Taking on an investment property can lead to financial prosperity if done correctly. But an investment this huge can be overwhelming -- especially when it comes to financing. With that in mind, we have created an ultimate guide to financing an investment property so that you can locate the best options for your goals and financial circumstances.
What Is Investment Property Financing?
While some aspects of investment property financing may look similar to residential property financing, there are some key differences to consider before you embark on this journey. After all, you want to obtain the correct type of financing to get the best possible return on your investment. So before you sign on the first loan you’re offered, it’s important to consider the entire spectrum of financing options available for investment properties.
Should You Purchase an Investment Property?
Purchasing an investment property is a huge decision that needs to be carefully considered before you pull the trigger. Although it could be very profitable if done right, it also comes with a considerable amount of risk. Here are some of the pros and cons that you should consider before purchasing an investment property:
- A smart rental property purchase would increase in value enough for you to sell it for a profit down the line
- Rental properties may offer certain tax deductions for things like mortgage interest, property taxes, repairs, insurance, and property management costs that you can then use to lower your taxes
- Long-term rentals could provide you with consistent income that you can then reinvest in other areas whether it be other real estate properties, retirement savings, college funds, etc.
- You can use rent payments to pay off the mortgage and build equity in the property to boost your future profits
- Purchasing an investment property requires a substantial amount of up-front costs in terms of down payment and closing costs that can leave you hurting for cash
- You could lose money if you’re unable to sell the house for a profit when flipping it or find a suitable tenant when renting it
- You could also lose money on the property if the value or the market tanks for whatever reason
- If you’re renting out the property, you will either need to manage the property yourself or hire a property manager to do it for you
- If you choose to manage the property yourself, this is not easy as tenants can have problems at any time that you’re solely responsible for solving
- Real estate isn’t a liquid asset and is essentially useless if you need quick cash since the selling process can be lengthy and convoluted
- The costs of maintaining an investment property are unpredictable and may rise over time to the point that it’s no longer a smart investment
Investment Property Due Diligence Checklist
You can take steps to mitigate some of the risks involved in purchasing an investment property by doing your due diligence. Here are some of the different items that should be on your pre-purchase checklist:
- The first thing you need to research regarding an investment property is the location. As you probably know, location is everything when it comes to real estate. Purchasing a property in the right location could be the difference between profiting off your investment or losing money. Even though it’s impossible to predict the future, you can pick out good areas based on things like school districts, crime rates, property taxes, job market, and public transportation.
- The second thing you need to consider before pulling the trigger on a property are your margins. Generally speaking, you should set a goal of a 10% return when factoring in things like homeowners insurance, homeowners association fees, property taxes, landscaping, pest control, and other maintenance costs.
- The third thing you need to calculate for your potential investment property are your operating expenses. Your operating expenses should fall somewhere between 45% and 80% of your gross operating income.
- The fourth thing you need to know when buying an investment property is your rate of return. It’s normal to have a relatively low rate of return at first. However, with the right approach and patience, you can increase your rate of return over time.
- The fifth and final thing you need to know before you buy an investment property is that you have to plan for the unexpected. As a landlord, you’re on the hook for maintenance, upkeep, and even emergencies. It’s recommended that you maintain about 20% to 30% of your rental income to cover any unexpected costs that may come up.
Different Types of Financing to Consider for an Investment Property
There are several different financing options that you should consider when purchasing an investment property, including:
If possible, the best type of financing for an investment property is straight cash. This allows you to avoid the entire loan process and can save you a ton of money in interest, but it isn’t an option for everyone, especially new investors trying to build their portfolios. Thankfully, if you don’t have hundreds of thousands of dollars in cash lying around to finance your investment property, there are loan options out there that can make your investment dreams a reality.
Conventional Bank Loans
Another financing option for investment properties is a conventional bank loan. This type of loan is very similar to the loans that you receive to purchase a property for residential purposes. A residential loan is ideal for individuals looking to invest in a multifamily property with less than four units while living in one of the units themselves. In this scenario, you should expect to put down 25% to 35% on the property and have a credit score above 620.
Another situation in which a residential loan may be ideal is for individuals who want to invest in a single-unit investment property. In this scenario, you should expect to put down 15% to 20% on the property and have a credit score above 620. Residential conventional bank loans feature competitive interest rates that are only slightly above those offered for regular mortgage loans -- making them a great option for investors.
Finally, there are commercial loans that are designed to finance properties that consist of more than five units or are non-residential altogether. These loans typically come with higher interest rates and shorter repayment timeframes that often involve balloon payments that are required after a period of five to seven years. Your qualifications are also considered differently for a commercial loan. For instance, lenders will consider factors like the ability of the property to provide cash flow, the investor’s experience, and the debt service coverage ratio (DSCR).
Bridge loans are ideal for financing all different investment properties, from flipping a single-family home to purchasing a large office building. Bridge loans provide investors with quick and easy financing that gets them to the closing table in no time. This financing option helps investors remain competitive in a crazy real estate market that seems to be moving at the speed of light.
Bridge loans also offer more flexible requirements when compared to conventional bank loans. For instance, in-depth documentation, including credit reports, bank statements, tax returns, and income statements, are required for traditional loans. This can be difficult for those without a substantial work history or tax history, like foreign investors.
