Investment Property Loans And 4 Complexities You Should Know
There’s a lot of potential money in real estate. There are plenty of different ways that you can invest as well. However, just like when you bought your primary residence, you likely don’t have funds needed to buy an investment property outright and will need to take out a home loan. The thing is, taking out a loan for an investment property is a lot different than doing so to buy a house you’re planning on living in. The following is an overview of what’s required to take out an investment loan and what types of real estate investments you might consider.
Investment Property Loan Overview
Investment property loans are specific vehicles for purchasing property you make a profit from, whether by renting out the property over the long term or flipping the property. The reason that they are considered different than the standard mortgage loan is that there’s more risk involved for lenders approving a loan for an investment property purchase. The reason is simple: if the investment doesn’t pan out, you may not be able to pay back the loan.
While the lender can always foreclose on the property and sell it, there’s no guarantee that the sale will recover the full amount that was still owed on the loan’s balance. Borrowers who take out loans for investment properties are also more likely to default on those loans than on their own mortgage since they don’t want to lose their home. This means if they experience any financial trouble, regardless of whether the investment succeeded or not, they will prioritize payments on their personal homes over their investment properties.
Because of this, lenders tend to be much more strict when it comes to their lending requirements on investment property loans.
1. Loan-To-Value Ratio (LTV)
The LTV refers to the amount of the loan compared to the appraised value of the property. Lenders tend to require lower LTVs than traditional mortgages, necessitating that you make a larger down payment. While there are a few conventional loan programs out there that might allow an 80 percent LTV, it’s more common for lenders to require a lower LTV than that. You can expect to pay anywhere from 20 to 40 percent of the property’s price as a down payment. Compared to down payment requirements on conventional mortgages for primary homes of between 5 and 15 percent, this is relatively high.
2. Credit Score
Your credit score provides lenders with a pretty accurate idea of how financially responsible and/or capable you are when it comes to paying back your loan. Since you’re taking out a loan for a property you won’t be living in and are an inherently higher risk for lenders, they will require a higher credit score. Whereas conventional loans typically require a minimum credit score of 620 to 640, most lenders will prefer that you have a credit score of at least 740 to take out an investment property loan.
However, this doesn’t mean that if your score is below 740 that you can’t qualify. It’s not the only factor lenders consider when determining your eligibility. It does mean that your terms won’t be as favorable. Low credit scores will most certainly result in a higher interest rate and higher fees. It’s strongly recommended that you consider improving your score if it is below the 740 mark.
Taking out an investment property loan will be more expensive than a conventional loan, no matter how high your credit score might be. While the interest rate will be determined based on a variety of factors (your credit report and the current marketing being two major ones), expect it to be anywhere from 1 to 3 percent higher than a conventional loan interest rate.
This means that if the interest rate on a conventional loan is 4 percent, the interest rate for an investment property loan could be anywhere from 5 to 7 percent. This also applies to the points that you can purchase to lower your interest rate. Points will be more expensive to purchase on an investment property loan, and the upfront fees for taking out the loan will be higher as well.
4. Limitation On Mortgages
There are some limitations on how many investment property loans you can take out that are worth noting. You may want to invest in a number of different properties; however, even if you have amazing credit and a history of successful property investments, you may be limited. Most conventional lenders will not approve another investment loan once you have four mortgages on your credit, even if you’ve been making all of your payments on time and in full without any issues.
If you want to invest in a fifth property, you will have to go through a special Fannie Mae program that allows you to have between five and ten mortgages to your name. However, you will need to have at least six months worth of mortgage payments held as a liquid reserve at the time you take out your loan. Additionally, you will have to put down at least 25 percent on a single-family home and 30 percent on two to four unit properties as a down payment. To qualify for this program, you have to have almost a perfect mortgage payment record. If you have any bankruptcies, foreclosures, or late mortgage payments within the past year, you won’t qualify. There’s also a strict credit score minimum requirement of 720 if you have six or more mortgages.
If you own more than ten properties, your options are even more limited. You might be able to secure a loan from a small community bank that keeps their loans in their own portfolio. You could also potentially qualify for a blanket loan, which secures your loan against multiple properties. Another option could be to take out a home equity loan against your primary residence, although this puts your personal home at risk should you default.
Most Common Real Estate Arrangement
As a small investor, there are two types of real estate investments you’re probably considering–buying a property and improving its value so you can flip it at a profit or buying a property and renting it out. Both types of investments can be very profitable, although house flipping is generally more of a short-term investment while renting is a long-term investment. When deciding which investment suits your needs best, it’s a good idea to look at the pros and cons of doing each.
House flipping can be done in a few different ways. The most common way is to buy a house in need of extensive repairs or renovations. These types of properties tend to be available at much lower costs due to the work required. Once you fix it up, you’ll be able to sell at a profit. You can also buy a house in good shape and hold on to it. If the local housing market improves over the years, the property may appreciate in value, allowing you to flip it later down the line.
Here are the advantages and drawbacks to house flipping that warrant attention before making your decision:
Advantages Of House Flipping
- Potentially quick profit – If everything goes to plan, you’ll be able to purchase a property at well below its value due to its need for repairs and renovations. Once you make those renovations and repairs, you can put the house back on the market at a higher price than you purchased it for, thereby making a profit once it sells.
- Gain valuable experience – You’ll learn a lot about the real estate market by just flipping a single home. For example, you’ll learn about the costs of certain renovations and repairs, what homebuyers look for in a new house, how to identify fixer-uppers that have the potential for the most profit and more. This experience can help you earn bigger profits as you begin flipping more houses.
