How Buying an Investment Property Differs From Your Average Mortgage

How Buying an Investment Property Differs From Your Average Mortgage

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Unlike mortgages for primary homes, mortgages for investment properties such as rentals, fixer-uppers and multi-unit homes come with additional hurdles that buyers must navigate. These include extra documentation and more stringent underwriting requirements. It takes a more nuanced approach to successfully purchase a property for investment.

How is the Homebuying Process Different for Investment Properties?

The purchase process for an investment property is complicated by the fact that there is significantly more information that the lender will want to consider. Since an investment property makes your financial situation more complex that usual, the requirements are stricter and more numerous. In addition, the mortgage rates you’re quoted will likely be higher than if you were living on the property yourself.

Most of the things that might differ will be on the mortgage approval side. However, once your offer is accepted, purchasing a rental or investment property generally follows the same path as an owner-occupied primary residence. Below are some of the key points on which investment property purchases differ from a standard mortgage.

Debt-to-Income Ratio

When buying the first home you plan to live in, your debt-to-income ratio reflects the housing expenses for that property alone. If you buy additional properties for investment, the added costs of ownership for your new and existing properties need to be factored into your debt-to-income ratios for qualifying purposes. This added complexity increases the amount of time and effort required to obtain a home loan for an investment property.

Accounting for Additional Income

In mortgage applications for investment properties, lenders often request a Comparable Rent Schedule (known as an appraisal form or Form 1007) in addition to an appraisal to ascertain the revenue potential of the property relative to local rental rates. This is especially important if your lender will allow you to use that projected rental income to qualify for your loan. If you don't plan on renting out the property, you may be able to skip this step—though your chances of approval may take a hit from the loss of potential income.

Likelihood of Loan Approval

If you intend to fix up the property and resell it for a profit relatively quickly, lenders may be more reluctant to provide you with long-term financing. This is because an early repayment would reduce the total amount of interest the lender can collect from the loan, hurting its expected profits.

In such cases, your loan-to-value is going to depend on the current market appraisal, not the potential future value of the home. If you plan on buying a home to flip after a couple of years, you may want to consider short-term financing options like construction or rehabilitation loans that range from six to 18 months instead.

How Do Mortgages for Investment Properties Differ?

The fixed costs to obtain a mortgage for an investment property aren't very different from those on a primary home. You'll pay the same amount for items such as title inspection, escrow services and underwriting fees. However, you will face higher interest rates and loan pricing due to the higher risk of default on investment properties. Lenders also have stricter underwriting standards that affect each of the following factors.

Interest Rates

The biggest difference between an owner-occupied property and an investment property are the interest rates and loan-level pricing adjustments applied by the lender. Financing an investment property requires higher interest rates and more expensive discount points on those rates. Investment property owners typically have at least one other home, which makes them riskier applicants in the eyes of a lender and increases their borrowing costs.

Down Payment Requirements

A typical down payment requirement on a rental property is between 20% and 25%, though lenders can allow for lower down payments at their discretion. Certain property types and characteristics can require a higher down payment of 30% to 35%—for example, condos with hotel-like amenities or communities that allow for short-term vacation rentals.

Lenders require a higher down payment because borrowers who encounter hardship are more likely to default on these types of properties before they give up on payments for their primary residence. Lenders compensate for this risk by collecting a larger down payment on the property.

Qualification Thresholds

If you are a first-time investment property buyer, lenders will adjust for your relative inexperience by imposing stricter guidelines on vacancy factors, projected rental income and reserve requirements. As you become more experienced and build a track record of profitable property management, the underwriting process becomes more accommodating.

Unless you have a lease agreement already in place with a prospective tenant, lenders will assume a 25% vacancy factor, allowing you to qualify with 75% of the projected rental income they calculate. The amount you need to show in liquid cash reserves is up to the lender, but six to 12 months worth of principal, interest, taxes, insurance and HOA dues for each property is standard.

