What Are Investment Property Loans?

What Are Investment Property Loans?

Many individuals and small companies invest in properties for profit and finance their investments with loans. Investment property loans finance rehabilitation projects in which properties are fixed up and then either resold ("fix-and-flip" deals) or rented out. The loans financing these projects are usually short-term, and they're also known as hard-money loans or bridge loans. Investment properties can be residential or commercial, but they can't be the investor's primary residence. However, you might be able to live in one of the units in a multiunit residence and still secure the loan.

How Do Investment Property Loans Work?

The investment property acts as the collateral in an investment property loan. The lender (sometimes a bank but often a commercial hard-money lender) will finance the purchase of the property, the rehabilitation of the property or both. The loan amount is based on the lender's loan-to-value requirements. Typically, hard-money lenders will lend 60% to 80% of the property's estimated after-repair value (ARV). Notice that this is different from banks, which base their loan amounts on the current market value of the property.

In a typical transaction, a rehabber will ask an investment property lender to finance the purchase of a single-family house, condominium unit, multifamily dwelling or commercial building that requires repair. The lender will evaluate the property's asking price, the amount the rehabber will invest in the fix-up and the estimated after-repair value. Based on the evaluation, the lender will offer a loan within its loan-to-value parameters, specifying an interest rate and payback period. In some cases, the loan may be broken into tranches, one for the property purchase and one or more for the rehab. The borrower agrees to provide the lender with a lien on the property, allowing the lender to seize the property in case of default.

If the property is a fix-and-flip, the rehabber will sell the completed property and use the proceeds to repay the loan and, hopefully, extract a profit from the deal. If the property is to be rented out, the rehabber will typically replace the short-term loan with a conventional long-term mortgage, often at a more favorable interest rate.

As an example, Joe and Betty are a husband-and-wife rehab team. They find a foreclosed single-family home for sale that they feel would be a good fix-and-flip project. The property was last purchased for $200,000, but the bank is willing to sell for $120,000. Joe and Betty believe that a $40,000 investment will create a property that will sell for $200,000 after repairs. They find a hard-money lender who agrees with their ARV estimate and is willing to lend 70%, or $140,000. Joe and Betty agree to the loan, and they use the proceeds to purchase the home and pay for half the rehab. They give the lender a lien on the property and contribute $20,000 to complete the project. If they then sell the property for $200,000, they will clear a profit of $40,000, which is a 200% return on their $20,000 equity contribution.

Bank Loans vs Hard-Money Loans

Investment property loans from hard-money lenders are different from bank loans in several ways:

1. Access: Hard-money lenders focus on the value of the property rather than the credit standing of the borrower. That means you can access a hard-money loan if you can present a good deal, even if your credit rating isn't perfect.

2. Speed: Bank loans can take weeks to arrange, since banks thoroughly assess the borrower. Hard-money loans are usually completed in a few days, as it's much easier to evaluate the property rather than the borrower.

3. Equity: Many banks will make investment property loans at an 80% loan-to-value ratio, but that number applies to the before-repair value. Hard-money lenders might offer a lower loan-to-value ratio, but it's based on the after-repair value, which might end up being a larger loan amount.

4. Cost: If you can get an investment property loan from a bank, it means you have a good credit rating, so expect to pay less interest than you would for a hard-money loan. Don't forget to factor in closing costs, which usually come to 1% to 3% of the loan amount.

Average Rates and Terms for Investment Property Loans

These are the average rates and terms for investment property loans.

Hard-Money LenderBank
Amount Financed60% to 80% loan-to-value ratio of after-repair valueUp to 80% loan-to-value ratio of current market value
Interest Rate10% - 18%5% - 9%
Funding Time2 - 4 days2 - 5 weeks
Credit Score RequirementsNoneExcellent (720+)
Loan Term3 - 12 months3 - 12 months

How to Qualify for an Investment Property Loan

If you want an investment property loan from a bank, you'll generally need to have an excellent credit score (at least 720 on the FICO scale) to qualify for a reasonable interest rate, but that is not necessary for a hard-money loan. Your project will have to fit within the lender's loan-to-value ratio requirements. Banks typically lend 80% of the before-repair value, whereas hard-money lenders will lend 60% to 80% of the after-repair value. You will have to show you have enough cash to contribute 20% to 40% of the cost to the project. The lender will require a lien on the property, which acts as collateral on the loan. You might have to provide a business plan for the project, including a budget for construction or renovation costs, title statements and property assessments. Banks require copious amounts of paperwork, but hard-money lenders require much less.

Where to Get an Investment Property Loan

The two main sources of investment property loans are banks and hard-money lenders. Some large banks in this market include U.S. Bank, Bank of America and Wells Fargo, but you might be able to get a better deal from a local bank or credit union. You can get hard-money loans from commercial financial firms such as RCN Capital, LendingHome, Patch of Land and Lima One Capital. If you research lenders online, be sure to check their credentials and the complaints lodged against them, using resources like the Better Business Bureau and your state's attorney general's office. You may also be able to work out a financing deal directly with the owner of the property.

Another option is to tap into your home’s equity through a home equity loan or line of credit (HELOC). These loans allow you to borrow against the equity you’ve built up in your primary residence, generally up to 80% of the equity value. However, these loans are secured by your home, meaning that the bank can foreclose if you fail to make payments. We don’t recommend this option for new or inexperienced rehabbers.

Justin is a Sr. Research Analyst at ValuePenguin, focusing on small business lending. He was a corporate strategy associate at IBM.