Investing in real estate has the potential for great rewards, but navigating the loan process can be a daunting task if you’ve never done it before. Whether you’re a first-time buyer or a seasoned investor looking to expand your portfolio, we will walk you through the essential steps to secure financing for your rental property.
In this article, you’ll learn how to get a loan for a rental property. We will break down the difference between a normal loan and a loan for a rental property and explore some other options available to you.
Difference Between a Normal Mortgage and a Mortgage for a Rental Property
A traditional mortgage is a loan obtained to purchase a primary residence, which is the home where the borrower intends to live. It is designed for individuals or families looking to buy a house to live in as their main dwelling.
The borrower typically needs to occupy the property as their primary residence for a significant portion of the year, usually within 60 to 90 days of closing on the mortgage.
A mortgage for a rental property, also known as an investment property mortgage or non-owner-occupied mortgage, is a loan used to purchase a property with the intention of generating rental income.
The borrower does not intend to live in the property themselves; instead, they plan to rent it out to tenants. This type of mortgage is specifically designed for real estate investors who want to build a rental property portfolio or generate passive income from renting out the property.
Since this is for an investment, it’s typically riskier, has more requirements for approval, and will have higher interest rates (0.5-0.75% more) than traditional mortgages.
What Lenders Will Look at When Approving Your Loan for a Rental Property
Typically, there are four factors that all lenders will evaluate with a lot of scrutiny before they approve a loan for a rental property. Since the risks are high, the standards that must be met are also going to be higher:
A credit score is a numerical representation of your creditworthiness. It is based on your credit history, including factors such as payment history, credit utilization, length of credit history, and types of credit used. For this kind of loan, lenders will typically want a minimum credit score of 620, with 700+ being the requirement to secure a better rate and loan terms.
The debt-to-income ratio is used to assess your ability to manage monthly debt payments relative to your income. It is calculated by dividing your total monthly debt obligations (including the mortgage) by your gross monthly income.
If your DTI is somewhere between 35-45%, you should be good to go. In case you have already been a landlord in the past, you may also use 75% of the rental income you’re hoping to get from the rental property to reduce your DTI further. This will be determined by the lender when they are appraising your profile.
The down payment is the initial cash amount that the borrower pays upfront when purchasing a property. For a rental property mortgage, the down payment is typically higher than for a primary residence.
Since there is no private mortgage insurance to protect borrowers in the case of defaulting on a rental property loan, the down payment can be as much as 5-6 times higher than what you would pay for a traditional mortgage. Depending on the specific investment you are making, this multiplier can be even higher, so you will need to be prepared for that.
Savings represent the amount of money that you’ve set aside after the down payment and closing costs are paid. Typically, it is recommended that you should have at least six months’ worth of mortgage payments in your savings in case you run into financial difficulties and do not have any income for a while.
How to Get a Loan for a Rental Property
Once you have calculated and evaluated the factors discussed above, you can move on to the process of actually securing a loan by following these steps:
1. Get Pre-Approved:
Approach lenders to get pre-approved for a mortgage. This process will give you an idea of how much you can borrow and help you narrow down property options before you finalize one.
2. Shop for Lenders and Loan Options:
Compare offers from different lenders, including banks, credit unions, and online lenders. Explore various loan types and choose the one that suits your financial situation best.
3. Prepare Necessary Documents:
Gather all required documents, such as income verification, tax returns, bank statements, and rental property details to make the process as smooth and quick as possible.
4. Apply for the Loan:
Submit your loan application with the chosen lender. Be prepared to answer questions and provide additional documentation during the underwriting process, which is much stricter in the case of a rental property mortgage.
5. Property Appraisal and Inspection:
The lender will conduct an appraisal to determine the property’s value and an inspection to identify any issues that may affect the loan approval. You can use an online address lookup service such as Information.com to learn more about a property.
6. Closing the Loan:
If the appraisal and inspection are satisfactory, you will move to the closing stage. Review all loan documents carefully before signing and be prepared to pay closing costs.
Consult a Real Estate Professional Throughout the Process
While the general advice provided in this article can get you through the process, the personalized and real-time advice you would get from a seasoned professional cannot be substituted by anything else.
Doing your own research is great, but we recommend that you speak to a lender because they’d be more than happy to answer all your questions.