How To Get A Mortgage For A Rental Property
If you’ve ever thought about investing in rental property, now may be a good time. Mortgage rates remain historically low, and rental income could offer valuable protection against ongoing economic uncertainty. And with economists predicting a wave of foreclosures in 2021, there may be more people looking for available rentals.
But how do you finance a rental property? The answer, for most people, is the same way you finance the purchase of your own home: with a mortgage. Whether you plan to live in the property or not, a mortgage is the most secure method of financing a rental purchase because it’s secured by the home.
What Makes a Rental Property Mortgage Different
“Mortgage lending is all about risk levels,” says Brooke Dalzell, director of production at Minute Mortgage in Scottsdale, Arizona. “A mortgage for an investment property carries a higher level of risk than a mortgage for a primary home, simply because the mortgage holder isn’t living in the home.”
Here are three ways a rental property mortgage differs from a mortgage for your primary residence.
1. You May Have to Make a Larger Down Payment
In most cases, the minimum down payment required for investment property is 15% to 20%. You can make a down payment on your own home of as little as 3% in some cases.
However, for a down payment lower than 20% on your own home, a borrower is required to pay for private mortgage insurance (PMI), which can cost between 0.25% and 2% of the loan balance per year. PMI does not cover investment property, so investors must make a larger down payment.
“Borrowers usually get the best deal on an interest rate if they put down at least 25%,” Dalzell says. She recommends asking a lender to work up an estimate for both 20% down and 25% down, so you can see the difference in interest rates and payments.
2. Your Mortgage Rate Likely Will Be Higher
In a low interest rate environment, the interest rate on a mortgage for a rental property is still relatively low. For most borrowers, the rate will be about three-quarters of a percentage point higher for an investment property than it would be for a primary home, Dalzell says, or about the mid-3% range currently.
3. You May Have to Pay Off the Mortgage Sooner
In some cases, the loan may have a shorter term than the typical 30-year term offered on the purchase of a primary home. But, just like with other types of mortgages, a rental property loan can either be fixed or variable, depending on the loan and the borrower’s relationship with the lender, says Tom McCormick, regional officer of branch administration at Trustco Bank in Saratoga County, New York.
Types of Rental Property Loans
When you get a mortgage for your primary home, you have several options, including government-backed loans such as those provided by the Federal Housing Administration (FHA), Veterans Administration (VA) and U.S. Department of Agriculture (USDA). But because these types of loans are restricted to financing primary residences, you can’t use them to purchase a rental property unless it’s a multi-unit property and you’ll be living in one of the units.
Generally, the loans most available for rental properties are conventional mortgages and jumbo loans. If you already own a home, you may be able to access the equity in your current home to purchase a rental property. You can access your home equity through a home equity loan or home equity line of credit.
How to Apply for a Rental Property Mortgage
The application process for a mortgage involves all the same steps, whether the mortgage is for a primary home or an investment property, Dalzell says. Those steps include qualifying the buyer, appraising the property, researching the title and underwriting the loan.
You’ll typically need a credit score of at least 620 and a debt-to-income (DTI) ratio that is no higher than 35% to 45%. But you’ll also need to document that you have the income to cover the rental property mortgage along with your other monthly obligations.
One difference for investment property mortgages is that if the buyer plans to earn income through renting the property, that projected rental income can sometimes be included in the qualification process.
“An appraiser can create a rented income schedule to show what the property will typically rent for,” Dalzell says. “Then the lender can figure your income to include that projected rental income, which may help you qualify for better terms and offset your payment.”
Many lenders require additional steps and documentation during the mortgage application process for an investment property. For instance, banks are more likely to view a real estate investor as a commercial customer, requiring a commercial loan relationship with the institution.
“The document requirements for commercial loans differ substantially from that of a mortgage on one’s primary home,” McCormick says.
For instance, commercial borrowers are required to provide financial statements for the past three years, financial projections for the next 12 months, tax returns for the past three years (typically two years for residential mortgages), current personal financial statements and tax returns of any principal owners and copies of current and projected rent rolls for loans that involve the finance of rental properties.
Is it a Good Time to Take Out a Rental Property Loan?
Even if it requires extra paperwork and documentation, getting a mortgage for an income-producing rental property may be a good idea, especially at the moment. Low mortgage rates help make purchasing real estate more affordable, while economic uncertainty may make it appealing to have a passive income stream available through a rental property.
“If the property in question provides a solid cash flow and is in a desirable location, this can be a solid long-term investment,” McCormick says. “Median rents have increased steadily over the past 50 years, providing a nice income stream to rental property owners.”
Low rates are driving interest from a wide variety of real estate investors, but rental properties are one of the safer bets.
“Investing in a real estate property for a short-term purpose, such as a flip, would likely be far riskier in the current real estate environment,” McCormick says. “There is likely to be an influx of real estate supply through foreclosures, which could depress prices and have a negative impact on real estate speculation in 2021. This may be offset by the large demand we have continued to see in the past several months for real estate, but nevertheless remains a risk.”
If the coming months result in a wave of foreclosures—particularly after the government’s Covid-related foreclosure moratorium ends—that will likely result in a tsunami of new applicants for rental properties, which will be a boon for rental property owners. For investors who are able to qualify for a rental property mortgage and are willing to handle or outsource property management tasks, now could be the right time to make an investment that will pay off for many years to come.