How to Qualify For a Mortgage on an Investment Property

When you’re in the market for a mortgage on an investment property, there are several things you should do to increase the odds of qualifying:

  • Maximize Your Credit Scores: Do everything you can to boost your credit score prior to applying for a mortgage on an investment property. The minimum qualifying scores are higher on investment properties than they are on primary homes, and the best interest rates and terms go to the applicants with the best credit scores and credit profiles.
  • Minimize Your Debt-to-Income Ratio: The lower your debt-to-income ratio, the easier it will be to qualify for a mortgage on an investment property. Pay down installment loans and revolving debts ahead of your purchase to get your ratio as low as possible. You should also avoid adding any significant amounts of other debt before applying.
  • Report All Verifiable Sources of Income: If you have any alternative sources of income like pension checks or rental income, adding them to your application can increase the likelihood of approval. Also, while it’s unlikely that you would find your own tenant ahead of closing on a property, investors often “inherit” existing tenants if the property was already rented out prior to the sale. If there's enough time left on their current lease, or if they're willing to extend it, you may be able to use this income to qualify.
  • Make a Large Down Payment: Making a bigger down payment increases your initial stake in the property and reduces the amount the lender must finance, effectively transferring risk from the lender to you. The resulting decrease in your loan-to-value ratio will make it easier to qualify for a mortgage.

Alternative Ways to Finance Investment Properties

If you’re having trouble qualifying for a mortgage on an investment property, here are some alternative financing options for you to consider. Some of these options are more expensive than a traditional mortgage, but others may actually save you more money in the long run.

Home Equity Financing

If you have a considerable equity stake in your current home, you could refinance and take cash out of the property or use home equity to fund your investment property purchase. The benefit of this is that you don't have to offer up any new properties as collateral, although the home you're taking equity out on would be put on the line if you encounter any financial difficulties with your new investment property.

Cross-Collateralization Financing

This specialty program allows you to create a single mortgage spanning two or more properties, with both properties used as collateral for your loan. This is especially useful if you already own a significant amount of equity in an existing home. Pledging additional assets makes your case stronger and more attractive to the lender. The risk of this strategy is that all of the properties are pledged as collateral and are therefore subject to foreclosure in the event of default.

Seller-Based Financing

Sometimes called seller-carry financing, this method involves creating a private mortgage in which the seller also acts as the lender. One of the downsides of seller-based financing is that few sellers are able or willing to participate. Also, the interest rates on a private loan will be much higher than a traditional mortgage.

Private and Portfolio Lending

Also called "hard money" loans, portfolio loans involve private equity firms or portfolio lenders creating custom loan options without needing approval from external investors. Interest rates are high, and the loans themselves can carry costly features like balloon payments and prepayment penalties. If you choose this option, examine the terms and conditions carefully to make sure you fully understand them.

Personal Loans and Credit Cards

These uncollateralized or unsecured loans are made directly from the lender to you, solely based on your income and qualifying assets. They aren’t tied to the property at all, which means that appraisals, loan-to-value ratios and occupancy status don't come into play. However, this also means that if you default, you won't be able to give up your house in order to pay off the loan. This form of financing can also cost more due to the high interest rates on personal loans.

Credit cards should never be used to make payments on mortgages, since they involve expensive revolving terms and may be treated as cash advances by the lender. Fannie Mae lending guidelines also prohibit the use of credit cards for down payments, making them a non-option for home purchases.

Kenny Zhu

Kenny is a Banking and Mortgage Research Analyst for ValuePenguin and has worked in the financial industry since 2013. Previously, Kenny was a Senior Investment Analyst at PFM Asset Management LLC. He holds a Bachelors of Science from Carnegie Mellon University, where he majored in International Relations & Politics. He is a CFA® charterholder.

Editorial Note: The content of this article is based on the author’s opinions and recommendations alone. It has not been previewed, commissioned or otherwise endorsed by any of our network partners.

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