Buying a rental property is one way to create another stream of income. Likely, you must finance the property with a mortgage. But, it’s usually harder to qualify for a mortgage for a rental property than when buying a home. To help you navigate the rental property buying process, it’s important to understand the requirements. Here are some of the factors lenders take into consideration.
A financial advisor can help you create a financial plan for your mortgage and rental property needs.
Rental Property vs. Home: Getting a Mortgage
The mechanics of applying for a home mortgage or rental property one are similar. The biggest differentiator, however, is that the lender takes on more risk by offering an additional mortgage for a rental property. This is because lenders know that if you face financial struggles of any kind, paying your home mortgage is more important than making payments on your rental property. For this reason, there is a higher chance you could default on your rental property loan.
Because of the higher chance of default, lenders apply stricter guidelines for a mortgage on a rental property. As a result, your debt, income, credit and employment history have to be in great standing to qualify.
Lender Requirements to Qualify for a Rental Property
Here are a four lender requirements you should keep in mind before applying for your second (or third) mortgage.
Down payment. Depending on the type of financing you choose when you buy a home, you may only need a 3% down payment to qualify for approval. But, if you do put less than 20% down, your lenders will likely require private mortgage insurance. This policy protects your lender’s interest if you can’t fulfill your mortgage payments.
Because private mortgage insurance (PMI) doesn’t apply to rentals, you must have a larger down payment, usually 15% to 20% minimum. However, in some cases, you might need to put more down. For example, if you’re buying a multiunit property, the lender may require 25% down.
Debt-to-income ratio. Another main aspect of your finances a lender considers is your debt-to-income ratio (DTI). This is the ratio of your income to debt every month. Essentially it tells the bank how much of your income goes to paying off your debt.
Your ideal DTI to qualify for a rental property mortgage is usually between 36% and 45%. Most of the time, you can factor in 75% of your potential monthly income from renters as additional income. This is calculated during the appraisal and can lower the DTI.
Lenders don’t consider 100% of income from rental payments in case of possible vacancies. One thing to remember is if this is your first-time renting, a lack of history as a landlord may mean your lender won’t consider your rental income in the approval process. When that happens, lenders only consider your personal income.
Credit history. As a general rule, you must have at least a 620 credit score to qualify for financing. Ideally, a 740 or higher will help you qualify for the best interest rates and terms.
Rainy day fund. Since issues can arise with your rental, you must also prove you have sufficient money in your bank account. Having three to six months of savings set aside in a rainy day fund is a great idea. This sum should include the entire mortgage payment for three to six months.
What Type of Mortgage Do I Need for a Rental Property?
When getting a mortgage for a rental property, you don’t have as many financing options as you would with buying a home. There are typically more hurdles to jump than a traditional mortgage, and interest rates are higher. Always compare your options to find a loan with the best rates and terms available. Here are four types of loans to keep in mind.
FHA mortgage for multiunit home. Government-sponsored lending such as Veterans Affairs and U.S. Department of Agriculture loans and Federal Housing Administration is not an option for buying rental properties. But, if you plan to buy a multiunit property (up to four units) and live in one, you can potentially qualify for an FHA loan. Keep in mind FHA requirements might be less strict than qualifying for a conventional loan.
VA mortgage multiunit home. Through the U.S. Department of Veterans Affairs (VA), loans don’t require a down payment or minimum credit score. Active-duty service members, eligible spouses and veterans who qualify can buy a multiunit home with a VA loan. However, this property can only have up to four units, and you must occupy one.
Conventional mortgage. But, if you’re not in the market for a multiunit home that you plan to live in, you can apply for a conventional loan, either fixed or an adjustable-rate mortgage (ARM). Usually, you can get terms ranging between 10 and 30 years. Conventional mortgages have a 15%-20% down payment requirement, depending on the property type, plus your minimum credit score requirement will be higher. But you can own the property without having to reside in it.
Alternative mortgage solutions. Another option is to apply for a home equity loan or a home equity line of credit to purchase your investment property. Lenders typically let you borrow up to 80% of the equity in your home.
Lastly, you could consider private lending from an individual or group of investors. Exploring all of your options will help you pinpoint the suitable financing option for your needs.
Should I Buy a Rental Property?
Becoming a landlord can be financially abundant since it creates an additional stream of income, yields tax advantages and it aids in the accumulations of long-term financial security. But, it is also a big responsibility, so it is important to consider all of the details of owning a rental property.
For example, you’re responsible for repairs or problem tenants. All of which can be very costly if you’re not careful.
Here are a three key points to consider before investing in a rental property.
Your finances are in order. Any investment property requires a significant amount of financial stability. Nearly all lenders ask for a 15% down payment minimum to buy an investment property. However, this down payment amount isn’t usually required to buy your first home.
Unfortunately, a higher down payment isn’t the only expense, though. In addition to the initial purchasing expenses, you must budget to cover inspection costs, any reoccurring maintenance bills and repairs that may come up.
As a rental property owner, it is your responsibility to handle crucial repairs promptly. Unfortunately, repairs can become costly, especially when fixing HVAC or plumbing issues. Something to remember is that certain states allow tenants to stop paying rent until repairs are complete. That said, it’s wise to allow an ample budget to complete emergency and regular maintenance concerns.
Also, consider budgeting for advertising and credit checks to ensure your tenants are top-notch. Good tenants are essential and an asset. Conversely, bad tenants can increase your expenses significantly.
The investment is a good choice for your pocket book. It doesn’t make sense to invest in a property if you won’t see a return on your investment (ROI). There are a few steps to calculate your ROI.
First, estimate the annual cash flow from your renters. If you search and find comparable properties for rent and see the average monthly rent, multiply that by 12 to get your yearly income.
Then, you need to figure out your net operating income (your annual cash flow minus your annual operating expenses). These expenses equal the total amount of money it takes to maintain your property annually. Examples include:
- Property taxes
- Property insurance
- Homeowners’ association fees
- Maintenance costs
Avoid adding your mortgage into the calculation. After deducting your property expenses from your estimated rental income, you’re left with your net operating income.
Lastly, divide that number by the total value of your mortgage. That number left is your ROI.
Here’s an example:
- Let’s say your rental property mortgage is worth $300,000, for example. If you can get $1,000 of rent per month, your annual cash flow is $18,000 ($1,500 x 12). Assuming operating expenses are $600 per month, your total operating expenses are $7,200 ($600 x 12).
- Subtract your operating expenses from your annual rent income ($18,000 – $7,200) = $10,800 of net operating income.
- Divide your net operating income by the rental property mortgage amount ($10,800 ÷ $300,000) = 0.036. This means your rental property’s ROI 3.6%.
An ROI of 3% is a good benchmark for properties in communities with long-term responsible tenants. But, on the other hand, if the area is known for tenants who don’t stick around, an 3% ROI might not be enough.
You have time flexibility. Managing an investment property takes a lot of time. As a landlord, you must advertise when you have a vacancy, interview tenants and run background checks, keep track of rental payments and more.
So, when considering buying an investment property, make sure you have the time to run and maintain it. Hiring a property manager can take away some of the operational headaches, but it’s an additional expense.
Bottom Line
Investing in a rental property can help you create a stream of income and build wealth. But, there are a few things to consider before doing so. Knowing how a rental property mortgage is different from a home mortgage is first and foremost. Be aware of the differences in lender requirements and the different types of mortgages available.
Tips for Real Estate Investment
- A financial advisor could help you create a financial plan for your real estate investment needs. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- One of the most common investment forms is stocks. Though they can be a bit of a risky investment without ample diversification. Although EFTs and mutual funds present inherent diversification, a wonderful option for inexperienced investors.
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