There are myriad of good reasons to buy an investment property, from creating another income stream to diversifying your portfolio. Once you head down that path, the next step is to determine how to finance the purchase of your rental (unless you’re paying in cash).
As you investigate options, keep in mind your end goal as well as how the financing works with what you want to accomplish. You’ll uncover more than one way to pay for your investment. Educate yourself on the details of each. That way, you take advantage of the financing tool that helps your investment pay off and doesn’t impact your bottom line.
Decide on a Down Payment
You typically don’t have access to mortgage insurance for investment properties, which means that you’ll need 20% or perhaps 30% of the property’s price for a down payment. If that seems out-of-reach, then you may reconsider either the type of property you’re purchasing (maybe something less expensive would work) or whether investing in property makes sense at the moment.
While putting down 20% or 30% is required, paying more is ideal for multiple reasons. If you can afford a more significant down payment, then you’ll have less to borrow, and a smaller payment each month. The result should improve your monthly margin, and leave you with more monthly cash on hand for unexpected expenses. A larger down payment also gives lenders more confidence in your capabilities as a borrower. That may help your ability to negotiate the terms of the loan as well. In some cases, you may be able to finance the down payment with a second mortgage. But that’s much less common and puts you at an increased risk of being able to repay the borrowed funds.
Financing Options for an Investment Property
Before you approach lenders, be sure to review your credit report and scores. Having the highest score possible can positively influence your loan terms and potentially grant access to better interest rates. Once you begin the financing search, consider the following options:
A Conventional Bank Loan
As with your mortgage, your lender will review your financial situation and evaluate your ability to service another mortgage for an investment. With this in mind, a lender will look at your total debt-to-income ratio and your ability to pay all of your obligations. Banks often want borrowers to have three to six months of cash available that covers all of their existing debt. Take note: Lenders rarely consider the rental income as part of the financial picture. So having additional cash to cover the debt if you can't rent the property is critical.
A HELOC or Home Equity Loan
Some investors—especially those getting started—may borrow against their current home to fund the purchase of a rental. With a home equity line of credit, you borrow against your equity at a variable rate and then pay it back monthly, usually beginning immediately. HELOCs are more flexible in terms of the amount you’re borrowing and could work well if you were purchasing a home to flip and needed a line of credit for repairs. A home equity loan entails refinancing your home to tap into the equity you’ve earned. You usually land on a fixed rate, which can be low, but you’ll most certainly extend the term of your existing mortgage. Using your home equity can work, but be sure to do the math to determine how much you can earn off your investment and whether it’s enough to warrant the new debt you'll take on.
A Hard Money Loan
So-called hard money lenders provide loans outside of conventional banks. The financing is often easier to obtain than a traditional loan and can be an option for first-time investors. The loans are most often used by high-income investors who can pay them down quickly. However, if you're considering a hard money loan, proceed with caution: In exchange for the financing, hard money lenders use the property as collateral. They can provide the financing much faster than a traditional bank, but if you can’t repay per the terms, the lenders will take ownership of your investment property. While hard money loan terms can be flexible, the money is costly. Interest rates can be well into the double digits. The loans are often used by high-income investors who can pay them down quickly, and needed a source of fast cash.
Purchasing your first investment property opens up a new world of income and investment opportunities. Be smart about how you fund the purchase, and you'll hopefully reap the rewards.