Rental properties can make excellent sources of revenue for the ambitious investor, inspiring increasing numbers of people across the US to look at investment properties as the best supplement to their own personal incomes.
However, first-time buyers often find that purchasing a rental property turns out to be much more complicated than they had imagined. This is particularly true when it comes to qualifying for that all-important additional mortgage…the rental property mortgage.
Financing the purchase of a rental property is not the same as financing a primary residence. Lenders tend to be more reticent about underwriting loans on rental properties, and first-time buyers should be prepared to meet some fairly stringent requirements before they can expect to be approved for a mortgage.
Though it seems daunting, it is more just a matter of understanding. You must clearly understand how a rental property is legally defined, and the extra qualifications a lender will be seeking from borrowers to grant a mortgage for a rental property.
Banks and mortgage lenders make a definite distinction between property types when it comes to underwriting loans. This can be confusing for first time property investors who assume one mortgage is the same as another, while it is simply not true.
As a general rule, it is much easier to qualify for a mortgage when purchasing your first home than it is when purchasing a rental property. This is largely due to risk management on the part of the lender. To get a better idea of how lenders view the different types of properties we'll quickly compare and contrast the two.
The term primary residence refers to the typical owner-occupied property. This is where you live full-time. It may be a single-unit property or a multi-unit property, but it is legally where you reside throughout the year.
Mortgages for owner-occupied properties are generally easier to obtain than rental properties. Even if it is your first home purchase you will find lending terms and requirements are much more in the borrower's favor.
Some key points to consider:
When it comes to approving a mortgage on a rental property lenders are much more stringent in their requirements. Because the owner will not be occupying the property, and potentially transient occupants may adversely impact the property's value, the risk for the lender is considered much greater. Consequently, borrowers are held to a higher standard.
Consider how the mortgage requirements differ for rental properties when compared with those for a standard home loan:
Down Payments
The minimum down payment for an investment mortgage is typically 25% of the total cost on a single-family home or 30% of cost on a 2-4 unit property. A higher down payment can help to secure better loan terms, but traditional lenders well hold firm at a minimum of 20% – 25%. This is partly due to the perceived risk assumed by the lender as well as the unavailability of PMI insurance on rental mortgages.
Credit Scores
Buyers applying for mortgages on a rental property typically need to show a minimum credit score of 740. That's a sizable jump from the relatively easy to obtain 580 required for a traditional home loan. Having a credit score that falls below 740 doesn't necessarily preclude borrowers from obtaining a rental mortgage, but will naturally lead to higher interest rates, higher fees, and lower loan-to-value ratios.
Interest Rates
Interest rates on investment property mortgages are typically higher than those applied to standard home loans. As a general rule borrowers should expect 1% – 3% more points in interest on a rental property mortgage than on a standard home loan.
Loan to Value Ratio
LTV ratios typically have a greater impact on investment property mortgages. Lenders expect borrowers to have more skin in the game and the lower the LTV the better the chance of qualifying for the mortgage. 80% is still acceptable, but borrowers will pay for that privilege.
Proof of Income
When it comes to proof of income, lenders expect to see more from borrowers applying for an investment property mortgage. Typically, the underwriter will want to see at least 2 years worth of income in the form of W-2s and tax returns.
Liquid Reserves
In addition to proof of income, lenders will expect borrowers applying for a rental property mortgage to have a minimum of six months of liquid reserves available. This can either be cash or assets that can be quickly and easily turned into cash.
As you can see, creditors have considerably tighter lending standards when it comes to approving mortgages for investment properties. Borrowers have to jump through more hoops to win approval, and the extra requirements can often lead to delays in finalizing a sale. Borrowers interested in securing an investment property loan should take those potential delays into account when searching for a lender.
While an active rental property can be a good source of revenue, first-time landlords should be prepared to manage the additional costs that come with the same ownership. These range from the interest on the mortgage itself to the day-to-day operating costs of maintenance and repairs.
Fortunately, many of the attendant costs associated with owning and managing a rental property can be deducted property owner's taxes. Some of the more valuable tax deductions available to rental property owners include:
1
Mortgage Interest – All interest paid to the lender is an ‘above the line' deduction and remains so throughout the life of the loan.
2
Landlord Insurance – Much like homeowner's insurance for a primary residence rental property insurance is tax deductible.
