Securing funding to purchase a rental house is challenging; it’s much harder than getting a loan on your primary residence. If you are familiar with a traditional mortgage, you are halfway there, but there is much to learn. I have over 70 rental properties, most with loans, so I have been through the process numerous times and will explain the best way to finance rental properties.
Getting a loan for a rental property is harder than getting a traditional mortgage. A loan on a rental house will require a larger downpayment and a more strict approval process. You should expect your debt-to-income ratio, source of income, and employment history to be highly scrutinized.
While getting a loan on a rental house is more complex, it is undoubtedly doable if you know your options and plan ahead. This article will explain the options, illustrate when each is suitable, and show you what to prepare for.
Traditional Mortgage
Conforming Mortgage
A conforming loan is a mortgage loan that meets the guidelines set by the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac). A single-family rental requires a 15% downpayment and 25% for a multi-family property (up to 4 units). The minimum credit score to qualify for a conforming mortgage is 640, but this could go as low as 620 with an additional downpayment. This type of mortgage is unavailable if the borrower has more than ten mortgages. For further details, see the Fannie Mae Eligibility Matrix.
FHA Loan
An FHA loan is a type of mortgage loan insured by the Federal Housing Administration (FHA), a government agency within the U.S. Department of Housing and Urban Development (HUD). This type of loan is typically used to purchase a primary residence and cannot be used for a single-family rental property. However, an FHA loan can fund the purchase of a multi-family property if the borrower occupies one of the units. These multi-family loans require a downpayment of at least 10%.
VA Loan
A VA loan is a mortgage loan guaranteed by the U.S. Department of Veterans Affairs (VA) and is available to eligible veterans, active-duty service members, and their surviving spouses. Similar to the FHA loan, the only type of investment loan offered by the VA is a loan for a multi-family property with the borrower occupying one of the units. In many cases, no downpayment is required for a VA loan. For more details on this loan, see the VA underwriting rules.
Commercial Loan
It’s harder to get a loan for a rental property, but smaller community banks generally offer commercial loans, which are structured differently than residential loans. These loans usually have higher interest rates and more strict underwriting requirements than residential loans. Lenders will typically consider the buyer’s creditworthiness and the property’s cash flow when evaluating whether to extend a commercial loan.
Commercial loans tend to have shorter repayment terms than a traditional mortgage and often require a balloon payment at the end of the term. Under normal circumstances, the balloon payment is financed, at current rates, giving the effect of a long-term adjustable-rate mortgage. The interest rate of these loans depends on the specific situation, but they are usually about half a percentage above the prime rate.
These commercial loans from local community banks are not subject to Fannie Mae guidelines and are not limited to borrowers with less than ten mortgages. A borrower may qualify for a commercial loan with any number of mortgages and can bundle many properties into a single loan. In addition, commercial lenders are more adept at analyzing business tax returns. This skill can often get loans approved that failed to pass underwriting for a traditional mortgage.
Other Options
Home Equity Loan
A home equity loan is a type of loan that allows homeowners to borrow money against the equity they have built up in their primary residence. This equity is the difference between the current market value of a home and any outstanding mortgage balance. These equity loans are also available as an equity line of credit, which allows the borrower to pull money from the line as needed. Interest is only charged on the outstanding balance, and the borrower can pay down the line anytime.
When a borrower has substantial equity in their primary residence, a home equity loan (or line) is an excellent way to fund a rental property purchase. The rental house is unencumbered as the loan is on the borrower’s personal home. This has the effect of putting the owner’s primary residence at risk in the event of foreclosure.
Hard Money Loan
A hard money loan is a type of loan secured by the property. These loans are typically offered by private investors or companies rather than traditional banks or credit unions. Hard money lenders generally focus on the property’s value as collateral rather than the borrower’s creditworthiness.
Hard money loans have higher interest rates and fees than traditional loans. However, they can be a valuable tool for real estate investors and developers who need quick access to capital or cannot qualify for a traditional loan. These loans rarely require a downpayment if the property has sufficient equity. A hard money loan can be a good fit for short-term financing but is rarely a good choice as a long-term loan.
Conclusion
Is it harder to get a loan for a rental property? Yes. Getting a loan for a rental property can be more complicated than a primary residence. Lenders may view rental properties as riskier investments since they are not the borrower’s primary residence and may not be occupied by the borrower. As a result, lenders may have more stringent requirements for rental property loans, such as higher down payments, lower loan-to-value ratios, and higher credit score requirements. In addition, lenders may require borrowers to have a certain amount of experience as a landlord or in the real estate industry before approving a loan for a rental property.
Local community banks and specialized lenders focus specifically on rental property loans and may offer more flexible requirements and loan terms. In most cases, a conventional mortgage offers the best rates and terms, and a local community bank can handle situations specific to investment properties. If neither works, a borrower can consider a personal home equity loan or money from a hard money lender. As always, borrowers need to shop around and compare loan offers to find the best loan for their specific needs and financial situation.