Bridge loans are a short-term financing option that essentially bridges the gap between closing and permanent financing. The terms of bridge loans can last up to a year -- giving investors plenty of time to secure permanent financing. The interest rates offered by bridge loans are lower than other financing options and, due to their short-term nature, are often quite beneficial.
Hard Money Loans
Like a bridge loan, a hard money loan can provide investors with quick and easy cash that they need to purchase an investment property. Again, this type of loan comes with less stringent requirements that make it accessible for buyers without the best or most extensive financial history. This is because hard money loans use the property as collateral and aren’t necessarily concerned about getting their money back since they can get it back through the property itself in the event of nonpayment.
While hard money loans can be quick and accessible, they come with extremely high interest rates that can reach up to 15%. As a result, this financing option is best suited for short-term circumstances.
A fix-and-flip loan is essentially a type of hard money loan that is designed to cover both the purchase price of a property as well as the costs for repairs to fix it up before reselling it for a profit. Like a hard money loan, this is a short-term loan with high interest rates that should be paid back as soon as possible. As a result, you’re going to need to put all your renovations and your eventual listing of the property on the fast track to pay back the loan and avoid losing money in the process.
Private Money Loans
Private money loans are loans provided to you by a friend or family member instead of going through an institution. There are “angel investors” that may give you money for a revolutionary business idea if you’re lucky. Since these loans don’t include institutions, they are highly flexible with terms that are totally up to you and the lender.
Home Equity Loans
Last but not least, you can use home equity loans to finance an investment property. This financing option allows you to use the equity of your home to purchase a second property. A home equity loan, a home equity line of credit, or a cash-out refinance often allows you to borrow up to 80% of your home equity with lower interest rates and better terms than some of the other options available.
Which Option Is the Best for You?
With all these different options, it can be challenging to find the best option to finance your investment property. And while there’s no easy answer to this question as it depends on your investment goals and your financial situation, here are some things that you may want to take into consideration:
- Interest rates: Interest rates matter more than you think. This is especially true if you’re dealing with large sums of money, as is common with investment properties. As a result, you may want to consider loan options with lower interest rates like bridge loans to save money.
- Loan term: You should also choose your financing option based on loan terms. For instance, if you’re in it for the short term, like with a fix and flip, you should consider short-term financing options like bridge loans or hard money loans.
If you’re in it for the long term and plan to rent out and manage your investment property, then you should consider long-term financing options like conventional bank loans or home equity loans.
- Timeframe: Another thing that you should take into consideration when deciding on financing for your investment property is your timeframe. If you’re looking to move quickly by making a competitive offer and getting to the closing table, you should consider speedy financing options like bridge loans or hard money loans. On the other hand, if you have time to spare, you could choose conventional loans or home equity loans.
- Qualifications: Finally, the last thing you should consider when choosing your financing is the qualifications for the loan. If you have stellar credit and employment histories, you may want to consider a conventional loan that can offer you favorable terms in exchange for stellar qualifications.
On the other hand, if you have less than stellar credit and patchy employment history, you may want to consider hard money loans or bridge loans that utilize other factors to determine your eligibility.
How to Find the Right Lender for Your Investment Property
Once you have determined which financing option is right for you, it’s time to find a lender. While you may think that the hard work is over, it’s just begun as your lender is just as important as your financing. So here’s what you need to know about finding the right lender for your investment property:
- For starters, you should know that not all lenders offer all types of financing. For instance, some lenders exclusively provide a single type of financing. Working with an exclusive lender can be beneficial as they will be well-versed in this specific type of financing.
- One way to locate lenders based on your ideal type of financing is through a simple internet search. Such a search may leave you with countless options that can be difficult to narrow down if you don’t know what to look for.
- When narrowing down your potential lenders, you need to look for key qualities and qualifications to ensure that they will be an ideal partner for your investment. You need a lender that’s transparent with its clients about loan terms and conditions, for starters. You also need to make sure that your lender is helpful and responsive in customer service by answering any questions and concerns that you may have.
Finally, make sure that your lender is dedicated to a quick and easy closing process that will get you your money quickly so you can get moving on your investment property.
How to Qualify and Apply for an Investment Loan
Qualifying and applying for an investment loan is a completely different process than with a residential loan. For starters, many traditional lenders have stricter requirements in terms of who qualifies for investment loans. You may need to have a credit score above 700 and a hefty down payment above 20%.
However, specific requirements depend on the lender and there are more flexible options out there. Alternative and online lenders are often more willing to lend to those with less-than-stellar credit scores, credit histories, and lower down payments. However, this is often in exchange for a higher interest to mitigate the risk on the part of the lender.
Once you have identified the right lender and verify that you qualify, it’s time to actually apply for the loan. You should have your documents in order as many lenders will request things like income tax returns, bank statements, income statements like W-2s or 1099s, and information about other accounts or assets. Additionally, your lender will run your credit report to see if you have any missed payments, defaults, or bankruptcies in your past.
Some lenders will process your application quickly while others will take their time. Make sure that you’re given a general timeline when applying to ensure that it works with your needs.
The Rundown on Investment Property Financing
If you’re looking for a bridge loan provider that meets all of these qualifications -- and more, look no further than Vaster Capital. Vaster Capital is a premier bridge loan provider that helps buyers and investors of all kinds fund their purchases. For the best terms, timeline, and support, contact Vaster Capital today for more information about our financing options.
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