Investment Property Loans And The Difficulty Of Acquiring One
Real estate can provide a great opportunity for investment if you know what you’re doing. Even small investors have made a tidy profit off of flipping houses or renting out properties. However, just because you invest money into a property doesn’t mean that you will automatically make a profit. In fact, this is exactly why securing an investment property loan can be more challenging than you might think.
What Is An Investment Property?
An investment property is one that you purchase as a way to make money. It’s not a primary residence, secondary home, or vacation home. For example, many small investors will buy homes that need work done on them. They are undervalued because of the repair work and renovation work that’s required to get them into good condition. Investors know that making those repairs and renovations can help bring the value up. Afterward, the house is then flipped back onto the market for a profit. House flipping is a short-term property investment strategy. A more long-term strategy would be buying a property and renting it out while the property continues to appreciate in value, allowing you to increase the rent –and your profits– over the years.
What Is An Investment Property Loan?
If you’re looking to invest in a property, whether it’s to flip it over the short term or rent it out over the long term, you’ll probably need to take out a loan so that you can afford the purchase. However, lenders consider investment properties to be a particularly high risk. Investment properties don’t always work out, and the borrower may not be able to pay back the significant amount of debt they’ve taken on–especially if they’re still paying down the mortgage on their primary residence. As a result, investment property loans tend to be more difficult to qualify for, tend to be more expensive to take out, and tend to have less favorable terms.
Types Of Investment Property Loan
As challenging as it may be to qualify for an investment property loan, you should still consider it if you’ve found an investment property that you think could be particularly rewarding. Here are the different types of investment property loans you should look into if this is the case:
Obtaining a conventional investment property loan from a private lender will require you to have a credit score of at least 720, although this number is flexible depending on other factors (such as your debt-to-income ratio and credit history). You will need to make at least a 20 percent down payment as well, and you can expect your interest rate to be between one to three percent higher than that of a traditional home loan. Fees will be higher as a result of the Fannie Mae risk-based pricing adjustment, which is an additional 0.75 percent. The LTV will need to be 80 percent or less. Finally, some lenders will require that you have liquid reserves of up to six months.
Be aware that if you have four mortgages to your name, you’ll no longer be able to take out a conventional investment property loan. You would have to go through a special program established by Fannie Mae, which allows investors to have between five and 10 mortgages to their name. To qualify, you’ll need to make a 25 percent down payment on single-family homes or a 30 percent down payment if it’s a two to four-unit property. If you have six or more mortgages, you will need a minimum credit score of 720.
Hard money loans are also known as commercial real estate loans. They’re used most often by professional real estate investors and investors who want to buy fixer-uppers and flip them within a short period of time. What makes them particularly beneficial is that these types of loans are often approved on the same day the application is submitted and funding is generally available within three days of the approval. Additionally, as long as you can put down between 25 and 30 percent as a down payment, you may be able to qualify despite not having the best credit score or despite having more than four mortgages to your name.
As you can imagine, there are a few potential drawbacks. First of all, hard money loans are for short-term investors. You’ll have to pay them back within 1 to 2 years or 3 to 5 years. Interest rates tend to be quite high as well at 9 to 14 percent. Even upfront fees can be as high as 2 to 4 percent of the loan. These types of loans are obviously poor for long-term investors (such as if you’re purchasing a rental property).
You don’t necessarily have to go to a professional money lender, like a bank. Private money may be available to you from individuals who have extra money and are looking for good ways to invest it. Such people could include family members, friends, co-workers, or other property investors. There are a number of advantages to borrowing private money. There are fewer formalities involved, conditions are much less strict, and interest rates are usually lower. The length of your loan will be more negotiable as well.
Of course, you will need to secure the loan with the income property’s existing mortgage or with a promissory note, meaning that if you don’t pay the loan back, the lender can foreclose. While you risk foreclosure when you take out a professional loan, remember that if you borrow private money from someone you know, there is a risk that you could damage your personal relationship with them if you don’t pay your loan back according to the agreed upon terms.
Home Equity Loan
Instead of getting a loan specifically for buying an investment property, you could also take out a home equity loan against the equity you’ve built up in your primary residence. A home equity loan is easier to qualify for and will likely have better terms since your personal home will be used as collateral, reducing the risk that you will default on your loan. Generally, you’ll only need to have a credit score of 620 or higher, a debt-to-income ratio of 43 percent or lower, and a solid credit history in order to qualify.
The reason you can use a home equity loan for an investment property is that the loan is provided in a lump sum that can be used in any way you want, including on another property. You could borrow up to 80 percent of your home’s equity value using a home equity loan. However, this will only work if the investment property isn’t significantly more expensive than your personal home’s value.
Investing in commercial real estate is a different matter altogether. Commercial real estate tends to be more expensive to begin with, requiring a commercial investment property loan. In addition to having to make a down payment of at least 15 to 30 percent and having a good credit score, you will also need to have a good business plan outlined. Lenders will want to see that you have a solid plan to ensure a steady cash flow. Keep in mind that such a loan is expensive–interest rates tend to be between 8 and 13 percent and most financing options are for terms that only last one to three years.
Fix-and-flip loans are perfect for investors who want to buy fixer-uppers, renovate them, and then sell them at a profit. Fix-and-flip loans are short-term loans that aren’t too difficult to qualify for, which means they are very similar to hard money loans. Lenders focus more on the potential profit of the property than the credit score and income of the borrower (although those factors remain important). There are some drawbacks for such a loan, however. The loan term is often quite short, sometimes as short as a year, interest rates can reach as high as 18 percent, and you can expect closing costs to be higher than conventional loans as well.
