What you should know when purchasing your first investment property

Financing the purchase of residential rental properties is a bit different from buying a primary residence. Lenders often have stricter requirements, and there are additional financial considerations when investing in rental real estate. Here's an overview of the main aspects involved in financing rental properties.

When financing a rental property, you have several loan options to choose from, including:
Conventional Mortgages
These are traditional loans not backed by the government, typically offered by banks, credit unions, and mortgage lenders. For rental properties, lenders often require higher down payments (typically 15-25%) and charge higher interest rates than for primary residences.

Government-Backed Loans
 While FHA (Federal Housing Administration) and VA (Veterans Affairs) loans are primarily for primary residences, you might be able to use an FHA loan to finance a multi-unit property (up to four units), provided you live in one of the units. This option allows for a lower down payment, typically around 3.5%, but requires mortgage insurance.

Portfolio Loans
Some lenders offer portfolio loans, where they keep the loan in-house instead of selling it on the secondary mortgage market. These loans are more flexible and may have less stringent requirements but often come with higher interest rates.

Private Loans
These can be an option if you’re having trouble qualifying for a traditional mortgage. Private lenders include individuals, investment groups, or companies willing to finance real estate deals. These loans usually have higher interest rates and shorter repayment terms but offer flexibility.

Hard Money Loans
Hard money loans are short-term loans secured by real estate. These loans are easier to obtain but come with higher interest rates and shorter repayment periods, making them better suited for investors looking to flip a property rather than hold it long-term.

When purchasing a residential rental property, the down payment requirements are usually higher than for a primary residence. Here are some general guidelines:

Single-Family Rentals
For most lenders, you will need a down payment of at least 15-20% of the purchase price. In some cases, a down payment of 25% may be required to get a better interest rate.

Multi-Family Properties
If you’re purchasing a multi-unit property (up to four units), you might be able to qualify for an FHA loan with a lower down payment, but for conventional loans, you will likely need 25% or more down.

Lenders require these higher down payments because rental properties are considered riskier investments than primary homes. If you face financial difficulty, you're more likely to default on an investment property than your primary residence.

Your credit score and debt-to-income (DTI) ratio will play significant roles in securing financing for rental properties:

Credit Score
Most lenders will require a credit score of at least 620 for a conventional loan, though 700 or higher is often needed to secure the best rates for investment properties.

Debt-to-Income Ratio
Lenders typically require a DTI ratio of 43% or less for investment property loans. The DTI ratio calculates your monthly debt payments relative to your income. If you're purchasing a rental property, potential rental income may be considered in this ratio, though many lenders discount this income to account for vacancies.

One of the advantages of financing a rental property is that lenders will often factor in potential rental income when evaluating your application. However, they may not count the full amount:

Rental Income
Lenders typically only consider 70-80% of the expected rental income when determining whether you can afford the mortgage. This accounts for potential vacancies and maintenance costs.

Cash Flow
It's important to analyze the property's cash flow before purchasing. Calculate your potential income (rent) and subtract all expenses, including the mortgage payment, property taxes, insurance, maintenance, and property management fees. Positive cash flow is key to a successful rental investment.

Loan Terms
The most common loan terms for rental property mortgages are 15 or 30 years. Shorter-term loans generally come with lower interest rates but higher monthly payments, while longer-term loans have higher interest rates but more manageable monthly payments.

Interest Rates
Interest rates for investment property loans are generally higher than for primary residences. You can expect rates to be about 0.5% to 1% higher, depending on your credit score, down payment, and other factors. Rates can also fluctuate with changes in the market.

Points
Some lenders may charge points (prepaid interest) to reduce the loan's interest rate. Each point typically costs 1% of the loan amount and reduces the interest rate by about 0.25%. The amount saved could calculate to a big savings over the life of the loan.

Closing Costs
Expect to pay closing costs similar to a primary home purchase. These typically range from 2-5% of the loan amount and include origination fees, title insurance, appraisal fees, and other processing costs.

Before applying for financing, it’s important to prepare by:

Improving Your Credit Score
Pay down debts and make timely payments to boost your score.

Saving for a Larger Down Payment
A larger down payment can increase your chances of getting a loan and lower your interest rate.

Documenting Your Income
Lenders will require documentation of your income, including tax returns, pay stubs, and bank statements. Make sure all your financial information is up to date.

The type of property you're buying also affects financing options. Lenders view non-owner-occupied properties (rental properties) as riskier than owner-occupied homes, so the rates and terms may vary. However, if you plan to live in one unit of a multi-family property, you may be able to qualify for more favorable terms as an owner-occupant.

In summary, financing a rental property involves more stringent requirements, higher down payments, and often higher interest rates than for primary residences. However, with careful planning, strong financials, and proper research, securing financing for a rental property can be a solid step toward building wealth through real estate investment.