If you're an investor looking to expand your portfolio through real estate, you need to know how to finance a rental property. While you may already have experience getting financing for primary residences, financing rental properties comes with unique challenges.
Understanding these differences and what to look for when securing financing can help you make smarter investment decisions and maximize your returns. In this article, you’ll learn all about rental property financing, including the options available, loan terms, and how to qualify for the best rates.
While financing a rental property is similar to financing a primary residence, there are significant differences in the qualification requirements.
For example, lenders will look at your personal finances, credit history, and employment status when reviewing your application, just as they would for a primary residence. However, they will also consider the financial viability of the investment property, including its potential rental income and expenses, vacancy rates, and overall cash flow.
Generally, the minimum down payment for a rental property is 20% or more of the purchase price, when working with a bank or mortgage company. This amount may be less in cases where the property is owner-occupied, such as a small multifamily building or house hacking property.
Lenders require higher down payments for rental property loans because they are considered riskier investments than primary residences. The lender views a larger down payment as the borrower-investor having more "skin in the game." It reduces the lender's risk and may encourage the borrower to make smarter investment choices to minimize their potential risk.
Lenders have stricter credit score requirements for financing a rental property. According to a report by LendingTree, the minimum required credit score can vary, but generally needs to be at least 640 or above.
Some lenders may approve borrowers with lower credit scores if they have strong financials in other areas or a proven track record of successfully investing in rental properties. Ultimately, the better your credit score, the more likely you are to secure financing with favorable terms.
When lenders finance a rental property, they don't just look at your personal finances and credit score. They also consider the property's financials. These financials—rental income, operating expenses, vacancy rates, and cash flow—help lenders ensure the property will be profitable and generate enough revenue to cover its costs, including the mortgage payments.
If the rental property can produce sufficient cash flow to pay for the mortgage and other related expenses, it reduces the risk of default or loss for the lender.
Lenders often use a debt-service coverage ratio (DSCR) to determine whether a rental property generates enough rental income to cover its mortgage payments. The DSCR is calculated by dividing the property's net operating income (NOI) by its annual mortgage payments.
Lenders usually require a minimum DSCR of 1.2 or higher, although some may accept a lower DSCR if the borrower has solid personal financials or a high level of cash reserves in an escrow account. A higher DSCR indicates that the rental property is less likely to default, giving lenders more confidence in financing the investment.
Debt-service coverage ratio (DSCR) and debt-to-income (DTI) ratio are both used by lenders when assessing rental property financing. However, they measure different things.
DSCR measures the property's ability to generate enough rental income to cover its mortgage payments. DTI measures the borrower's ability to pay all their debts, including the mortgage on the rental property.
A lender considers the DTI to ensure the borrower can afford to make the monthly mortgage payments, given their other debt obligations. In general, most lenders prefer borrowers to have a DTI of no more than 43% to 50%, depending on the type of loan.
If the rental property generates sufficient income to cover its mortgage payments, the lender may be more flexible on the borrower's DTI. That's because their risk is lower and the rental income from the investment property could help increase the borrower's income.
Lenders also evaluate the borrower's cash reserves when deciding whether to finance a rental property. A general rule of thumb is that the borrower should have enough cash to cover at least six months of mortgage payments and the rental property's regular operating expenses in case of cash-flow disruptions.
A significant amount of cash reserves can help reassure the lender that the borrower is financially responsible and can handle any unexpected expenses related to the rental property. This, in turn, reduces the risk to the lender's loan and the borrower's investment.
As a residential real estate investor, you may find many more financing options for your rental property investment than for your primary residence. By understanding various loan types for rental properties, you can choose the one best suited to your investment strategy and financial situation.
Traditional loans through a bank or credit union can finance a rental property, but there are some differences compared to securing a loan for a primary residence. Lenders adhere to guidelines set forth by Fannie Mae and Freddie Mac, the government-sponsored enterprises that purchase and guarantee many mortgage loans in the United States.
These guidelines establish minimum lending standards for rental property investments, including minimum down payment and credit score requirements, debt-to-income ratios, and more.
The Federal Housing Administration backs these programs and offers several benefits, including low down payment requirements and flexible credit guidelines. More specifically, borrowers may qualify for an FHA loan with as little as 3% down and/or a credit score of 580 or higher.
An investor must occupy one of the units for the first 12 months in a building with 2–4 units.
VA loans can finance rental properties for veterans and active-duty military members and their families, as long as one of the units serves as their primary residence. These programs offer favorable loan terms, including a lower interest rate, up to 100% financing, and simplified qualification criteria.
These loans also provide funds for closing, rehabilitation, and other related expenses associated with purchasing or constructing a multifamily property.
A portfolio lender is a bank or financial institution that holds its loan portfolio in-house rather than selling it on the secondary market.
By keeping its loans, the portfolio lender can offer more flexible loan terms and customization options for real estate investors. That’s because they are usually not bound by strict underwriting guidelines or regulations from third-party entities.
A private lender is any entity, including an individual, that offers loans to borrowers. They may have a wider variety of offerings and terms than traditional lenders, tend to be more flexible with loan qualifications, and offer fast approvals.
However, private lenders rarely provide the same consumer protection as federally insured banks and credit unions. So, make sure you understand the loan terms completely before signing any agreement.
A home equity loan and a home equity line of credit (HELOC) allow homeowners to borrow money using their home's equity as collateral. A home equity loan provides a lump sum upfront that is repaid in fixed monthly installments with a fixed interest rate.
Conversely, a HELOC provides a revolving line of credit that you can borrow from when needed, similar to a credit card. The funds can be used for down payments or related costs associated with purchasing or rehabbing rental properties.
Cash-out refinancing is a method used to fund a rental property by refinancing your current mortgage balance for more than what is owed and receiving the difference in cash. The money could then be used as a down payment or cash purchase of another property.
However, interest rates can affect the viability of a cash-out refinance strategy, as a higher rate (and larger loan balance) could mean that the new mortgage is more expensive than the original.
You may use a hard money loan to finance a rental property when traditional financing options are unavailable or do not fit your needs. Hard money lenders typically base their loan approval on the property's value rather than the borrower's creditworthiness or financial situation.
These loans typically require a quick repayment schedule and may have high fees and interest rates, making them ideal for short-term investments, flips, or bridge loans.
When traditional financing options are limited or have high-interest rates, the seller can act as a lender, allowing buyers to purchase the property and pay for it in installments.
For sellers, "carrying the note" can offer an additional revenue stream and a quicker sale. For buyers, it can provide negotiable repayment terms, flexible down payment options, and more manageable financial commitments than traditional lending.
Group investing is a popular real estate investment strategy whereby multiple investors pool their resources to finance a rental property purchase. By creating an LLC or partnership, investors can share ownership, risks, and responsibilities associated with owning a rental property.
This approach can offer various advantages, including increased purchasing power to buy larger or multiple properties, creating diversified investment portfolios, and streamlining property management processes.
Financing options for rental properties differ from those for primary residences. Choosing the right strategy can make all the difference, and selecting the right one depends on your goals and unique circumstances. Remember to take the time to evaluate the options and make an informed decision that aligns with your needs.
One essential aspect of protecting your rental property investment is getting the right insurance coverage. With adequate insurance, you can safeguard your property and minimize the financial impact of unforeseen events. It's crucial to take the next step in protecting your investment by obtaining the correct insurance coverage.
If you're looking for more information on insurance for rental properties, check out our guide to How Much Landlord Insurance You Need.