What Makes An Investment Property Loan More Difficult Than Other Loans
Qualifying for an investment property loan is more challenging because lenders view investment properties as a greater risk. Some of the reasons why it’s more difficult to qualify include:
Higher Credit Score Requirement
Unless you get a home equity loan against your own home or you go get private money involved, you will have to have a relatively high credit score. Your credit score shows lenders how financially responsible and capable you are (it takes into account things like debts, late payments, bankruptcies, foreclosures, collections, and more).
Better Debt-To-Income Ratio
Lenders will not only want to make sure that you earn enough money (and that your income is stable) to afford monthly mortgage payments on your investment property, but they will want to know that you don’t have too much debt as well. Because you may already be paying down another mortgage at the same time (such as that on your personal home), it will be more difficult to maintain a low debt-to-income ratio as it is. Even then, lenders require a lower debt-to-income ratio than with conventional loans (typically around 43 percent).
Down Payment Of At Least 20%
A large down payment helps to offset the risk of having to foreclose on the investment property and sell it to make back the balance owed. The sale may not recover the total of the loan, so a large down payment helps mitigate this risk. In comparison, most conventional loans require a down payment of around 5 to 15 percent.
Hitting Mortgage Ceilings
If you’ve invested in several properties already, it will become more and more difficult to obtain additional investment property loans. You’ll need to go through Fannie Mae’s special program if you have four or more mortgages on your credit–and even if you qualify for their program, some lenders may still not be willing to provide you with the loan you need.
Perceived to Be a Higher Risk
Some lenders may not be willing to take on the risk at all if you’re trying to secure an investment property loan. This can occur if they’ve lost money in the past on investment property loans and are unwilling to take the risk again. Their rationale is that if the borrower’s investment fails, they may prioritize other debts over the investment property’s mortgage (such as their car payments or the mortgage on their primary residence).
What Can Be Done to Increase the Likelihood of Approval?
In addition to eligibility requirements being quite strict, some lenders may be risk-averse when it comes to investment property loans. There are a few things that you can do to improve your chances of being approved for an investment property loan, such as:
Have a Formalized Investment Strategy
Lenders will feel much more comfortable knowing that you seem to know what you’re doing and that you have a plan of action. For example, if you’re planning to buy a fixer-upper, you might outline all of the renovations you plan on making and the cost of those renovations along with how much you expect to make once you turn around and sell it. You might even provide examples of similar houses that sold in the same area as a way to justify the selling price.
Proactively Improve Your Credit Rating
For the most part, you’ll need good credit to obtain an investment property loan. Work on improving your credit to make qualifying easier by paying off outstanding debts and by making sure you pay all your bills on time. If you have credit card debt, try to get your debt-to-credit ratio down to 30 percent.
Maintain High Personal Cash Reserves
If you have a significant amount of cash on hand, enough to make a down payment and pay six months worth of mortgage payments on your loan, it will go a long way towards convincing lenders that you aren’t a big risk. Having cash reserves is particularly important if you’re looking to fix and flip a house since you’ll need money to pay for the repairs and renovations.
How To Get A Good Investment Property Loan
While you’re improving your chances of qualifying, consider these ways of ensuring that you don’t just qualify for an investment property loan, but also one that provides favorable terms.
Always Shop Around
Different lenders offer different terms. Some lenders may be more favorable toward investors because they have good experience lending to investors in the past. This can sometimes be all it takes. Compare eligibility requirements as well as terms for a variety of different lenders.
Prepare Your Credit Report
Request your credit report from one of the three major credit bureaus. Go through it carefully. Look for debts that you can pay off as well as any blemishes that shouldn’t be there. Mistakes do occur. If you find any errors, report them so that they are taken off.
Consider Your Long Term Goals
Taking out an investment property loan means that you will be taking on significant debt. This may only be temporary if you’re able to successfully flip an investment within a short period of time. However, when it comes to rental properties, you’ll likely be stuck with that debt for some time. Consider what your long term goals are in terms of not just investing, but in terms of your life. Are you willing to have such a significant debt hang over your head for such a long time in the hopes that the long term profit will be worth it?
Determine The Property You Can Afford
Don’t just assume that you can afford whatever amount you can obtain through a loan. Sit down and carefully go over your personal budget to determine what you can afford. Consider the worst case scenario when you buy an investment property. For example, if you buy a rental home, don’t assume you’ll rent it out in the first month and that you’ll be able to use that income to make your monthly payments. It’s entirely possible that you may not be able to find a tenant for more than a few months and have to budget for that possibility.
Try To Reduce The Interest Rate
Interest rates tend to be quite high when it comes to investment property loans. There are a few ways that you can reduce these rates. First, work on improving your credit score and debt-to-income ratio. The better your financial standing is, the more flexible lenders will be with your interest. Then consider saving up a larger sum for your down payment. The bigger your down payment is, the more favorable your interest rate will likely be (and the less of it you’ll have to pay over the duration of the loan’s term).
While it is Harder to Get an Investment Loan it is Still Not Impossible
Qualifying for an investment property loan (and one with favorable terms) can be a difficult task. However, it’s not impossible. If you do your research and practice patience (by improving your credit score and saving up cash reserves), you’ll put yourself in a better position to secure the investment loan you need.
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