Secure financing for the property
If you're planning to pay cash for your first investment property, you can skip this section. Otherwise, you'll have to figure out where the money is going to come from.
Financing an investment property can be very different from financing a primary home. You should expect to need excellent qualifications, as lenders typically consider investment property mortgages to be higher risk compared to loans on owner-occupied properties.
With that in mind, when it comes to investment property financing, you have a few different options. Whichever type you choose, it's a smart idea to have a preapproval for a loan or have otherwise secured a financing source before you start to look at properties. Here's what you need to know about your options before you get started:
Conventional financing is a broad term referring to a mortgage that you obtain from a bank and that is backed by your personal qualifications. This can refer to a conforming loan, which meets the lending standards for Fannie Mae or Freddie Mac, or another type of bank lending product, such as a jumbo loan.
The requirements for conventional financing of an investment property depend on factors such as the type of property (single-family versus multifamily), your credit score, employment, and assets, as well as your other debts. One important point to know is that while you may be able to use some of the property's expected rental income for qualification purposes, your current income is the main basis for qualification. If your existing mortgage or other debts consume a substantial amount of your gross income, you might find it difficult or impossible to obtain conventional financing for an investment property.
If you can qualify for a conventional loan, it's usually the most cost-effective way to go. Interest rates tend to be a bit higher than an owner-occupied home loan, but it's generally cheaper than the alternatives.
When it comes to long-term financing options for investment properties, asset-based loans are the main alternative to conventional mortgages.
As the name implies, the primary basis for loan qualification with an asset-based lender is the underlying asset itself -- in this case the investment property -- and not the borrower's personal qualifications. To clarify, an asset-based lender will still check your credit score and use this to determine eligibility and your interest rate, but your personal debts, income, and employment situation won't be considered. In fact, I obtained an asset-based loan for a triplex I purchased and the lender never even asked for a copy of my tax return, W-2s, or a pay stub.
The primary condition for approval is that the property generates sufficient cash flow to cover the mortgage payments with a reasonable cushion. Specifically, the lender uses a metric called the debt service coverage ratio, or DSCR.
Other financing options
In addition to conventional loans and asset-based mortgages, there are a few other ways to finance investment properties that you might want to consider. This isn't necessarily an exhaustive list of financing options, but it could give you some good ideas:
- Second home financing: Many lenders offer three types of financing -- primary residence, investment property, and second home. The short explanation is that second home financing might be available if you plan to occupy the home some of the year. So, if you plan on investing in a vacation rental, this might be an option. Second home financing typically has lower down payment requirements and easier qualifications than investment property mortgages.
- House-hacking: You can read our guide to house hacking for more details, but the short version is that if you buy a multiunit property and live in one of the units while renting out the others, you can consider the entire property to be a primary residence and can finance it as such. For example, you can buy up to a four-unit property and get an FHA loan with 3.5% down if your income and other qualifications justify the loan.
- Home equity: One common way to obtain easy financing for an investment property is to tap into the equity you've built in your primary home, through either a home equity loan or a home equity line of credit (HELOC).
- 401k loans: If your plan allows it, your 401k or other qualified retirement plan may allow you to take loans of as much as $50,000. While borrowing against your retirement savings isn't always a good idea, it can be a good source of low-cost financing for an investment property.
Learn how to calculate cash flow the right way
Cash flow is one of the most important concepts for new real estate investors to understand. You can get a seemingly great deal on an investment property, but if your costs of ownership are more than the rent it brings in, it will drain your bank account over time. So, it's essential that you determine whether a potential property will realistically generate positive cash flow from day one.
The key word here is realistically. It's not enough to simply subtract your monthly mortgage payment from your rental income and get a positive number. That just tells you that you'll have positive cash flow when things are going perfectly.
In the real world, your property will be vacant from time to time, and there will be maintenance items you'll have to pay for. Keep all this in mind when estimating cash flow.
Now, there's no bulletproof way to determine how much these expenses will be, but I generally set aside 15% of my rental income to cover vacancy and maintenance. So, a good cash flow calculation might look like this:
- Start with the property's expected monthly rental income.
- Subtract your mortgage payment, including taxes and insurance.
- Subtract your property manager's fee (if applicable).
- Subtract any other recurring expenses (e.g., pest control or lawn maintenance).
- Subtract your vacancy and maintenance allowance.
For example, let's say you want to acquire a duplex that will rent for $2,000 per month. Your expected mortgage payment will be $1,200, and your property manager charges 10% of collected rent. You don't pay any other property expenses and anticipate vacancies and maintenance will consume 15% of your rental income.