5 Things You Need to Know When Financing a Rental Property

More and more investors are placing real estate into their portfolios. It’s a special asset class that both appreciates over time and provides the owner a monthly cash flow. Investors also know to leverage their money with today’s low interest rates. It simply follows that the lower the cost of funds the greater the cash flow. If you’re thinking of buying real estate and financing it with a new mortgage, there are five things you need to know when financing a rental.

Financing a Rental Property

Down Payment. Lenders want to see a little more “skin in the game” when financing a rental property in the form of a larger down payment. Owner occupied homes and vacation homes have lower down payment requirements, but financing a rental property will ask for a down payment of 20 percent in most cases while providing slightly better interest rates when the down payment is 25 percent or more.

Interest Rates. Lenders also see non-occupied properties as a greater risk of default compared to a primary residence. It makes sense that if someone gets into some degree of financial straits and some of the monthly bills will have to be put on hold, a rental property will be sold or let fall into foreclosure before losing someone’s primary residence. A larger down payment and higher rates offset some of that risk. How much higher are rates for financing a rental property? Not a lot, but you can expect a rate increase ranging from 0.50 to 1.00 percent.

Income. The primary purpose of investing in real estate is to create wealth and income. If a particular property doesn’t command enough rent to cover the mortgage payment and other ownership expenses such as property taxes, insurance and maintenance. But what many first time investors don’t know is the rental income from an existing property cannot be used to help qualify for a new mortgage. The income may certainly exist, and the appraiser will note the income on the appraisal, but the rental income can’t be used to offset the cost of ownership.

Two Year History. On the other hand, if someone has owned investor properties for two years or more, the income may be used. The lender wants to see that not only is the income from the rental consistent, but the owner can also properly manage the property and keep it occupied. This means that once that two year guideline is met, future properties can be purchased by using the income from subsequent units. It’s for this reason that it’s not uncommon for a real estate investor to ultimately own several rental property units because the new mortgage payment, taxes, insurance and maintenance is not only paid for by the rental property income but also provides the owner with additional monthly cash.

Vacancy Factor. Finally, when calculating how to qualify for financing a rental property income, the lender will apply a vacancy factor to the amount. This accounts for times when the unit is in between tenants and not generating any revenue. This vacancy factor is typically 25 percent of gross rental income. If the unit produces $2,000 in revenue, if there is a two-year history of owning a rental property, the income can be used by only up to 25 percent of $2,000, or $1,500.