draw period and the repayment phase. During the draw period, typically around 10 years, a borrower will have access to the available credit in their home while making interest-only payments. This means that the borrower does not have to make payments towards the principal and only needs to pay the interest during this time.
During the repayment phase, typically around 20 years, the borrower can no longer access the funds and must begin making payments on the principal plus interest. The borrower must pay back the entirety of the loan and accumulated interest during the repayment period.
The U.S. Department of Veteran Affairs also works with private lenders to back mortgages for veterans, active duty service members and their surviving spouses.
VA loans require no money down and low interest rates. Like conventional loans, they typically have repayment periods of 15 years or 30 years.
Unlike conventional loans, VA mortgages allow borrowers to factor in future rental income in their debt-to-income calculations. On the down side, before a VA loan is approved, the rental property must be move-in ready and receive approval from a VA home appraiser. Therefore, these loans are not great for fixer-uppers.
In addition to choosing a loan program and saving for a down payment, real estate investors will also have to pay a plethora of closing costs to finalize their mortgage. Closing costs are a myriad of fees for the services and expenses to finalize a mortgage, including:
● Origination fees: An upfront fee that a lender charges for processing and executing a new loan application, typically around 0.5% of the principal amount.
● Title insurance: Title insurance protects the owner from any disputes about a property’s true ownership and typically costs 0.5% of the purchase price of the home. Usually, lender’s title insurance is required, but it is also a good idea to purchase owner’s title insurance.
● Appraisal fees: Before a lender approves a borrower for a loan, they will want to make sure the property is worth the loan amount, and therefore will require a home appraisal. The cost of a professional home appraiser ranges from $300 to $1000.
● Home inspection fees: Lenders, especially those backed by the federal government, will usually require a home inspection to ensure the property is structurally sound and safe to live in. Home inspection fees can cost between $300 to $500.
● Property taxes: Buyers are usually required to pay two months’ worth of city and county property taxes at closing.
● Homeowners insurance: A lender will often require a buyer to purchase homeowner insurance before the final settlement in order to protect the property against any damages.
Borrowers should also account for loan servicing fees, which is a fee that mortgage servicers charge borrowers for keeping a record of payments, collecting, and making escrow payments. These fees range from 0.25% to 0.5% of the monthly outstanding mortgage balance.
In a world of fees, there are still ways for savvy investors to save money. In some states, investors can work with a real estate agent to see if they qualify for a home buyer rebate. These
rebates are issued when the buyer’s agent refunds a portion of their commission from the sale back to the buyer.
Although attorney fees can range between $150 to $300 an hour, hiring a real estate attorney is another good consideration for investors looking to save money in the long run. Even though a real estate agent should know local laws and regulations, as well as details about the property to leverage during negotiations, a good real estate attorney can save you money with contingencies, find loopholes in the purchase agreement, and shield you from future liability.
Attorneys are also skilled negotiators and can help investors with bidding-war tactics, such as offering to pay some of the seller’s commission.
Finally, when considering long term ROI, you can factor in the rent your tenants will pay you each month. To determine what your ideal tenant can afford, check the rent prices of similar properties in the area and try an affordable housing calculator.
Purchasing a rental property is a huge financial decision, and the type of financing you choose may ultimately make or break your investment. However, with careful planning and budgeting, a rental property can be a great way to earn passive income and shield yourself from market volatility.
Just make sure you’re being honest with yourself about your investment goals and the level of risk you’re willing to take when choosing a loan program.
Justin Malonson is the Founder of LyfeLoop a 16+ year tech innovator, investigative media researcher and host of the Freedom Not Control Podcast live on Voice America. Justin is a highly sought-after tech entrepreneur, industry speaker and winner of the coveted Business Achievement Awards “Top Digital Marketer” award. With 16+ years of demanding experience, Justin has worked with over 3,000 businesses including amazing clients such as Blue Cross Blue Shield Association, Sotheby’s International Realty, Duke University, White House Black Market,Tiffin Motorhomes, Bass Pro Shops and Beazer Homes USA.