How to Get a Mortgage on an Investment Property
Getting a mortgage for an investment property is different than getting a loan on a property that you live in and requires extra effort and investment by borrowers. Lenders apply stricter qualification requirements because investment properties involve more risk than a home you occupy as your primary residence. This is especially the case if you have not owned or managed a rental property before. Managing tenants, collecting rent and maintaining a property can be challenging, time-consuming and potentially costly. Plus, most people who buy investment properties are usually also paying the mortgage or rent on the property they actually live in so that is an extra cost to consider.
To account for these factors, lenders apply specific guidelines to make sure that you can qualify for the mortgage and afford the property. First, to get a mortgage on an investment property you are required to make a larger down payment. This provides extra protection for the lender and makes the borrower more invested in the property. The higher you down payment, the more money you could potentially lose if you default on the loan.
Borrowers are also typically required to paying a higher mortgage rate and closing costs for investment property mortgages plus hold savings in reserve at the time your loan closes. These are all measures applied by the lender to manage the additional risk associated with financing rental properties. For example, requiring reserves is intended to help borrowers manage unexpected financial challenges such as a tenant not paying rent or expensive property repairs.
There are also some aspects of the application process that may not be as simple as you would think, especially if you are applying for your first investment property mortgage. It is important that you understand how lenders calculate projected rental income as there are multiple methods and the income figure that lenders use may be different or lower than the rental income the property actually generates. You may expect that a property is cash flow positive but that does not mean the lender comes to the same conclusion. Additionally, your personal income and debt expenses also impact your ability to qualify for the mortgage. If you have too much personal debt you may not get approved for the loan even if the rental property is profitable, especially if it is your first property and you have no landlord or property management experience. Additionally, if the property is breakeven or expected to be cash flow negative, you must earn sufficient personal income to absorb the loss.
Another point to keep in mind is that many mortgage programs cannot be used to finance investment properties. For example, most no or low down payment programs including the FHA, VA and HomeReady programs do not permit rental properties. Although you can use these programs to purchase multifamily properties with up to four units, you are required to live in one of the units. This restriction limits investment property financing options.
As you can see, there are many points to consider if you want to buy a rental property. Below we outline how to get a mortgage on an investment property. Understanding how the process works before you apply for a loan should position you to successfully grow your investment property portfolio.
Understand the Down Payment Required
Most lenders require you to make a down payment of at 15% to 25% to qualify for a mortgage for an investment property and some lenders may require a larger down payment for jumbo mortgages. Additionally, you may be required to make a larger down payment if the investment property does not generate a profit. For example, if a property is not profitable the borrower may not qualify for the mortgage if he or she does not have sufficient personal income to absorb the losses. In that case, the lender may require that the borrower make a larger down payment, which reduces the mortgage amount and mortgage payment, making the property more profitable for the buyer.
Use our Down Payment Calculator to understand the total upfront funds required to buy an investment property
As a general rule, although lender guidelines permit a lower down payment, you must typically put down at least 33% of the purchase price for the property to be cash flow break-even or profitable. Be sure to understand a lender’s down payment requirement upfront before you apply for a non-owner occupied mortgage.
Know How Lenders Calculate Rental Income
Lenders can use several methods to calculate rental income for a property and the actual amount of rental income generated by a property may be different than the income figure used by the lender to determine your ability to qualify for an investment property mortgage.
To include rental income from an investment property to qualify for the mortgage, lenders typically require that you provide the Schedule E from your tax returns for the prior year to verify the income. Schedule E shows your income or loss from an investment property and lenders usually average the income and add back certain non-cash expenses such as depreciation.
This approach is more common when you are refinancing an investment property because your tax returns provide a record of historical rental income. Please note that if the property’s rental income has increased since your most recent tax return, you may not get full credit for the higher rent amount.
If you do not have a tax return that demonstrates the rental income, such as when you buy an investment property, lenders typically use the lower of 75% of the rental income according to an investment property appraisal report or 75% of income according to a signed lease agreement.
To prepare an investment property appraisal report, an appraiser compares the subject property to other investment properties in the area to determine the estimated market rent for the property. The appraised market rent may be higher or lower than the rent you actually receive when you lease the property.
Lenders apply a 25% discount to the rental income from the investment property appraisal report or executed lease agreements to account for vacancy and maintenance costs. To be even more conservative, the lender uses the lower of the two discounted figures to determine your ability to qualify for the loan.
So if 75% of the estimated monthly rent according to the investment property appraisal is $8,000 and 75% of the monthly rent according to signed lease agreements is $10,000, the lender uses the lower $8,000 figure to determine the mortgage you can afford.
