Real estate has always been a popular strategy for building wealth. Beyond amassing equity in the house you live in, you could possibly turn a profit by purchasing investment properties and charging others rent. In an ideal situation, an investment property could rise in value while renters foot the bill for the mortgage and even repairs.The good news for investment-property owners is there is money to be made in being a landlord. A 2018 study by apartment search website RENTCafé found that millennials alone spend approximately $93,000 in rent by the time they’re 30.
However, buying an investment property isn’t as easy as purchasing a house you plan to live in yourself. Not only are the loan eligibility requirements stricter, but you’ll likely have to come up with more cash. If you’ve been thinking about purchasing your first investment property, here are some factors you should consider first.
You may pay higher interest rates. Lenders charge higher interest rates when they believe there is a higher risk that the borrower will default. Investment properties are considered riskier than buyer-occupied homes because lenders figure people are likely to try harder to pay the mortgage on the home they live in than they would for an investment property if times get tough. As a result, the interest rates are typically a point or more higher for investment properties, said Rick Bettencourt Jr., a mortgage professional based in Danvers, Mass., and board president for the National Association of Mortgage Brokers.
Interest rates on multi-unit dwellings tend to be the highest of all. “Buying an investment property that’s a multi-family unit is the riskiest type of home loan that you can get,” Bettencourt said. As with other types of home loans, the lower your credit score, the higher the interest rate you’ll pay. Rising interest rates, such as in the current environment, will also likely have an impact on the buyer’s borrowing power. As mortgage rates rise, investment properties may stay on the market for a longer period of time, Bettencourt said.
You may need a larger down payment. When you buy a house that you plan to live in, many lenders let you put down less than 20% as long as you pay mortgage insurance. However, mortgage insurance is not an option for borrowers who are buying investment properties. Borrowers will typically have to put down 20% in order to be approved for a loan — and to get the lowest rates, expect to put down 25%, Bettencourt said.
You’ll likely need more in cash reserves. Not only will you need to come up with the cash for the down payment, but lenders also typically require investment property buyers to have enough stashed away to cover several months of mortgage payments. A good rule of thumb is to have six months of mortgage payments, so if your mortgage payment is $2,000, you’ll need $12,000 Bettencourt said. Assets held in checking and savings accounts, CDs, mutual funds and retirement accounts can all count toward your reserves.
Rental income may be included in your debt-to-income (DTI) ratio. Lenders will consider how much income you have relative to debt when determining whether they’ll lend you money and how much you will qualify for. They want to know that despite current debt obligations, you have enough money coming in to pay the mortgage. When you buy a rental property, lenders not only consider your current income, but they consider how much money you could potentially make charging rent. That means they calculate a higher income for you than you currently have, and as a result, you could likely qualify for a more expensive rental property than a house you intended to live in.
Your credit rating may be more important. Because lenders consider investment property financing a riskier type of loan, they’re going to be looking a lot harder at your credit score when determining whether to lend you money. To get the best rates, many lenders will look for a minimum score of 720, but if you can get your score in the 740 to 760 range, that would be ideal, Bettencourt said.
You may incur other costs. Don’t just consider the costs of buying the property — also factor in whether you’ll be able to maintain it. Could you afford the costs of hiring contractors when you need repairs? Have you considered the costs of property maintenance and utilities?
“If the cost to maintain the property is going to be expensive, that will eat into any of your profits,” Bettencourt said. Also, consider whether you’ll be able to pay the mortgage if you’re between tenants for a long period.
Financing your investment property
Once you’ve weighed these factors and decided that an investment property is for you, the next step is determining how to finance it. Here are some options to think about.
Conventional loans. If you have a high credit score and assets, a conventional loan could be your best bet. Keep in mind that conventional lenders likely will have the strictest requirements. For example, Wells Fargo requires borrowers to have two years of property management experience in order to use potential rental income to help qualify for the loan.
Home equity loan or HELOC. Depending on how much equity you have in your principal residence, you may be able to leverage it to pay for an investment property. One reason this may be a good option: Home equity loans and home equity lines of credit, or HELOCs, typically come with lower interest rates than investment property loans because they don’t carry as much risk. However, there’s always the risk that if your investment property struggles and you can no longer afford the payments, you could end up losing your house as well.
Financing through the seller. In some cases, owner financing may be available. With such an agreement, you and the seller would decide on the terms of the loan and you’d make payments directly to the seller rather than going through a traditional lender. Without a lender, the requirements may be less stringent and there may be less paperwork involved. If you finance through the seller, know that the transaction might not be on your credit report unless the seller reports it to a credit reporting agency.
Loans from private lenders or investors. If you’re looking for a loan with more flexibility, you may be able to get it by finding a private lender or investor who is willing to underwrite your deal. They may be more willing to negotiate with you about the terms of the deal than a traditional lender. Some peer-to-peer lending networks bring together borrowers with potential investors for real estate projects.
FHA loans and VA loans. Many homebuyers find loans backed by the Federal Housing Administration and the U.S. Department of Veterans Affairs appealing because they allow you to put down less than 20% on a property. FHA loans allow you to put down as little as 3.5%, while VA loans can be taken out with no down payment. For the most part, you can’t use FHA or VA loans for purchasing an investment property because they are designated for owner-occupied homes. But there is an exception: If you buy a house with up to four units and live in one of them, you may be able to satisfy that requirement.
Buying your first investment property can get you started on building your own real estate empire. But like all investments, real estate comes with risks. The housing market could crash or you could be stuck paying the investment property’s mortgage between renters. Before you make such a major investment, it’s important to consider how you would handle a downturn in the housing market or other potential challenges. If you do decide that buying an investment property is for you, do your research and ensure that your financing strategy will benefit you in the long term.