Gaining Investment Power: 5 Best Ways to Finance Rental Properties

2022-05-02

Gaining Investment Power: 5 Best Ways to Finance Rental Properties

 

Like most people, you probably don’t have enough cash on hand to invest in a rental property. After all, most regular people barely have any disposable income to pay off their student loans or buy a car flat-out.

So, how do real estate investors usually do it? 

They turn to loans and mortgages to gain greater buying power and finance their investments. But this can be a complex process, especially as there are multiple ways to finance a rental property—all with their respective benefits and drawbacks.

To give you an idea, here are 5 financing options you can choose to fund a rental property. We will also outline the pros and cons of each financing method, so it’s easier for you to make the right decision.

1. For Homeowners: Home Equity Loans

You probably already own your primary home and are looking for a way to finance a second property for investment purposes. In this case, you can try to get a home equity loan.

Home equity loans are “second mortgages” where your home’s equity becomes the collateral. The loan amount you’ll be able to borrow will depend on the combined loan-to-value (CLTV) ratio, which is 80% to 90% of your home’s appraised value. The maximum amount you can borrow depends on your credit score and payment history.

There are also two types to choose from—fixed-rate loans and home equity lines of credit (HELOCs). The main difference is that fixed-rate provide one lump sum, while HELOCs will provide you with revolving lines of credit.

Using a home equity loan is a great way to take advantage of what you already have, expand your investment portfolio, and avoid taking out a traditional home loan. As long as you have enough equity to extract, it’s a good option to get a lump sum of money against collateral you already own.

2. For Mortgage-Payers: Conventional Loans

A conventional mortgage or conventional loan refers to any home buyer’s loan from private lenders instead of a government entity. These are the loans from credit unions, mortgage companies, or banks. They can be guaranteed by Fannie Mae (Federal National Mortgage Association) or Freddie Mac (Federal Home Loan Mortgage Corporation), but they are not offered or secured by the government.

These conventional loans have stricter approval requirements, such as the following:

  • A credit score of at least 629
  • A low debt-to-income ratio
  • A stable employment history
  • A strong history of making on-time payments

Additionally, the lender may ask for a down payment of 30% (instead of the usual 3% to 20%), especially if it’s for an investment property. This means you have to prove that you can afford both your primary and secondary mortgages in case your tenant suddenly can’t pay rent.

People choose traditional loans because they typically have a fixed interest rate—albeit higher than government-backed mortgages. Also, they won’t mandate borrowers to pay mortgage insurance premiums, making it more affordable in the long run.

3. For Tighter Budgets: Federal Housing Administration (FHA) Mortgage Loans

Federal Housing Administration (FHA) loans are insured by the government and issued by a lender approved by the agency. Since they are made to help low- to moderate-income families own their homes, these loans typically require lower down payments. They’re also more forgiving of lower credit scores.

However, FHA loans aren’t designed to finance rental properties, as the homes must be owner-occupied. You can find a way around this, but you have to ensure that you stay within rules and regulations. Here are a few examples if you plan to invest in single-family homes:

  • You must live in the property within 60 days of closing the mortgage.
  • You must live in the property for at least one year before you rent it out.

As you can meet these requirements, it’s easier to purchase a multi-family property while renting out other units simultaneously. But remember, investing in a larger property will come with bigger payments.

Either way, with a credit score of at least 580, you can borrow up to 96.5% of the property value and only pay a down payment of 3.5% with an FHA loan. If your credit score is somewhere between 500 and 579, the down payment then becomes 10%.

Now, the FHA doesn’t technically lend money. Instead, it only guarantees the loan that an FHA-approved financial institution issues, making it easier for you to get bank approval. This is also why some people refer to these mortgages as “FHA-insured loans.” 

FHA loans are ideal for those seeking affordable mortgage options but will require careful examination of the rules if it’s to finance a rental property investment. Moreover, you’ll need to purchase mortgage insurance, with all premium payments going straight to the FHA.

4. For Under-qualified Borrowers: Portfolio Loans

If you’re unable to qualify for an FHA or traditional loan, then portfolio loans are your next best option. 

Portfolio loans are mortgage loans originated and retained in a bank’s portfolio. They don’t have the requirements of FHA or traditional loans, so banks can’t sell them on the secondary market. Instead, the bank holds it in their balance sheet for the long term, where they’ll set their own standards, limits, and approval requirements—making it easier for you to get approved.

However, in exchange for lower approval criteria, you’ll have to deal with higher loan interest rates, origination fees, and possible prepayment penalties. 

Nevertheless, most real estate investors love portfolio loans since it gives them the chance to finance more than one rental property with each loan. You don’t have to manage multiple loan payments, as they’re consolidated into one payment.

Plus, there aren’t any capital limitations or property restrictions with portfolio loans, so you can get the amount you need without living in the home for a particular time (like FHA loans). You also don’t have to worry about the bank selling the loan or transferring it to a new servicer.

It’s the perfect loan for:

  • Self-employed individuals
  • People with a tarnished credit history
  • Anyone with a poor debt-to-income ratio, 
  • Those who need a loan above $484,350 for a one-unit property

5. For a Non-Traditional Method: Seller Financing

Lastly, you can opt for seller financing, owner financing, or purchase-money mortgage real estate agreement. This is where the seller will handle your mortgage process instead of a financial institution. In other words, you’ll purchase directly from the seller and set up payment to them. This is often via a balloon payment scheme.

Now, this may sound easy. But it does come with a lot of legal paperwork to protect both you and the seller throughout the transaction. 

You’ll want to discuss the following:

  • The down payment percentage (often dictated by the seller)
  • The interest rate (often higher than market-rate mortgage from a bank)
  • The time it takes to pay off the amount (often shorter than the average mortgage loan)

These variables mean you have to have expert knowledge in the industry, so you can protect yourself and secure a good deal with the seller.

Still, the closing process with a seller financing agreement is often quicker than with a traditional loan. Once you and the seller agree to the financing method, the property title will be immediately transferred to you as the new homeowner.

All you have to do is find a seller willing to do this deal with you, but this can be a challenge in and of itself.

Increase Your Investment Power with Financing Methods

It’s not easy to be a successful real estate investor without the proper financial backing. Luckily, there are many types of loans for you to increase your investment power and start earning rental income. 

As always, there are trade-offs and risks with each option. It may take some time to explore your individual needs before making an informed decision. The good news is that our team of property managers can help you navigate this complex process, so it’s easier for you to make wise, monetary commitments for your investment properties.

Contact us today for expert guidance in deciding what type of money loan or mortgage will best suit your needs. Drop a comment below if you have any questions!

 

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