How to Finance an Investment Property

How to Finance an Investment Property

If you’re toying with the idea of buying your first rental property or even your second, lending guidelines have changed somewhat over the years. Knowing what lenders look for when evaluating your request to finance an investment property will make the process a smooth one for setting up your first rental. And perhaps what many don’t know is that lenders will actually make it easier to qualify for your second rental property compared to the first.

Financing an Investment Property

Lenders categorize occupancy in three basic ways: a primary residence, a vacation or second home, and an investment property. Interest rates and general loan terms are the most favorable when financing a primary residence compared to a vacation home or rental. The reasoning behind this is that lenders understand that when someone owns multiple properties and later run into some sort of financial issues, rental properties and second homes will be disposed of first leaving the primary residence as a place to live. For example, interest rates for a 30 year fixed rate rental property will be about 0.25-0.50% higher with most programs. A vacation home or rental will be nearly identical but will ask for a bit more in down payment.

A Few Guidelines

Okay, you’ve got a rental property in mind and you’re going to be a first-time landlord. The most favorable terms to finance a rental are provided with conventional loans using guidelines established by Fannie Mae and Freddie Mac. You’ll need to have a down payment at least 20% for a rental property. Unlike a primary residence, private mortgage insurance isn’t available for a rental investment property and 20% down is the minimum to avoid PMI.

If the investment property is currently being rented and this is your first rental property, unfortunately you can’t use the rental income to help qualify. When landlords set their rental payments for their properties it’s enough to cover the mortgage payment plus property taxes, insurance, maintenance and some extra profit each month. In essence, it is the tenant that is paying the landlord’s house payment each month. This can make it difficult to qualify for your first rental as an investment property. Your gross monthly income will need to be enough to cover your current mortgage payment, taxes and insurance plus monthly credit obligations such as credit cards or car payment, plus the new monthly payments on the new home. But things change when you get ready for your second rental.

By owning a rental property for at least two years the rental income may be used to offset the new mortgage payments, taxes and insurance. You’ll be asked to provide copies of bank statements showing rental deposits, Schedule E from the last two years of federal income tax returns and lease agreement from all properties. You’ll then provide the appraiser with a copy of the lease agreement. The appraiser will also perform a Market Rental Analysis and calculate the market rent for the unit. The lender will use the amount listed in the appraisal along with a slight reduction to account for any potential vacancies.

What’s Next

Once you’ve owned your first property for two years and want to acquire more investment property, financing your next investment property will be much easier because the second and third time around, the rental income from the new property can be used.