While there are several ways to invest your extra money, one of the more exciting methods is to invest in real estate. When buying real estate as a landlord, there are some significant differences compared to being a homeowner. One of these differences is the process of taking out a mortgage. When acquiring a mortgage for rental property, the lenders often hold you to a much stricter standard. They realize that your ability to repay the mortgage can depend on your ability to acquire and maintain tenants. However, many find it well worth it. We encourage you to continue reading to learn more about qualifying for this type of mortgage.
What is the difference between a mortgage for a rental property and a traditional mortgage?
It’s easy to think that all mortgages would be the same. However, there are some key differences between these two types of mortgages. Many of these come down to the risk being assumed by the lender.
When referring to your primary residence, we mean the owner-occupied property. This is where you legally reside. It can be a single-family home or a multi-unit property. Lenders are more willing to take on the risks associated with a primary residence mortgage.
When it comes to rental properties, which the borrower does not occupy, lenders are more cautious. They realize that the potential for transient occupants increases the chance of the property value being negatively impacted. This increases the risk to the lender and leads to stricter requirements for borrowers.
How are mortgages for rental properties more difficult to get?
Lenders are well aware that default rates for rental property mortgages are higher than those for primary residences (See our first time home buyer’s guide). That’s because the borrower is dependent on cash flow from tenants. If the borrower encounters any financial difficulties, they are likely to prioritize paying the mortgage for their primary residence.
Because of this, the underwriting standards for rental mortgages tend to be stricter, and the interest rates will typically be a bit higher. For example, lenders will often require a higher down payment. The potential landlord is often subject to stricter debt-to-income ratios and credit score requirements. Lenders might also look at the savings held by the borrower, in addition to the usual income requirements.
Some lenders will also look for previous experience as a landlord before approving the mortgage.
How to get a mortgage for a rental property
There is a good potential for financial gain when becoming a landlord, but like any investment, it isn’t necessarily easy. Financially speaking, a rental property often means managing a second mortgage on top of the one for your primary residence. And rental income can be inconsistent. Lenders are well aware of this, and they adjust their mortgage standards for those who apply for a rental property mortgage. As a potential landlord, you should be mindful of the nuances when applying for a mortgage. Below is a closer look at the lender requirements.
Lenders often require a 25% down payment for a single-family home and 30% for a multi-family dwelling. Compare that with financing on a mortgage for a primary residence, which can sometimes be done with no money down. One upside to the higher down payment is a lower monthly payment and greater equity in the property from the start. The higher down payment is to offset the perceived greater risk for the lender when making loans for investment properties, along with the inability to get PMI insurance on rental mortgages.
There’s a sizable difference in the required credit scores needed for different types of mortgages. It’s possible to have a credit score of 580 and still get approved for a conventional home loan; however, when applying for a mortgage on a rental property, expect the lender to require a minimum credit score of 740. That’s a big jump. While a credit score under 740 won’t necessarily block you from getting a mortgage on an investment property, it will lead to higher fees, higher interest rates, and a lower loan-to-value ratio.
The interest rate on an investment property will almost inevitably be higher than what you could receive on a conventional home loan. While the difference could be as little as 0.5%, it’s possible that it could have an interest rate that’s as much as 3% higher than that for a home loan on a primary residence.
Loan to value ratio
While lenders will look at loan-to-value ratios when considering traditional mortgages, they have a much more significant impact when investment property mortgages are concerned. This is because lenders expect the landlord to have a bigger stake in the property. The lower the LTV, the better the chance of having the mortgage approved. At a minimum, the LTV should be 80%, but the borrower will pay for that with higher interest rates and fees.
Debt to income ratio
Like the LTV ratio, lenders will want to see a lower debt-to-income ratio. The better this ratio is, the less risk the lender feels they are taking on. Again, lenders want the landlord to be as invested as possible in the property. Paying down existing debts and maximizing the down payment can help lower the debt-to-income ratio. Ideally, you want to have a DTI of 36-45%. Fortunately, lenders will typically allow for as much as 75% of the anticipated monthly rental income as qualified income, which does help to reduce the DTI. However, some lenders will not allow potential rental income as qualified income if the borrower doesn’t have a history as a landlord.
Proof of income
Lenders may expect to see a longer income history. For example, where a traditional home loan might only require three months' worth of income in the form of W-2s, a rental property mortgage might require up to 2 years' worth of income in the form of both W-2s and tax returns.
