Different Ways to Finance an Investment Property
There are several reasons why people encourage others to invest in real estate. An investment property can provide a steady stream of income even when markets are down and is a great way to build generational wealth aside from other ways to invest money.
Becoming a property owner is great way to generate a stable and passive income stream, but it also takes a certain amount of capital to get started. If you don’t have enough capital to get started you may consider options for various loans that will help you close on your next investment or rental property.
Investment property financing or financing a rental property can take several forms and there can be strict requirements that borrowers need to be capable of meeting. When seeking financing options choosing the right type of loan is vital to the success of your property investment. It’s important to consider the requirements for each type of loan and how those requirements will affect you before you contact a bank or lender.
Financing for investment properties usually comes in the form of shorter term loans that allow you to fund the expenses for converting or renovating a current property or land into apartments, single-family or multi-family units. These are typically provided as a loan, backed against the property or a land estate.
Read the following to find common financing options you may want to explore to finance your first rental property and investment property:
Conventional Financing or Bank Loans
Conventional bank loans, home equity loans and hard money loans are the three types of loans you would want to consider for your investment property. These loans will allow you to invest in Buy-To-Let (BTL) or ‘buy to rent’ properties and taking out a mortgage that is secured against that property.
If you're an existing homeowner you’re probably already familiar with conventional financing options. A conventional mortgage follows the guidelines created by Fannie Mae or Freddie Mac. One thing to keep in mind is that unlike with FHA, VA or USDA loans, these are not subsidized by the federal government.
Typically, a 20% down payment is required with conventional financing. However, don’t alarmed when a bank or lender requires a 30% down payment for an investment property. As a borrower you’ll also need to allow the bank or lender to review your credit score, credit history, existing income, and assets that you own. This will show them that you’re able to afford your existing mortgage on top of the new payments that would be required for the investment property.
It’s also not uncommon for a bank or lender (creditors) to require borrowers (you) to have a few months of cash reserves. This is referred to as mortgage reserves. Some banks or lenders require borrowers to show a few of months while others require borrowers to show a year’s worth of cash reserves from a seasoned asset account. What they’re looking for is your ability to make the PITI (principal, interest, taxes, and insurance) payment amount for the loan.
Fix-and-Flip Home Rehab Funding
Owning and renting an investment property has its perks. But what if you don’t wish to become a landlord? As a property investor you can do what’s known as flipping a property. Most investors will purchase a property and rehab the property to get it ready for sale (or rent). A fix-and-flip loan is a form of short-term loan that helps the homeowner to finish repairs and renovate the property so it can be placed back on the market as soon as possible. Fix-and-flip loans are common when conventional financing solutions aren’t available.
Fix-and-flip loans are also referred to as ‘hard money loans’ and these loans ensure that the property backs the debt. While banks and lenders still evaluate things such as credit and income, a higher concern is weighted on the potential profitability of the property so these types of loans are usually easier to apply for than a conventional loan.
Pro of a fix-and-flip loan
- Apply and get loan funding for the loan in days rather than weeks or months.
Con of fix-and-flip loan
- Depending on the bank or lender you may see very high interest rates up to 18% on the loan.
Depending on the lender you may be able to find some who offer fix-and-flip loans with interest only or longer periods of time and flexible payment schedules. Home Equity Line of Credit (HELOC) Banks and lenders are usually reluctant to offer a HELOC, often referred to as a second mortgage, since it poses a higher risk to the lending institution. Tighter restrictions and standards for HELOCs have been imposed following the financial crisis in 2008.
Many investors will consider a HELOC on their existing primary residence or investment property they already own. Here are a few items you’ll want to have prepared if this is the route you are considering:
- Know your loan-to-value (LTV). This is the appraised value of your property divided by the balance remaining on your loan. Minimum LTV usually ranges from 65-80%.
- Recent credit report and good credit scores to lock in lower interest rates.
- Proof of income through bank statements, pay stubs, W-2s or 1040s.
You’ll want to make sure that you don’t overextend yourself securing a HELOC. The interest rates on HELOCs are usually variable and can increase as well. Lastly, remember to treat HELOCs like a credit card and not to draw more than you can repay in full.
Bridging Loans and Financing
If you’re looking to sell your existing investment property and purchase a new investment property then a bridging loan may be what you’re looking for. This short-term loan will allow you to buy the new property without selling your existing property first. There are two main types of bridge loans. These are:
- Closed bridging loans
- Open bridging loans
A closed bridging loan is when you set or agree to a date that your existing property will be sold so you can pay off the principle of the loan.
A open bridging loan is when you have found a new property but haven’t sold or put the existing property on the market.
If you’re considering an open bridge loan you’ll be asked a lot more questions since banks and lenders see this type of loan as more risky. Be prepared to show proof that your existing property is actively listed.
What financing option should you consider?
This article briefly covers the tip of the iceberg when it comes to lending and financing your investment property. We encourage you to contact banks and lenders to discuss all of your options to understand the pros and cons of each before making your decision. Investment properties, whether you rent or flip, will expose you to many risk factors that you should fully understand before taking the leap.
If you're still wondering how much you can afford, our friends over at Credit Donkey talk more about markets, loans and down payments. They also have loan estimate calculator to project loan payments and help you determine how much of a housing payment you can afford.