- Successful house flipping is rewarding – Besides the potential financial reward, you’re putting a lot of effort into renovating the house as well. It can be incredibly fulfilling to renovate and repair what was previously a rundown home into something beautiful that homebuyers flock to.
Disadvantages Of House Flipping
- The property might not sell – The worst-case scenario of house flipping is that you put a significant amount of money into renovations and repairs and it doesn’t sell. It’s why careful research about the neighborhood, about how much renovations will cost, and more are needed to help prevent serious financial trouble since you’ll be on the hook for the investment property loan if the house doesn’t sell. The longer it doesn’t sell, the lower you’ll have to reduce your asking price, to the point where you could lose money.
- The cost of unanticipated expenses – If you don’t do your research, you may find that flipping a house will cost more than you might have expected. If you didn’t budget for this properly or take this into account when determining if there was potential for profit, this can cause serious issues. Common unanticipated expenses for house flipping include building permits, permit delays, contractor delays, material delays, newly revealed problems that you have to pay to repair, costlier-than-expected renovations, and more.
- Increased property taxes – Once you’ve completed renovations, there’s a chance that the city may increase your property taxes. This can be costly the longer it takes for you to find a buyer.
- You’ll have to pay for holding costs – You have to pay for the costs of ownership throughout the time that it takes to renovate the house and to sell it. These costs include mortgage, insurance, and taxes. The longer it takes to fix the property and to sell it, the more costly it will be.
- You’ll need cash for renovations – Renovations can be expensive on a fixer-upper, which means that you will need to have cash set aside to pay for them.
Rental properties can be very financially rewarding if you invest in the right ones and know what you’re doing. But just like any investment, there are some potential drawbacks. Pros and cons of investing in a rental property are listed below:
Rental Property Advantages
- Earn additional monthly income – Renting out a property means that you will be earning regular monthly income from your tenants. This money can help to offset your monthly mortgage costs. In fact, depending on the property and its location, you’ll hopefully make more per month than what you’re paying back on the loan. Eventually, the loan will be paid back and the income you’re earning will be mostly profit.
- Increase income from property value growth – Rental properties are a long-term investment since it will take some time for the income you earn to pay for the loan you took out. However, if you’re smart about where you’ve bought the property, it may appreciate in value. You’ll be able to increase the rent as this occurs, thereby increasing your income.
- Add value over time without significant costs – Sweat equity can help add value to your property. Even minor upgrades, such as refinishing the interior or repainting the exterior can add value to the property without requiring significant investment.
Rental Property Disadvantages
- You may not be able to rent out the property – You may not be able to rent out the property, which means that you will be losing money through mortgage payments, taxes, and more. Because tenants typically only sign one-year leases, you may have to deal with months throughout the future where it’s unoccupied as well.
- You may have problematic tenants – It can be costly if your tenant falls behind rent or refuses to pay and you have to evict them. The whole process of eviction can be quite expensive and it may take some time to find another tenant. You may also have issues with repairs and maintenance if the tenant did damage to your property prior to moving out.
- You’ll have to pay regular taxes, fees, and insurance – You will still be responsible for paying property taxes, property insurance, and any homeowner’s association fees associated with your property even though someone else is living in it.
- You’ll be responsible for maintenance and repair costs – The tenant is not responsible for any maintenance or repair costs unless you can prove that they intentionally damaged your property, which means that any maintenance or repair needs that pop up will have to be paid for by you.
Should You Flip Or Rent?
If you’re trying to decide whether you should invest in a house that you can flip or a rental property, understand that there’s no clear-cut answer. It all depends on your individual situation. In addition to weighing the pros and cons of each and determining the level of risk you’re willing to take, identify what your goals actually are–do you want to make a short-term profit or a long-term profit? Do you have the cash reserves necessary to pay for renovations on a house in order to flip it? Will you be able to afford to run a rental property that’s without tenants for certain periods of time?
Do your due diligence by researching your local market. Look at how property values have increased over the years and pinpoint areas that have grown significantly in demand. Look into houses that have been flipped in your area to identify what kind of profit you might be able to expect. If you’re thinking about flipping a house, research how much renovations and repairs actually cost and what kind of home features buyers are looking for. If you’re thinking about renting out a property, check the local rental market. For example, rental markets in college towns tend to be quite strong since there are always new students coming into town who need a place to rent.
Always Have Cash Ready
When investing in real estate, having cash on hand will give you much more flexibility. Investors need cash even when taking out loans for the typically large down payments and closing costs. If you’re taking out a loan through Fannie Mae as a result of owning more than four properties, even more cash reserves may be necessary. Cash may be needed for repairing or renovating the property you’re investing in, whether you’re flipping it or not. It is strongly recommended that you put away the cash you make off of any investment property sales to be put towards the purchase of your next investment property–even if you haven’t lined it up yet.
Investment Property Loans Are a Different Beast to Your Owner Occupied Home Loan
When it comes to investing in a property, whether it’s to flip or to rent out, there are risks involved, just as there are with any other investment. This risk translates to the lender as well. Because you’re not buying the house to live in and you’re buying it as a way to potentially make money, taking out an investment property loan is much different than taking out a conventional home loan for a primary residence. There’s a chance that you will lose money, after all, which means that there’s a greater chance that you will default. Lenders take this risk into account in the form of stricter requirements and less favorable terms to obtain an investment property loan.