For property investors who are just getting started on their investment journey, the first hurdle they have to scale (and there are many) is how to finance the purchase of their investment property. For most of these new investors, the only option is an investment property loan.
Buying a rental property costs a lot of money, and most investors don’t have the cash to buy a property outright. As an investor in this position, LREShomes.com advises you should know that the process for getting an investment property loan is very different from that for getting a loan for your home.
It is more difficult to get approval for a rental property loan because lenders view these loans as riskier. The reason is the higher default rates for investment mortgages. As a rule, borrowers are more likely to default on an investment property loan than their home mortgage.
To guard against potential losses, lenders work to ensure that only the most qualified applicants can assess these loans. They will look at several factors – mainly your credit history and current financial position – to decide whether you qualify.
What do lenders want to see before they give you money to invest in a rental property?
1. A good credit score
This is an assessment of how committed you have been to meeting your obligations to creditors in the past. Incidents of late payments or out-and-out defaults will dent your credit history and lower your credit score. Lenders expect an absence of defaults in your credit history to extend an investment property loan to you. As a rule, they want a minimum credit score of 620, although some lenders will accept 600. But to get the best loan terms, a score of 740 and higher is recommended.
2. Down payment
Down payment requirements for rental properties vary. Typically, you should expect a minimum of 20%, but you can get away with paying as low as 3%. Any down payment below 20% will require you to buy private mortgage insurance. There are two major down payment options for rental properties:
Buying as an Owner-Occupier: If your rental has 2-4 living units and you plan to live in one of them, you qualify as an owner-occupier. Owner-occupiers get better terms because they are less likely to default on their loans (since they live in the building). They also often invest in better quality buildings and are more diligent in caring for their rentals. Owner-occupiers are allowed to put down as little as 3.5%, especially if they use FHA financing.
Buying as a non-owner-occupier: If your property is a straight-up rental – you do not plan to live in it – expect a down payment of 20%-25%. In reality, the actual amount can get as high as 30%-35% when you include closing costs, escrow, and property renovation costs. It is also possible to pay just 10% if you can buy a Fannie Mae or Freddie Mac investor property.
3. Proof of income
Lenders require proof of adequate income earned sustainably. Salaried employees will be asked to provide pay stubs and a letter of employment no less than 30 days old. Some lenders will want to see completed tax returns. For self-employed applicants or if you earn income via commissions, you will be asked to show proof of income for the past 2-3 years, along with the financial statements for your business. Self-employed applicants must show their business registration documents or a website URL.
4. Debt-to-income ratio (DTI)
This measures your ability to make the mortgage payments while still being able to pay your living expenses. Lenders want to see if you will have enough cash to comfortably sustain two mortgages monthly (your home and the rental property). To check your DTI, lenders look at how much cash you have left every month after you have met your obligations to your creditors. The ideal DTI to aim for is somewhere between 36% and 45%.
5. Proof of funds
You will be required to show evidence that you have enough money to make the down payment on a rental. The funds must come from verifiable legit sources and they cannot be borrowed. Furthermore, you must show proof that you have enough cash to pay for the closing costs on the loan. Finally, lenders want to know that you have a rainy day fund: enough cash reserves to cover 3-6 months of mortgage payments on the rental property and your home.
Based on the above, do you still think you will qualify for that investment property loan? If you said NO, it does not mean you cannot fulfill your dream of becoming a real estate investor. It means you should devise a plan or look for alternative ways to reach your goals.
