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Real Estate 101 - Financing an Investment Property

Here's what you need to know before you start shopping for your next investment property.

[Updated: Feb 04, 2021] Nov 07, 2019 by Matt Frankel, CFP
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Investing in real estate can be an incredibly rewarding and lucrative way to put your money to work. But, unless you have tons of cash sitting around, you'll need to get financing when you buy an investment property. Even if you can afford to buy in cash, borrowing could be the best way to go.

However, financing an investment property is different than financing your primary home or even a vacation home. With that in mind, here's a guide to what you need to know about your various financing options to help decide which is best for you.

What's an investment property, anyway?

Before we get into a discussion of how to finance an investment property, it's important to clearly define what an investment property is.

There are three different categories a residential property can fall into:

  • A primary residence is a home that you live in. You don't need to live there all year long -- for example, many people in colder climates live somewhere warmer during the winter months. The point is that a primary residence is your "home base." One key point to know is that you can only have one primary residence at a time.
  • A second home is loosely defined as a home that you live in some of the time but isn't your primary home. Despite the name, you can have more than one second home. You can rent out a second home when you aren't there, but most lenders (and the IRS) have minimum occupancy requirements for second homes. We'll get into why the definition of a second home can be important for financing later on.
  • Finally, an investment property is one that you never live in. Your primary purpose for buying and holding it is to make a profit on it. This doesn't mean a property you buy to fix and flip for a profit. An investment property is one you hold to produce income and long-term capital appreciation, not simply to resell it at a profit.

These are listed in order of the easiest to finance to the most difficult. While it's not quite this simple, investment properties typically represent more of a risk to a lender than a second home, which in turn represents more of a risk to a lender than a primary residence.

Think of it this way: If times get tough and you had to choose, would you stop making payments on the home your family lives in or on a duplex that you rent out? Most people prioritize the home they live in, and lenders know that. They take this fact into account when making decisions about investment property financing.

How to get the best investment property financing possible

Different types of lenders consider different things when making decisions.

Investment properties represent a generally higher level of risk to lenders. One of the smartest things you can do before trying to get investment property financing is to make yourself as attractive a buyer as possible.

Your credit score

Your credit score is a good place to start. Different lenders and loan programs have varying credit score requirements, but I've never encountered an investment property lender that didn't perform a thorough credit check.

I won't get into a thorough discussion of how to improve your credit score, but there are a few important concepts to mention.

First, when you check your credit score, make sure you're looking at a FICO credit score, as this is the type that virtually all lenders use. Many of the "free credit score" services provide a credit score that's based on your actual credit information, but the FICO Score can be significantly different than these.

Some credit card companies have started to provide a FICO Score for free as a perk to their customers, but you may have to pay for it.

Another reason you might want to pay for your credit score is that you have three different FICO Scores -- one from each of the major credit bureaus. And there are several different versions that can be generated from each bureau's credit file. In fact, most mortgage lenders use different versions than other consumer lenders.

In all, there are actually 28 different FICO Scores lenders could see. It could be worth it to buy access to these if you're serious about maximizing your credit score. I've used for the past 12 years, and I have nothing but great things to say about it.

While the FICO scoring formula is a closely guarded secret, we know that it's made of five weighted categories of information:

  • 35% of your FICO Score comes from your payment history.
  • 30% comes from the amounts you owe on your various credit accounts.
  • 15% comes from the length of your credit history.
  • 10% comes from new credit activity.
  • 10% comes from your "credit mix," or the diversity of accounts on your credit report.

FICO Scores range from 300 to 850. Higher scores are better. Different lenders have different cutoffs, but a FICO Score of 740 or higher should qualify you for virtually any loan program you want. A score of 760 or above should get you a lender's best rates.

Your debt-to-income ratio

Your personal debts and income only matter for certain types of investment property loans. But, when trying to finance investment properties, it's a good idea to give yourself as many options as possible.

The lower your monthly debt obligations are as a percentage of your pre-tax income, the stronger your application will be. For example, if your mortgage, auto loan, student loan, credit card, and any other monthly obligations on your credit report add up to $3,000 and you earn a pre-tax income of $10,000 per month, you have a debt-to-income (DTI) ratio of 30%.

Lenders may consider two different DTI ratios. Your front-end DTI ratio is your mortgage payments as a percentage of your income. Lenders place more weight on this factor when financing a primary residence. Your back-end DTI ratio is all of your monthly obligations, including your mortgage payments.

