If you want to get started investing in real estate, you don’t actually need your own money. Instead, you can get a loan for a rental property. Read on and you’ll learn what loans you can get, how to apply for them and how they can help you purchase your dream rental property.
1. What is a Rental Property Loan?
A rental property loan is a first lien mortgage loan (which means if you default, the lender can sell the property to pay back the rental property loan before any other loan on the property is paid ) on a single family residential property that is meant to be occupied by a tenant and not the owner.
To qualify for a rental property loan, the property must be a turn-key rental (ready to rent) and though typically the qualifying rental is long-term, you can also get a rental property loan for a short-term rental, such as a vacation home. Rental property loans for vacation homes or AirBnb are typically offered by private lenders or mortgage brokers and are allowed to be vacant 80% to 90% of the time.
2. How Do Rental Property Loans Work?
Rental property loans are similar to conventional commercial real estate loans in that lenders still set the timeline for loan repayment, still set the monthly payment amount and still set the interest rate.
As an applicant who may have secured a mortgage for your primary residence before, you will see more similarities to rental property loans. You’ll still have to fill out an application and must be prepared to have your income, assets and credit score verified.
Beyond that, rental property loans have a higher barrier for entry than standard owner-occupier mortgages. A rental property loan carries a higher risk of default, so lenders have stricter criteria, including the following:
- Higher down payment amounts ( 20% or higher)
- More cash reserves required (six months per any existing mortgage plus the new mortgage)
- A debt-to-income ratio at or below 36%.
- A higher credit score for better loan terms (640 and up)
In addition, rental property loans are typically more expensive than conventional mortgages. You may even have a good to excellent credit score and still pay 0.5% to .875% higher than conventional residential mortgages.
There is good news though, as private mortgage insurance doesn’t apply to rental property loans. Private mortgage insurance is usually applied to conventional residential mortgages with a low downpayment to cover the lender in case you default. However, you pay private mortgage insurance as the borrower, which can increase the cost of your mortgage by 0.5% to 1%, so that’s a bit of a cost savings on rental property loans.
That being said, as a landlord on a rental property, you will need other kinds of insurance. For more information on the types of insurance you will need, read Baselane’s Landlord’s Guide to Insurance.You can also use rental income from another rental property to qualify for a rental property loan. According to LendingTree, lenders will credit $0.75 on the dollar using the current market rate when factoring in rental income as part of a rental property loan application, which will make it easier for you to qualify in combination with your conventional income.
3. What are the Different Types of Rental Property Loans?
There are several different types of rental property loans that an investment property owner can qualify for. Below are eight of the most popular examples and the attributes that define them.
Conventional Loans (a.k.a Conforming Loans)
- Offered by conventional lenders (banks, credit unions and mortgage brokers)
- Government-backed, guaranteed by Fannie Mae and Freddie Mac and must meet Government-Sponsored Enterprise guidelines.
- Eligible for the lowest interest rates with a good credit score
- Down payments between 15% and 25%
- It’s possible to get up to 10 mortgages (though for most lenders there’s a limit of a maximum of four)
- Offered by private lenders or groups that specifically provide loans to real estate investors
- Experienced real estate lenders pool their capital and offer financing to real estate investors
- Loan terms and fees customized to the real estate investment experience of the borrower and the deal potential (e.g. cash flow)
- Often do not require Income Verification to qualify but rather rely on the rental properties cash flow (rental income)
- Lenders may take equity and get a cut of the profits of the rental property project in exchange for lower fees and interest rates
- If the rental property does well as an investment, private lenders may finance future rental property investments
FHA Multi-Unit Financing
- A loan for a multi-family dwelling backed by the Federal Housing Administration
- Offered by mortgage brokers and traditional lenders like banks and credit unions
- Good for new construction, properties that need significant rehabilitation and rent-ready purchases
- Down payment and credit score requirements lower than conventional loans (as low as 3.5% down with a credit score of 580 or higher)
- Existing rental income can be used to help qualify
- Must live in one of the units for at least a year or more
VA Multi-Unit Financing
- Multi-family loan backed by the U.S. Department of Veterans Affairs
- Offered by mortgage brokers and traditional lenders like banks and credit unions
- Available to active duty military service members, veterans and eligible spouses of each
- No minimum down payment or credit score
- Purchase up to seven units, but you as the borrower must live in one of the units
- Finance multiple single-family or small multi-family properties from the same lender
- Offered by mortgage brokers or private lenders which may offer a “group discount” for multiple loans
- Loan terms such as down payment, credit score, monthly payment, fees and interest rate can be customized to fit the needs of the borrower
