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One topic that crops up again and again among new investors is how to finance an investment property. In truth, the answer to this age-old question is simply to get an investment loan. With that in mind, this is a primer on how investment loans work. We'll cover what investment loans are, what types of financing are available to real estate investors, and what the best practices are for anyone who's considering taking out one of these types of loans.
What is an investment loan?
At its core, an investment loan is just another term for any loan used to finance the purchase of an investment property. Generally, investment loans tend to fall into one of two categories. Either they are put toward a fix-and-flip strategy, where a property is fixed up and then sold quickly for a profit, or they are put toward a buy-and-hold strategy, where the property is meant to be rented out and kept in the Investor's portfolio long-term.
An investment loan can be put toward any type of real estate investing, whether it's commercial real estate or residential. However, these loans typically cannot be put toward the purchase of a primary residence. Notably, since you will not be living in the property you purchase, these loans are considered higher risk. As such, they often come with stricter qualifying requirements than a simple home loan.
What types of loans are available to property investors?
Now that you have a better idea of what an investment loan is, it's important to go over the different types of loans that are available to property investors. While there are many different investment loan options out there, they all tend to fall into one of three categories.
We've laid them out below for your consideration. Read them over to figure out which type of loan might be the best fit for you.
First, you could try to take out a conventional loan. A conventional loan is a traditional bank loan that meets the qualifying guidelines set by Fannie Mae and Freddie Mac. Unlike an FHA loan or a VA loan, a conventional mortgage is not backed by any particular government agency.
The advantage of using a conventional bank loan for your investment property mortgage is that conventional loans tend to offer the best loan terms. While the mortgage rate you'll pay for financing the purchase of an investment property will undoubtedly be higher than if you were purchasing a primary residence, the investment property mortgage rate you'll receive from a conventional lender will probably be close to the market rate. Like a traditional loan, you'll likely also have the option of selecting either a 15-year or 30-year loan term.
That said, there are disadvantages to selecting a conventional loan as well. Typically, these loans are only available to the most qualified borrowers. In general, these loans require either a good or excellent credit score and a sizable down payment, usually 20% to 30%.
Hard money loan
While a traditional loan may be the best option for a rental property loan because of the ability to select a longer loan term, if you're following a fix-and-flip investment strategy, you may want to look into getting a hard money loan instead. A hard money loan is a type of private money financing option. Typically, these loans are meant to be short-term financing, but that's not always the case.
The big advantage of hard money loans is that, in this case, your investment property lender will likely have much different qualifying criteria than a bank or another financial institution. Where traditional lenders are focused on your financial profile as the investor, hard money lenders are typically much more interested in the property itself. Typically, the after-renovation value of the property is what dictates how much you're allowed to borrow.
However, there are also disadvantages to using a hard money lender. Specifically, these loans tend to come with much higher interest rates than you might find at a bank. Hard money loans can also come with much steeper fees if you are unable to keep up with your monthly payments.
As a real estate investor, it's your responsibility to make sure you understand any outlined loan terms before you sign on the dotted line and to make sure you have enough cash flow to follow through on your payments.
Home equity loan
If you own your own home already, the other option is to take out a home equity loan. As the name suggests, a home equity loan allows you to borrow against the equity you've built up in your home from making mortgage payments. You should know that home equity loans work like mortgages. In this case, you'll be given the money in one lump sum and you'll make a regular monthly payment toward both the principal and the interest on the loan.
Like with any type of financing, there are advantages and disadvantages to taking out a home equity loan. In particular, the biggest advantage is that these loans typically have competitive interest rates. Also, depending on your lender, you may not have to pay as many upfront fees with a home equity loan as if you were getting a conventional mortgage.
The biggest downside is that your home generally serves as collateral for a home equity loan, meaning that if you stop making your payments, the lender could foreclose on your primary residence. In addition, there is also a limit to how much you can borrow. Generally, lenders only allow you to borrow up to 85% of your home's equity.
Best practices for first-time investors
While each option for an investment property loan has its own unique quirks, there are some things you can do to put yourself in a better borrowing position and to ensure that you secure the best rates. With that in mind, we've laid out some of the best practices for first-time investors below. Take a look so you'll know what to do when you're ready to apply for a loan.
Have a strong borrower
If you're looking toward either a conventional loan or a home equity loan, there's a good chance your credit score will impact the interest rate you're offered. To that end, it's best if you get your credit score in shape before you apply.
As for how to make that happen, your payment history accounts for 30% of your credit score. If you can, make sure to pay all of your cards on time and to pay above the minimum payment. Your credit utilization ratio, which is the measure of the amount of credit you've used versus the total amount of credit you have available, also accounts for another 30% of your score. it's best to use as little credit as possible to keep your ratio low.
Have a bigger down payment
As a real estate investor, you're going to need a bigger down payment than someone buying a primary residence. Typically, bank loans look for you to have at least 25% -- if not more -- to put down on the property. However, no matter what type of financing you're after, having money in the bank will only help. Overall, it will lower your loan-to-value ratio, which should give you access to more favorable loan terms.
Consider house hacking
Lastly, you could consider house hacking. House hacking involves taking out a home loan for a multi-unit property, living in one of the units, and renting the others out to tenants. Choosing this method will give you the ability to use a government-backed loan like an FHA loan to buy your property. Since FHA Loans have more flexible qualifying requirements than conventional mortgages, going this route can give you access to traditional financing even if you have a smaller down payment or lower credit score.
The bottom line
By now, it should be clear that there are plenty of investment property loan options out there. That said, whether you are an experienced investor or just getting ready to buy your first property, it's important to know that you don't have to make this decision on your own.
If you're wondering what type of financing might be right for your investment opportunity, consider talking to a loan specialist in your area. They'll be able to look at the specifics of your financial situation and give you suggestions on what type of financing might make the most sense for you.
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