One important concept when it comes to investment properties is "can the property's rental income be included?" The answer is "maybe." If the property has a documented rental history or a rental appraisal, a conventional lender may count 75% of the expected rent as income to you.

Assets and reserves

Most lenders want borrowers to have a certain amount of money in liquid reserves. This is usually expressed as a certain number of months' worth of mortgage payments, including taxes and insurance.

Different lenders have different guidelines, but don't expect to get investment property financing without three months' worth of liquid reserves. Some lenders want at least six months' worth. Even more will make your application stronger.

How much of a down payment do you need?

The short answer is that you'll need at least 20% down to finance an investment property. It's not uncommon for lenders to require 25%, 30%, or even more in certain circumstances. You may have read other articles and books on financing investment properties with "creative" methods to buy properties with no money down. But you should plan to put at least 20% down unless one of the following exceptions apply:

  • You're using a conventional loan to finance a single-family investment property. You can do this with a 15% down payment. However, you'll also need mortgage insurance, which can eat into your rental income.
  • You use a house-hacking technique to buy an investment property.
  • You finance your investment property as a second home. Conventional financing can be obtained for properties that meet the definition of a second home with just 10% down.

We'll talk about each of these methods below.

Ways to finance an investment property

Besides traditional mortgage financing, there are several ways you can finance your next investment property.

Conventional financing

Conventional mortgages meet the lending standards of one of the government-sponsored mortgage giants (Fannie Mae or Freddie Mac).

If a loan meets their standards, one of these agencies will guarantee the mortgage. This makes it less risky to a lender than if they carried the risk themselves.

The down payment and credit score requirements for an investment property depend on the borrower's DTI ratio and liquid reserves. The number of living units also affect the requirements. You can find Fannie Mae's standards on its latest eligibility matrix. It's a good resource to help determine if conventional financing is right for you.

Conventional investment property loans have higher interest rates than comparable primary or second home loans. Also, know that it can be difficult to have more than four conventional loans on your credit report at any given time.

To open more than four conventional mortgages at a time, you'll need six months' worth of loan payments in reserve when you close. For mortgages five through 10, you'll need at least 25% down for a single-family home and 30% down for a multifamily property.

You'll also need a clean record when it comes to your other mortgages -- no late payments, bankruptcies, or foreclosures on your record. And you'll need a credit score of at least 720 if you already have four or more mortgages and want to open another conventional loan. Ten conventional mortgages is the absolute maximum any individual can have at any given time.

House hacking

Here's one of the best ways to buy an investment property with less than 20% down and without using any "creative" financing methods. But it isn't right for everyone.

House hacking is buying a multifamily investment property and living in one of the units while renting out the others. Multifamily properties have two to four units. If you're living on the property -- even though there's more than one housing unit -- you can finance it as a primary residence.

It can be far easier to get financing for a primary residence than an investment property. Credit and reserve requirements tend to be more flexible. Plus, primary residence mortgages typically have significantly lower interest rates than comparable investment property mortgages.

The best part for investors without a ton of cash is that primary residence mortgages can be obtained with less than 20% down. You can get a conventional mortgage with 15% down on duplex properties or an FHA mortgage on a property with up to four housing units for as little as 3.5% down. And if you qualify, you could even use a VA mortgage to buy an investment property you intend to live in with no down payment whatsoever.

You can repeat this hack to build a portfolio over time. You can generally only have one FHA mortgage at a time, but it isn't terribly difficult to have more than one conventional mortgage. And you can always refinance your FHA loan into a conventional mortgage to keep that tool in your arsenal.

If you get a primary residence mortgage, you're generally required to live in the property for at least a year. Your lender will tell you the exact requirement. Once this time has passed, you're free to house hack again.

One word of caution. Don't try this method unless you're actually planning to live in the property. Getting a mortgage under false pretense is mortgage fraud, and the penalties can be severe.

While it's rare that someone will actually show up to verify that you're living in a financed property, it's not worth the risk.

Investment property/commercial lenders

There are several reputable lenders that specialize in making loans to investors. These are often referred to as commercial lenders, but the terminology can vary. The common feature here is long-term mortgage loans that don't consider the borrower's personal income and debts.

These can be excellent options for investors who can't get a conventional mortgage. Commercial lenders generally base their lending decisions on two factors: the borrower's credit score and whether the property will produce sufficient cash flow to cover the loan payments.

Commercial loans can also be excellent choices for investors who want to buy properties through an LLC, partnership, or S-Corporation, as most other types of lenders generally won't lend to non-individuals.

