What is a Rental Property Loan?Jul 22, 2022
What is a Rental Property Loan?
A rental property loan is a first-lien mortgage secured by a single-family residence occupied by a tenant rather than an owner. The property must be ready to rent to qualify. The tenant is usually for a long period, but rental property loans can also be used for short-term rentals, such as vacation rentals.
Rental Property Loans vs. Conventional Home Loans
Lower Maximum LTVs. Rental property loans typically require much larger down payments. Therefore, it's a good idea to budget 20-25%.
Higher Reserve Requirements. Expect to show that you have liquid cash reserves equal to your down payment and closing costs, as well as 6-12 months' worth of monthly principal, interest, taxes, insurance, and any association dues. Some lenders may require you to prove reserves on all of your financed rental properties if you own more than one.
Higher Interest Rates. Rental property loans typically have higher interest rates and fees. They should be 100 to 400 basis points higher than for an owner-occupied property. One-hundredth of a percent is equal to 1 basis point. So, if a home loan is 4.5 percent, a rental property loan to the same borrower would be 5.5 percent or higher.
Documentation. You'll be asked for employment history and more for some types of rental property loans, especially if you already own other rental properties. However, instead of focusing on your personal employment and income, the lender will focus on the rental property cash flow for other types of rental loans. This greatly simplifies documentation.
2 Financing Options for Rental Properties
Agency Loans (Fannie and Freddie)
Borrowers must have good credit (typically a FICO score of 660-680) and a net worth of at least 100% of the loan amount, excluding retirement accounts. They should also have at least 10% of the total loan amount in liquid assets. These are not hard and fast rules, and exceptions can be made, mainly if a compensating factor, such as lower leverage, exists. Borrowers with multifamily ownership or management experience are also preferred by lenders and agencies, though this is sometimes negotiable depending on the specific deal. However, there are still some drawbacks, and here are some:
- Substantial documentation
- Lengthy and uncertain underwriting process with substantial reserve requirements that increase with the number of loans outstanding (Basically, the more mortgaged rental properties you own, the more cash reserves you need)
- Down payment requirements that increase with the number of loans outstanding (the more mortgaged rental properties you own, the more money you must put down for each new property)
- Restrictions on cash-out refinance
- Inability to borrow in a legal entity to protect your other assets and identity
Banks can be more flexible on underwriting in exchange for higher rates and fees because they plan to keep these loans rather than sell them. On the other hand, banks cannot portfolio 30-year loans, so they typically write 5 or 10 -year loans with amortizations of 15, 20, or 25 years. Working with a bank has some disadvantages, including:
- Exposure limits typically mean an investor will have to line up multiple local banks to finance a good-sized portfolio
- Uncertainty in that local banks often change direction quickly in response to their most recent regulatory review. This means they might be in the business of financing rental properties one month and then not the next month
- Local banks are not set up operationally to originate mortgages in high volumes and tend to work slowly
How do I qualify for a loan?
Calculate the appropriate down payment amount. You should budget at least a 20% down payment. If you have excellent credit, you may only need 15%. If your credit isn't great, you might need as much as 35 percent.
Am I financially ready? Plan on having 6-12 months of liquid cash reserves in addition to a larger down payment.
Increase your credit score. Lenders vary rental property loan pricing, terms, and conditions more than owner-occupier loans. So before applying, do everything you can to improve your credit score. Also, once you've applied, protect your credit score to ensure a smooth loan closing.
Demonstrate qualifying income. Prepare your documents if you're applying for a loan from an agency or a bank. File the pay stubs and tax returns with all of your tax return schedules. Prepare to answer questions about your tax returns from the previous 2 years. Also, ensure that you have enough personal income, including any net operating income from your rental properties, to cover your rental property's monthly payment.
Property should be rent-ready. Construction is financed separately from rental loans, so most lenders will check to ensure the property does not need any significant repairs.
Finally, it's given that there are FAQS on the internet about rental property loans, but of course, they vary on location, always on location, and I don't want to give you vague answers about that.
Consider your parameters about what type of loan you need, or maybe you can't put 20% or more down payment, your credit score might be to low and interest rates to high. I'll show you how you make ends meet.
I've been in real estate now for over 2 decades, I'm your guy on this real estate investing game to help you get started or get you to your next level. You can’t expect to get to the next level and reach your higher goals doing the same thing that got you to the level you’re at now.