What is the best way to finance a rental property?

By Harry Jensen, Trusted Mortgage Expert with 45+ Years of Experience

Edited by Michael Jensen, Mortgage and Finance Guru

Updated October 20, 2020

There are two main options to finance the purchase of a rental property: a cash out refinance of your primary residence or a non-owner occupied mortgage. We discuss the pros and cons of these two financing alternatives below so you can select the option that is right for you.

With a cash out refinance, the first point to understand is if you have sufficient equity in your current home to take out enough loan proceeds to buy the rental property. The maximum loan-to-value (LTV) ratio for a cash-out refinance of a one unit primary residence is 85%, which is higher than the maximum LTV ratio of 80% permitted for a non-owner occupied loan on a single unit residence.

The loan amount you are eligible depends on the value of your primary residence, your current mortgage balance and the price of the rental property.

If your home is worth significantly more than the rental property you want to buy and you own your home free and clear or have a low mortgage balance, then a cash out refinance may make sense. If you have a high current loan balance or your home is valued about the same as the rental property, then a cash out refinance may provide lower proceeds than a non-owner occupied mortgage.

If you determine that you have enough equity in your home, potential benefits of using a cash out refinance include that the interest expense for a mortgage on your primary residence is tax deductible, up to a $750,000 loan amount. Additionally, the mortgage rate on a cash out refinance may be slightly lower than the rate on a non-owner occupied mortgage.

The table below shows refinance mortgage rates and fees. We recommend that you contact multiple lenders to compare terms for a cash out refinance.

There are also downsides to consider with using a cash out refinance to buy a rental property. First, we typically do not recommend that borrowers mortgage their primary residence to purchase another property, especially if they own their home free and clear or have a low mortgage balance.

Although unlikely, something unforeseen could happen that could cause you to default on the mortgage. In this scenario you could lose the home you live in instead of an investment property. While the probability of something this negative happening is probably low, it is something to keep in mind from a financial planning and peace of mind standpoint.

Turning to the second financing option, a non-owner occupied mortgage also presents advantages and disadvantages. Using a non-owner occupied loan is simpler and exposes you to less risk, because you are using the rental property as collateral instead of your current home.

Additionally, the interest rate for a rental property mortgage should be comparable to the rate for a cash out refinance. The table below shows rental property loan terms. Comparing proposals from multiple lenders is the best way to save money on your mortgage.

From a tax standpoint, the interest expense on a non-owner occupied loan is typically not deductible against your personal income but is deductible against any rental income generated by the property. If the loan amount you need to buy the property is above $750,000, this may make a non-owner occupied mortgage a more attractive option.

One of the disadvantages of a non-owner occupied loan is that if you have a mortgage on your current home, you are basically required to qualify for two loans instead of one if you use a cash out refinance. You must demonstrate the ability to afford the monthly mortgage payment, property tax and homeowners insurance on both your primary residence and the rental property, which can be challenging.

If you want to include the income from the rental property when you apply for the loan, you are usually required to provide your tax return for the prior year that shows the income on your Schedule E . Without a history of rental income -- which is usually the case when you buy a property -- lenders use the lower or 75% of rental income according to a rental property appraisal report or 75% of income according to a signed lease agreement.

If the property generates positive cash flow based on the lender’s rental income analysis, then this cash flow is added to your personal income which helps you qualify for the loan. If the property produces a loss, then the loss is included as debt in your debt-to-income ratio, which reduces the mortgage you can afford.

Please note that if you are buying a rental property and have at least one year of experience receiving rental income or managing properties there is no limit to the rental income that can be included in your mortgage application.

If you have less than a one year history of receiving rental income or in property management, the rental income can only be used to offset the total monthly housing expense -- mortgage payment, property tax, homeowners insurance and homeowners association (HOA) fees, if applicable -- for the property being financed.  For example, if the property is expected to produce $4,000 in monthly rental income and the total monthly housing expense is $3,500, the lender only includes $3,500 in your mortgage application to offset the total monthly housing expense.  In short, in this scenario your application does not benefit from the additional cash flow generated by the property.

If you do not own or rent your primary residence and pay no monthly housing expense, then no income from the rental property is added to your application. In this case, you are required to qualify for the mortgage based on your personal gross income and monthly debt payments, which makes getting approved more challenging.

Although the application process for a non-owner occupied mortgage requires more time and documentation, you may be able to qualify for a higher loan amount if the rental property generates significant income.

While the financing option that makes the most sense depends on your individual circumstances and goals, on balance our preliminary recommendation is to use a non-owner occupied mortgage to buy the rental property. Although your interest rate may be slightly higher, this option provides the safest financing alternative while potentially enabling you to buy a higher priced property.

Sources

"Standard Eligibility Requirements: Investment Property, Cash-Out Refinance."  Eligibility Matrix.  Fannie Mae, October 2 2019.  Web.