Whether you’re purchasing your first rental property or your tenth, finding the perfect home to generate significant cash flow is exciting. It can hook investors from the start. Unfortunately, many people who want to start investing in real estate don’t because they think they need a lot of cash. In reality, you only need access to other people’s money through rental property loans.
In this article, we will discuss how rental property loans work and some of the most popular types of loans for purchasing properties. Understanding your options can help you find a loan that fits your investment goals, reduce costs, and simplify the purchase.
Additionally, we’ll also discuss ways to reduce the cost of borrowing and how to estimate your potential cash flow.
Marketing. Applications. Leases. Payments.
Rental property loans are similar to a traditional mortgage, except they’re meant for rental properties. However, there are some more significant differences that you should understand.
Rental property loans typically require a larger down payment and have a higher interest rate. For some context into why, lenders view investment properties as higher-risk opportunities. If the investment isn’t as profitable as the investor initially thought, the lender will likely walk.
While some borrowers might consider the higher down payment requirement a roadblock, it can actually benefit them. Larger down payments mean borrowing less money, creating more significant cash flow opportunities.
Let’s look at how rental property loans differ from traditional mortgages.
Are you ready to learn which type of rental property loan is best for your situation? Here are eight options to consider.
You’re probably acquainted with conventional loans if you’ve ever owned your primary residence. The federal government doesn’t back these loans, which means they need to conform to guidelines set by either Fannie Mae or Freddie Mac.
When you apply for conventional financing, the lender will consider your credit score and overall credit profile when deciding whether or not to lend you capital. These factors help them to determine the interest rate on your loan.
Lenders won’t look at conventional loans for investment properties like they do for an owner-occupied home. With rental properties, lenders will require your down payment to be at least 20% and possibly as high as 25%. You’re also going to receive a slightly higher interest rate.
Conventional lending will become more complex if you’ve already purchased your first rental property and are working on purchasing additional units. Banks and mortgage lenders tighten their requirements with each new loan you apply for. While Fannie Mae will technically allow you to use a conventional loan to own up to ten properties simultaneously, most lenders have a maximum of four.
The Federal Housing Administration backs FHA loans, which the United States government guarantees and tend to have less stringent lending requirements than conventional loans. Unfortunately, FHA loans aren’t available for all real estate investors.
The FHA restricts borrowers from using FHA loans for a rental property. Instead, they must be used for owner-occupied properties (minimum of one year). However, there is a workaround that you can use if you’re an investor.
If you purchase a property that includes multiple units, you could live in one of the units and rent out the remaining. This arrangement satisfies the owner-occupied requirement but still allows you to generate revenue from the property. Because the residency requirement only lasts one year, you could move out and turn the entire property into an investment when the time is right.
VA loans, backed by the U.S. Department of Veterans Affairs, provide active military and veterans with an easier way to purchase a home. However, VA loans are only available on owner-occupied properties, similar to FHA loans. This means you’ll need to live in the property for at least one year before converting it to an investment property.
If you qualify, VA loans can be a great way to get into real estate investing. The VA doesn’t require a down payment or have any credit score requirements, and there is no mortgage insurance on any VA loan. Plus, most VA loans offer comparable interest rates to conventional loans.
Private loans are offered outside of banks and traditional mortgage lenders. Private loans offered to real estate investors often come from other real estate investors pooling funds together.
Because most private loans come from individuals familiar with the real estate market, they can usually offer better terms based on the specifics of the investment deal. These loans also have a much quicker approval process but tend to have higher rates than traditional rental property loans.
Some investors might consider a private loan if they have trouble getting approved for a traditional loan or need a loan that can close quickly without undergoing a lengthy underwriting process.
Even though private loans have less oversight, they still work like other loans for investment properties. The lender will hold a lien on the property, and the borrower will make monthly payments. If you fail to make your monthly payment, you could default on the loan and go through foreclosure. Plus, since the private loan likely came from a personal acquaintance, it’s likely to hurt the relationship.