3
Repairs and Maintenance – The cost of basic repairs and maintenance (paint, carpeting, broken appliances, etc.) can be deducted from the property owner's taxes. However, large scale repairs that can be considered improvements to the property (new roof, window upgrades, etc.) are typically classed as ‘capital improvements' and do not qualify for a standard deduction.
4
HOA Fees – Fees paid to a Home Owners Association for the landscaping, maintenance and general community services are considered to be rental expenses and are tax deductible.
5
Property Management Fees – Property owners who contract with a property manager to handle the day-day-day management of their rental units can deduct the costs of service from their taxes as a rental expense.
6
Utilities – If the property owner pays for utilities (water, sewer, trash, etc.) the cost is tax deductible. However, if the tenant reimburses the landlord for those costs they will be considered income and must be reported as such.
One of the main advantages of owning a rental property is the steady stream of revenue that it can generate. But investment properties are just that – investments, and they can do more to generate wealth than simply provide a month-to-month income for the landlord.
Real estate, in any form, has always been one of the more consistent wealth builders for savvy investors, and rental properties are no different. It's true that the real estate market fluctuates, ebbing and flowing with the economic fortunes of the country. But over the long haul, real estate almost always appreciates in value, making ownership of any property a truly valuable asset, including or perhaps most especially a rental.
Recent research into the risk vs. return of the most popular investment products has shown that rental real estate consistently out performs both stocks and bonds when it comes to return on investment.
A report was generated using historical data going back over 145 years, comparing many different types of investment options. In the report's final analysis, rental properties proved to deliver the highest return and the lowest risk compared to other popular investment products.
When it comes to investment stability, trusting in something that has been so historically dependable as owning a rental property simply makes good business sense.
Before committing to the purchase of any rental property potential investors should consider some key metrics. While it's true that rental properties can generate steady income for their owners, and can be a valuable asset overall, it's crucial to invest in the right property.
There are three key real estate investment ratios to consider before making any purchase of a potential rental property. They include:
The rent ratio is determined by dividing the monthly rent generated by the total cost of the property (purchase price + financing costs + rehab costs). The higher the ratio the better. Most investors look to see, at minimum, a ratio of 1% – 2%.
The cap rate, or capitalization rate, is the ratio of net operating income to property asset value. To calculate the cap rate of a rental property determine the gross annual income of the property, subtract any and all operating expenses from the gross to arrive at your net income, and then divide the net by the property's purchase price. Ideally, the cap rate should be 6% or better. 8% – 10% is generally considered the sweet spot.
The final metric to consider is the cash-on-cash return. This is calculated by dividing the owner's pre-tax cash flow by the equity invested in the property. Most investors are looking for a minimum cash-on-cash ratio between 8% and 12%.
As with any property, there are times when it makes sense to consider refinancing a rental. Refinancing often gives the owner a chance to lower their interest rates, reduce their monthly payments, and even access some much needed cash.
Some of the key benefits of refinancing a rental property include:
As always, when it comes to refinancing a loan it is important to weigh the potential risks against the desired rewards. Refinancing a rental property offers some very real benefits, but there is always a downside to extending a mortgage beyond its original lifespan.
Financing an investment property can often be a challenge. Not only because of the stricter terms and conditions required to qualify for the mortgage, but also because rental financing may not always available from the buyer's bank of choice.
Consequently, buyers often have to look at other lending avenues to secure the financing they need. The most common mortgage providers for rental properties include:
Obtaining a mortgage on a rental property is often more time consuming than applying for, and receiving, a loan on a primary residence. Investors in rental properties need investigate all of their lending options and should be prepared to weather any delays in the approval process.
For your convenience here is a list of lenders offering competitive rates in your local area.
Rental properties can be excellent sources of income for the right buyer, and in the long run can be valuable assets in a diversified portfolio. They are also a good choice for first time investors who are looking for creative ways to build their personal wealth.
However, purchasing any investment property can be a complicated matter. First-time investors should take their time and carefully consider all of their financing options, as well as their responsibilities as a borrower and a landlord, before agreeing to any long-term financial and social commitments.
Seasoned investors tend to be well aware of the benefits found in owning rental properties. Wealth and cash flows are often managed best by an asset such as some rental real estate, which is why it has consistently remained a solid investment idea for more than 145 years.
When it is time to build your wealth, a careful review of rental property ownership will no doubt be a foundational part of the best laid plans.
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