It is important to highlight that if you are buying an investment 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 do not have a one year history of receiving rental income or managing investment properties, there may be a limit to the rental income that is added to your application. In this case, you may be required to qualify for the mortgage based on your personal income and debt payments as well as other factors. This is why it is usually more challenging to qualify for a mortgage on your first rental property.
To summarize, it is important to understand how lenders determine rental income as the figure they use for your mortgage application may be lower than the actual or potential rent generated by the property.
Review the Personal Qualification Requirements
When you apply for a mortgage on an investment property you must personally qualify for the loan. That means that the lender evaluates your credit score as well as your personal income and debt. If the property you are seeking to buy is not profitable after subtracting cost items such as property tax, homeowners insurance and homeowners association (HOA) fees from rental income, the loss from the property is considered personal monthly debt for the borrower. You must generate sufficient personal income from other sources to qualify for the mortgage according to the lender’s debt-to-income ratio requirement, after factoring in the monthly loss from the property.
Review Mortgage Qualification Requirements
If the property is profitable according to the lender's rental income guidelines, then this income is added to your personal income, improving your ability to qualify for the mortgage.
Compare Investment Property Mortgage Terms
Lenders typically charge higher interest rate on investment property mortgages as compared to owner-occupied loans. Interest rates vary by lender, down payment, loan amount, loan program as well as other factors but non-owner occupied mortgage rates are typically 0.25% - 0.50% higher than owner-occupied mortgage rates.
The table below outlines investment property mortgage rates and closing costs for lenders in your state. Because there is a wider spread in rates and fees for investment property loans, borrowers should compare proposals from at least four lenders to make sure they find the best mortgage terms.
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Be Aware of Higher Closing Costs
Closing costs for an investment property loan are typically higher than closing costs for owner-occupied loans. For example the appraisal report for a rental property is typically $200 - $300 higher than the appraisal for an owner-occupied property. Closing costs vary by lender, loan amount, loan program, property types and other factors but borrowers should budget for higher costs when they apply for the mortgage.
Know the Reserve Requirement for an Investment Property
The reserve requirement for an investment property mortgage is six months of total monthly housing expense which is comprised of your loan payment, property tax, homeowners insurance and homeowners association (HOA) dues, if applicable. For example, if total monthly housing expense on the property being financed is $5,000 and the reserve requirement is six months, you are required to hold $30,000 in savings when the mortgage closes.
Please note that for a cash out refinance of an investment property, the reserve requirement is twelve months if your debt-to-income ratio is higher than 36% and your credit score is less than 720.
If you own a second home or additional investment properties, you are required to hold extra reserves to qualify for the mortgage. According to the guidelines below, the more properties you own, the higher the reserve requirement:
One to four properties: 2% of the combined outstanding mortgage balance
Five to six properties: 4% of the combined outstanding mortgage balance
Seven to ten properties: 6% of the combined outstanding mortgage balance
The total combined principal mortgage balance includes any loans on the properties such as HELOCs and home equity loans. The total mortgage balance used to calculate the extra reserve requirement, however, excludes the mortgage on your home and the investment property being financed.
For example, if you own two properties including your principal residence and the investment property you are getting the mortgage on, you are only required to hold six months of reserves for the investment property. But if you own three properties including your home, the investment property you are financing and another investment property, you are required to hold additional reserves equal to 2% of the outstanding mortgage balance on the second investment property.
Get Pre-Approved for an Investment Property Mortgage
Because guidelines and requirements for investment property mortgages vary by lender it is important to get pre-approved at the beginning of the mortgage process. Be sure you understand the lender’s policies regarding rental income, borrower qualification and what size mortgage you can afford. Establishing a relationship with a lender and getting pre-approved for your investment property mortgage will also allow you to move fast when you find a property you want to buy. Our get pre-approved form is easy-to-use, free and enables you to connect with multiple lenders to review loan terms.
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Investment Properties Are Not Eligible for Many Loan Programs
Most conventional and government-backed no or low down payment mortgage programs such as the FHA, VA and USDA programs as well as the HomeReady Program only apply to owner occupied properties so you cannot use them to finance the purchase of an investment property. In most cases, however, you can use these programs to purchase properties with up to four units but at least one of the units needs to lived in by the individual(s) who obtained the mortgage to purchase the property. The USDA home loan program only applies to single-family residences.
Learn the Differences Between Owner-Occupied and Non-Owner Occupied Mortgages
Sources
"Rental Income Matrix." Freddie Mac Learning. Freddie Mac, December 2019. Web.