How to Get a Mortgage for a Rental Property
Get to know how the mortgage process works if you're buying an investment home.
By Rebecca Lake, Contributor April 23, 2019, at 9:00 a.m.
How to Get a Rental Property Mortgage
Government backed loans are harder to get for a non-permanent residence, so know your options. (GETTY IMAGES)
DEMAND FOR RENTAL properties remains high, so buying a rental investment property could be a good way to bring in some extra income each month. In fact, a 2017 report from the National Multifamily Housing Council and National Apartment Association indicates an average annual deficit of 200,000 rental units, meaning demand for rental properties is outpacing availability. But, here's one major wrinkle to iron out before you invest in a rental: how you'll pay for it.
Getting a mortgage to purchase an investment property isn't the same as getting a home loan for a primary residence. There are certain rules and requirements you need to know before you start shopping for a rental property or a mortgage lender.
What's Different About Rental Property Mortgages
If you own a home, you've likely been through the mortgage process before. Lenders set qualification guidelines for the down payment, credit scores and debt-to-income ratio to manage their risk; in other words, they want to be sure you can repay your mortgage. With investment properties, the guidelines become even narrower.
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"Lenders are more stringent for investment properties," says Steven Ho, senior loan officer at Quontic Bank, headquartered in New York City. "The theory is when someone buys a home for their primary use, it's their home. An investment is higher risk and easier to walk away from than a primary home."
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Take the down payment requirements, for instance. Conventional mortgages allow you to buy a primary residence with as little as 3% down. With an investment property, on the other hand, you'll typically need to put at least 20% down to qualify for a mortgage.
The reason? Private mortgage insurance, which homebuyers must carry when they put down less than 20%, doesn't cover rental or investment properties. PMI acts as an insurance policy for the lender. If you were to default on the loan for any reason, the lender would recoup some of its investment with the insurance policy.
Because PMI doesn't extend to rental properties, you're expected to have more skin in the game when getting a mortgage for a rental. The government-controlled mortgage financing giant Fannie Mae allows rental property investors to purchase a single-family home with 15% down, but you may only be able to take advantage of that if you're working with a direct lender. And be aware that even if lenders follow Fannie Mae mortgage guidelines, they can still require a down payment of 20% or more at their discretion.
What you pay for a rental property mortgage may also be different.
"Though the key steps are the same, an investment is considerably more risky, so rates are higher," Ho says.
Depending on the amount you're financing, your down payment and your credit scores, the interest rate for a rental property may be 0.25 to 1 percentage points higher compared with a mortgage for a primary residence. Though seemingly small, the difference can significantly impact your monthly payment and the amount of interest paid over the life of the loan.
For example, say you're buying a home you plan to live in full time. You get a $250,000 mortgage for 30 years at 4.38%. The principal and interest payments come to $1,249 a month, and over the life of the loan, you'll pay nearly $200,000 in interest.
Now, say you want to borrow that same amount for a rental property, but your rate is set at 4.88% now. Your monthly payment increases to $1,324, and the total interest paid grows to almost $230,000. That's a difference of nearly $30,000.
Ideally, your tenants cover those costs for you since they're paying rent. But, you have to consider your ability to maintain a second mortgage during times when the property is vacant or your rental relationship with your tenant goes south.
"The rental income of the property is meant to support the new mortgage payment," Ho says. "If the tenants don't pay, then the burden would go to the borrower, and he or she would have to cover the shortage."
What Kind of Loans Can You Use to Buy a Rental Property?
The range of mortgage options available changes when buying a rental property versus a primary home. Typically, government-backed loans – U.S. Department of Agriculture, Federal Housing Administration and Department of Veterans Affairs loans – require the property being purchased to be a primary residence, says Jason Larkins, branch manager and loan officer at United Fidelity Funding Corp. in Scarborough, Maine. "That leaves only conventional loans or nonconforming jumbo loans as options for a rental property."
There is a workaround to the rule regarding government-backed loans, however: You could use an FHA or VA loan to buy a multiunit home if you live in one unit while renting out the others. Or, you could do an FHA or VA cash-out refinance, which doesn't have residency requirements on the cash you take out.
If you own a home and you've been paying down your mortgage and seeing your property's value increase, you may be sitting on a sizable amount of equity. While homeowners often use their equity to consolidate debt or make home improvements, you could tap into it to purchase a rental property.
There are three ways to access your equity:
- Home equity loan
- Home equity line of credit
- Cash-out refinance
A home equity loan is essentially a second mortgage. You receive a lump sum of cash, typically at a fixed interest rate. You could then use that money to make a down payment on a rental property or buy one outright if you find a bargain.
A home equity line of credit, or HELOC, on the other hand, is a revolving line of credit that you can draw against as needed. Larkins says that while a HELOC can be a good way to raise cash for a down payment on a rental, it can be more difficult to obtain, as lenders typically look for borrowers with good credit.
Because HELOCs typically have a variable, rather than a fixed, interest rate, they may become a more expensive way to borrow compared with a conventional loan.
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Larkins also points out that rental property buyers may not benefit from a mortgage interest tax deduction with a home equity loan or HELOC. The Tax Cuts and Jobs Act of 2017 makes the interest on a home equity loan or HELOC deductible only when the funds are used to make substantial improvements to the home.
With a cash-out refinance, you can withdraw your equity in cash while getting a new mortgage on your primary home. This could be a cost-saver if you're able to get a lower interest rate. If you initially bought your home when rates were low, however, you may not see as much benefit as rates rise.
Lenders generally allow you to draw on up to 80% of your equity for cash-out refinancing, although that may increase to 85% or even 100% for FHA and VA loans. The main thing to keep in mind when using equity to buy a rental property is that you're essentially using your primary home as collateral. If you fall behind on the payments for a home equity loan or refinance, you could risk losing your own home to foreclosure.
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How to Qualify for an Investment Property Mortgage
Qualifying for a conventional mortgage usually means having a credit score of at least 620 and a debt-to-income ratio of no more than 36% to 45%. Income – not credit scores or debt – may prove most critical when applying for a rental property mortgage, though.
"Borrowers need to be able to qualify for two mortgage payments simultaneously," Larkins says. "There is a way to use projected rental income on the rental property for approval, but lenders can only use 75% of the fair market rent to count towards the borrower's income when qualifying them for a rental property purchase."
To make that work, the projected rental income associated with the property would have to be enough to bring your monthly DTI ratio to the 36% to 45% range. And, your lender may not even consider future rental income if you don't have a history as a landlord. If that's the case, your ability to get a mortgage for a rental may hinge on your income alone.
Assuming that you have sufficient income, Larkins says there's one more thing rental property buyers need to have: money in the bank.
"The borrower has to show they have three to six months of reserves remaining in checking, savings or retirement accounts after closing on the rental property," Larkins says. "One month in reserves is classified as one full mortgage payment, including the principal, interest, taxes and insurance, on the new property."
You could also follow the 2% rule, which suggests setting aside 2% of your rental property mortgage balance to cover your payments in an emergency. On a $250,000 mortgage, for instance, that works out to $5,000.
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Look Beyond the Mortgage When Preparing to Be a Landlord
Financing your rental property is a major step, but you also need to consider and plan for:
- Advertising and marketing your rental.
- Screening and approving tenants.
- Drawing up a legal rental agreement.
- Collecting rent payments.
- Insuring your rental.
- Maintaining the property.
"Unless you hire a management company, you may need to put on some work gloves and get your hands dirty," Ho says.
The bottom line? Decide early on how hands-on you want – and can afford – to be as you begin your real estate investing journey.
Rebecca Lake, Contributor