- Comes with higher fees and prepayment penalties because it’s easier to qualify for with multiple properties
- May feature a balloon payment where the entire balance is due at the end of the loan
Finance multiple rental properties under a single loan
Applicable to any type of income property
- Offered by mortgage brokers and private lenders
- Loan terms vary from lender to lender and can be customized to meet the needs of the borrower
- Properties within the loan are cross-centralized, which means each property is collateral for the others
- Borrowers can ask for a release clause that allows them to sell one or more of the properties without having to refinance the other properties still owned
HELOC and Home Equity Loans
- Home Equity Line of Credit (HELOC) and Home Equity Loans pull accumulated equity from one rental property to fund the down payment of another (waterfall technique)
- HELOC works like a credit card that can be drawn from at any time and repaid with monthly payments
- Home Equity Loan is a second mortgage that provides funds in a lump sum
- Lenders set borrowing limits on both loans at 75% to 80% of the rental property equity
- Interest rates and fees are higher compared to long-term, cash-out financing on conventional loans
- Quality source of funds when needed
- Sellers who own property outright with no debt can act as a lender
- Good option for buyers investing in rental property on a down cycle or a property that has difficulty qualifying for conventional financing
- Loan terms can be completely customized according to the needs of the buyer and seller
- Can be used to defer capital gains over the life of the loan as an alternative to a 1031 exchange
- By offering financing, sellers can generate interest income and earn a monthly mortgage payment instead of a lump sum
- Standard underwriting requirements like credit checks and a minimum down payment
4. How to Qualify for a Rental Property Loan?
If you want to qualify for a rental property loan, you’re going to need to have the following for most lenders approval:
- A 20-25% down payment or higher for a single-family home or a 30% or higher down payment for a two to four unit rental property (Fannie Mae/Freddie Mac do have 10% down payments)
- A minimum credit score of 640 or higher (expect higher interest rates and fees with a lower loan to value ratios and low credit scores)
- The ability to pay 1% to 3% more in interest compared to traditional owner-occupier home loans
- A lower loan-to-value ratio (the lower the better)
- Proof of at least two years worth of income in the form of W-2s and tax returns
- A minimum of six months in liquid reserves (either cash or assets that can be quickly turned into cash – this may vary by lender)
5. The Bottom Line: Rental Property Loans
A rental property loan can be a great option for getting started in real estate if you don’t have all the capital that you may need to finance a rental property free and clear.
Many rental property loan types have customizable terms that can fit the borrower’s specific needs, but, as a borrower, be prepared to put at least 20-25% down with a minimum of six months of cash reserves at the ready if needed and a credit score of at least 640 with a lower than average loan-to-value ratio then you would need on an owner-occupier residential home loan.
If you don’t know where to look to acquire a rental property loan, Baselane’s Marketplace is a great place to start.
Yes. A rental property loan is a first lien mortgage loan for a single-family or mult-family residential property that is occupied by a tenant or tenants and not the owner. Since the property is not occupied by the owner, the risk is higher for the lender than a standard mortgage on an owner-occupied property. As a result, the requirements needed to qualify for a rental property loan are more stringent than they are for a typical residential mortgage. With rental property loans, you need at least 20-25% down, a credit score of at least 640 and at least six months of cash reserves with a low loan-to-value ratio. There are other rental property loans backed by the Federal Housing Administration, Veterans Affairs and Fannie Mae or Freddie Mac where the requirements are less stringent, but otherwise, rental property loans are harder to qualify for.
No. Rental property loans are not tax deductible per se. However, you can deduct expenses associated with having a rental property including mortgage interest, interest on a Home Equity Line of Credit, insurance premiums, property taxes and depreciation. You can also deduct expenses for repairs and maintenance, as well as additions that improve the property over the long-term such as a deck, a pool, a gym or some other capital improvement. Track your rental property income and expenses using Baselane.
Yes and no. Rental property loans are more risky for the lender because the owner is not occupying the residence. As a result, the borrowing requirements for a rental property loan are more stringent than a traditional owner-occupier residential mortgage, which lessens the risk of default and means the qualifying borrowers are theoretically more financially stable.
However, beyond conventional rental property loans, there are rental property loan structures that are more risky. These include loans with seller financing and private money loans, where the terms can vary more widely according to the needs of the borrower and the lender. Also, mortgage insurance does not cover rental property loans, so if the borrower does default, the lender is less protected than with a traditional residential mortgage.
There are rental property structures that are backed by the U.S. Government and therefore, less risky. These include small business loans and those multi-family residential property loans backed by the Federal Housing Administration and Veterans Affairs, which offer less stringent borrowing terms for a rental property loan.