Occasionally, sellers who have paid off their loan or have very little left on their mortgage are willing to provide financing to buyers. This type of rental property loan offers flexibility. Sellers can modify loan terms that work for borrowers and avoid the lengthy application and underwriting process.
The process of seller financing is very similar to that of a traditional mortgage. The seller extends credit to the borrower, who makes monthly payments until the loan is paid off. However, most seller financing involves a balloon payment, which requires a large payment to pay off the remainder of the loan after 5 or 10 years.
The interest rate with seller financing is often higher than with traditional financing. Additionally, it’s important to obtain title insurance when you use seller financing because if there are outstanding taxes due on the property or liens, you could be held responsible.
Portfolio loans suit investors owning multiple properties. While each property has its own loan, they are all held by the same lender under one portfolio, allowing investors to make a single monthly payment.
Additionally, portfolio loans originate and are retained by the lender instead of being sold on the secondary mortgage market. Since portfolio lenders hold onto their loans, they can customize loan terms to suit investors’ needs better. They can also be more flexible with credit scores, debt-to-income ratios, and down payment requirements. However, these more relaxed lending requirements usually result in higher interest rates or fees.
Blanket loans are similar to portfolio loans in several ways. They allow real estate investors to finance multiple properties with a single loan, making managing them easier than having multiple monthly payments for each property. Blanket loans also offer flexibility regarding credit requirements and down payments.
Additionally, blanket loans are usually cross-collateralized, meaning each property serves as collateral for the others. However, most blanket lenders can add language to the contract that allows you to sell one or more properties without refinancing the entire loan.
With a home equity line of credit (HELOC), you can access the equity you’ve built in a property. You can use it to make a down payment on another property and for any needed upgrades.
HELOCs work much like a credit card, where you’ll pay each month until you repay the balance. HELOCs typically allow you to borrow up to 80% of the equity you have in the home and have slightly higher interest rates than traditional investment loans.
Your main objective as a real estate investor is to make a profit. However, profits can be significantly impacted if you don’t minimize your costs. Here are some ways to effectively minimize the costs you encounter:
When you begin securing a rental property loan, it’s essential to understand your potential cash flow. This will help lenders assess the risk they’re taking on and help you model how profitable an investment will be at different loan terms. Here are some things you’ll want to consider:
As a real estate investor, there are several ways to project a property’s financials. Not only can estimating help you understand your potential cash flow, but it can also allow you to negotiate better terms. Calculate each of the following numbers before moving forward with a property. When you understand these numbers, you’ll better know if the property makes financial sense.
One of the most essential financials to understand when assessing a rental property’s potential is its capitalization rate or cap rate. The cap rate allows you to compare the net operating income (NOI) to the property’s value.
Cap rate = net operating income/purchase price
For example, assume you’re purchasing a home for $200,000, and its net operating income is $10,000 annually. The cap rate would be 5%. Typically, investors’ target cap rate should be between 5% and 10%.
DSCR measures the relationship between net operating income and the total mortgage debt. This number helps you understand how much money remains after paying the mortgage principal, interest, and operating expenses.
DSCR = Net operating income/debt payments
For example, assume you have a net operating income of $8,000 on a home you want to purchase. If your monthly debt payments total $5,100, your DSCR would be 1.56.
Higher DSRs mean the property generates enough income to cover its debt payments. Anytime the DSCR is under one, the property isn’t generating enough income to cover its expenses.
Another key profitability metric is the cash-on-cash return for an investment. This measure calculates the investor’s profit compared to the cash invested, including the debt service from the mortgage payment.
Cash-on-Cash Return = Cash Returned/Cash Invested
For example, let’s assume you purchase a $200,000 property with a 30% down payment. Your cash invested would be $60,000. If your annual cash return (pre-tax with debt service) is $4,500, your cash-on-cash return would be 7.5%.
TurboTenant’s powerful integration with REI Hub helps rental property investors streamline their finances and maximize their returns.
Sign up for a free TurboTenant account today to make managing your properties easier.
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