Liquid assets available and savings
When assessing an application, the lender won't only look for proof of income; they will also expect the borrower to have a minimum of six months' worth of liquid reserves. This can be in cash or other assets that can easily and quickly be converted to cash.
Mortgage financing options for a rental property
You’ll find the same primary mortgage financing options for rental properties as you would find with primary residences. These include fixed and variable rate mortgages with repayment terms of 10 to 30 years. However, two options are not fully available when acquiring a mortgage for a rental property. These are the government-sponsored programs from the Federal Housing Administration, Veterans Affairs, or the U.S. Department of Agriculture. These loan programs help low-income borrowers, veterans and active military members, and rural homebuyers.
However, there is one exception to the rule. If you’re purchasing a multi-unit property and plan on living in one of the units, you can still secure an FHA loan or a VA loan. The rental property will need to have a minimum of four units, and you are required to live in one of the units for a minimum of one year. The benefits of an FHA loan include a lower credit score requirement and a smaller down payment. VA loans have no credit score or down payment requirement; however, the lender may have their eligibility requirements to meet.
Other alternatives to traditional mortgage financing include securing a private loan or using a home equity loan or line of credit to finance the purchase.
Important considerations before investing in rental property
Before you invest, you need to understand some key metrics. While rental properties can be valuable assets, these metrics help determine which properties will be best for income generation and asset appreciation.
The rent ratio is the monthly rent generated divided by the total cost of the property (purchase, financing, and rehab costs). A 1-2% ratio is acceptable, but higher is even better.
Cap rate is short for capitalization rate, and it is a ratio of net operating income to the property value. It is calculated by taking the net income (gross income minus expenses) and dividing it by the property's purchase price. A rate of 6% is acceptable, but generally, landlords prefer to see a cap rate of 8-10%.
Cash-on-cash return is determined by dividing the pre-tax cash flow of the property by the equity invested in the property. You should look for a cash-on-cash return of 8-12%.
Remortgaging a rental property
Often landlords look to refinance a rental to improve the mortgage terms or to access the equity locked up in the property. Here are some of the top benefits of remortgaging:
Switch from adjustable to fixed-rate – When refinancing, the loan terms can be changed. Switching to a fixed-rate mortgage can make budgeting more manageable and is preferable during rising interest rate environments.
Lower the interest rate – If interest rates have dropped, refinancing the mortgage can sometimes provide significant savings in interest costs over the life of the loan.
Renegotiate the terms – By refinancing, the borrower has the chance to renegotiate the terms of the loan, often leading to a mortgage that’s better for the buyer.
Lower monthly payments – A lower interest rate or extending the life of the mortgage should also lead to lower monthly payments, giving the landlord improved cash flow.
Pull out equity – A refinance can be one way to pull equity from the property, which can then be used to improve the property or as capital for additional investments.
Remember, there are many considerations when refinancing a mortgage. As the buyer, it’s up to you to weigh the benefits against any possible risks. While refinancing a mortgage does come with benefits, there are also downsides to extending the life of a mortgage.
The responsibilities of a landlord, mortgage and all
Before you commit to becoming a landlord, it’s essential to weigh all the relevant factors to decide if this is the right move for you. While there are many financial rewards to be had from rental properties, there are also several concerns that you should also consider.
Rental properties can be an excellent way to generate income and create long-term wealth. In addition, investment property ownership comes with some real tax advantages in the U.S. Landlords are permitted to take deductions for expenses and property depreciation. It’s even possible to defer the taxes owed when selling an investment property, so long as the proceeds are rolled into a similar investment (typically another rental property).
However, you have to consider the potential downsides of being a landlord. Rental properties often come with expenses for maintenance and repairs that can be quite significant. And then there’s the possibility of dealing with difficult tenants. While you could outsource these tasks, that adds another layer of costs, which will eat into your cash flow.
You should also understand the tenant laws that apply in your jurisdiction. While tenant laws can be favorable for landlords, that’s not always the case. For example, some states make it extremely difficult to evict a tenant, even if it is justified.
In many cases, the long-term benefits of becoming a landlord outweigh any potential problems. So do your research, learn as much as you can, and if the rental property still seems like a good idea, you can go into the process fully informed and ready to make the best of your rental investments.