The downside is that commercial loans typically have higher rates and fees than conventional investment property mortgages. Expect to pay at least a percentage point or two higher in terms of APR and a higher origination fee.

Another caveat is that these lenders often want experienced investors. For example, I know one large commercial lender that wants at least one investment property in their customers' portfolios before they'll consider a loan. However, there are some that will work with rookie investors.

A few examples of reputable commercial lenders are LendingOne, Lima One Capital, and Visio Lending, but there are several others.

Second-home financing

While conventional lenders want a minimum of 15% down to finance an investment property (and many lenders will want 20%), second home conventional financing can be obtained with just 10% down.

Second-home financing is only available for single-family properties. In other words, you can't call a triplex a second home.

Fannie Mae's underwriting standards allow second homeowners to rent out their properties when not in use, with the following requirements:

  • The property must be occupied by the borrower for some portion of the year.
  • A second home must be a one-unit dwelling.
  • The home must be suitable for year-round occupancy.
  • The borrower must have exclusive control over the property.
  • It must not be a rental property or subject to a timeshare agreement. However, there's a footnote that "If the lender identifies rental income from the property, the loan is eligible for delivery as a second home as long as the income is not used for qualifying purposes, and all other requirements for second homes are met (including the occupancy requirement above)."
  • The home cannot be subject to any agreements that give a management firm control over the occupancy of the property.

In simple terms, this means you can rent a property financed as a second home if you use it some of the time each year and don't hire a property manager to find renters.

Having said all that, it's important to mention that other lenders might have their own restrictions. Some will make second home loans as long as they conform to Fannie Mae's minimum standards. Others don't allow second home loans if the property is to be rented at all. Some have a rental restriction that's somewhere between the two extremes.

If you're going to use conventional financing, it's generally easier and more cost-effective to use second home financing if you're planning to occupy the property at all. Vacation rentals make excellent candidates for second home loans.

Hard money lenders

Yet another financing option is to find a hard money lender. I won't spend too much time on this because they're better short-term options than permanent financing methods like conventional and commercial mortgages.

Hard money loans generally have higher interest rates and shorter terms. For example, a hard money loan may be five years of interest-only payments with the entire principal balance due at the end. These typically only make sense if you're planning a quick sale of the property or if you anticipate being able to refinance before the term is up.

Other ways you could finance an investment property

If you've exhausted those options, there are some other ways you could get financing for an investment property:

  • Home equity loan or line of credit: Borrowing against the equity in your home could be a smart way to fund an investment property. These loans can generally be obtained with relatively low interest rates and reasonable fees. Plus this (as well as the next two options) effectively make you a cash buyer, which can make your offers more attractive to sellers.
  • 401k loan: Many 401k and similar retirement plans let participants borrow up to $50,000 from their funds. While retirement funds should be used for retirement, there's a solid value case to be made for investment properties. After all, you'll generally pay prime plus one on a 401k loan, and the interest is being paid to you, not a bank.
  • Owner financing: Getting a seller to finance a property themselves isn't unheard of, but it isn't common, either. Owner financing is often suggested as one of the "creative" ways to buy an investment property with little or no money down. If someone offers owner financing or you want to ask, great. But I'd advise against planning on using this method.
  • Crowdfunding: The real estate crowdfunding industry is evolving rapidly. Although there aren't a ton of choices when it comes to single residential rental properties, several new options will likely come to market soon. Groundfloor is a good existing option if you're interested in pursuing this route.

Three final tips to make financing your investment property as easy as possible

I'll leave you with three suggestions to make sure the investment property financing process goes as easily as possible:

First, don't just check major lenders. You might be surprised at how willing some smaller local banks and credit unions are to finance investment properties. These institutions also have an excellent knowledge of their local markets. Don't overlook them.

Second, get your documentation in order before you start applying. Besides a signed purchase agreement, gather your recent tax returns, W-2s, contact information for your employer, and other documents. When you apply for a mortgage, you'll need a lot of paperwork before your loan can be processed. The less time you take to get everything in your lender's hands, the better.

Finally, be responsive throughout the process, especially if you have a tight closing time frame. If your lender has a question for you (and they will, trust me), it's important to respond as quickly as possible. Expect curveballs and deal with them quickly.

Investment property financing is a complex topic, and it's important to know the practical options and best practices for navigating the process. There's no one-size-fits-all way to finance investment properties, so weigh the pros and cons of each financing method to find the best fit for you.

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