But it’s no secret that real estate can be expensive, and many people can’t afford to buy investment properties out of pocket. Luckily, there are plenty of ways to finance an investment property, including utilizing traditional lending and assets you already own.
What Is an Investment Property?
An investment property is a piece of real estate purchased to provide a return on investment or a source of income for the buyer. Popular investment properties include single-family homes and multi-family homes such as duplexes and apartment buildings. Investment properties are generally profitable because of the monthly cash flow they often provide. If you buy an investment property and rent it out to a tenant, your profit is the monthly rent above and beyond what it costs to own and maintain the home. An investment property can also provide a capital gain if it appreciates while you own it. The difference between an investment property and a primary or secondary residence is that a primary residence is one where you live most of the year, and it generally doesn’t provide a source of monthly cash flow. In the case of a multi-family unit, a property may serve as both an investment property and the investor’s primary residence.
Conventional Bank Loans
Similar to conventional mortgages for primary residences, lenders also offer conventional loans for investment properties. These loans have many of the same requirements as other conventional loans, set by Fannie Mae and Freddie Mac. One of the most significant differences between investment and primary-residence loans is that you’ll likely need a larger down payment. Primary residences can often be purchased with as little as 3% down. Fannie Mae-backed loans for investment properties typically require 15% down for single-family units and up to 30% down for multi-family units, depending on the loan type. Another difference is the income that’s used to qualify for a conventional loan on an investment property. Just like when you purchase your primary residence, you can use your personal debt-to-income ratio to qualify for a mortgage. But in the case of investment properties, you can also use your expected future rental income to qualify.
Fix-and-Flip Loans
A fix-and-flip loan is designed for real estate investors who plan to renovate and resell a property quickly. An investor who flips homes has very different needs than one who buys a property to rent out for many years, and so the loan they might need is also different. First, while a conventional mortgage is designed to cover the cost of the home minus down payment, fix-and-flip loans also take into account the repair costs the investors will incur. As a result, they may well be borrowing more than the home is currently worth. Another feature of fix-and-flip loans is that they often have higher interest rates than conventional loans. This rate accounts for the fact that the financial institution is lending more than the property is actually worth and the fact that the borrower is likely to pay off the loan in a shorter period of time. For example, a fix-and-flip loan might have a term of just 12 to 18 months. It’s important to note that while these loans come with some benefits, including the fact that they’re tailored to house flippers, there are also some risks. If you aren’t able to sell the home as quickly or for as much as you hoped, you could find yourself underwater on a loan with a high interest rate and unaffordable monthly payments.
Financing Based on Home Equity
Another option to finance an investment property is to use the equity you have built up in your primary residence or another property you own. With home equity loans, home equity lines of credit (HELOC), and cash-out refinance, lenders allow you to use this equity for other purposes.
Home Equity Loan
A home equity loan is a fixed lump sum you borrow from a financial institution, with a predefined repayment period and interest rate. You can often borrow up to 85% of your home’s equity for any purpose.
Home Equity Line of Credit
A home equity line of credit (HELOC) is a revolving line of credit homeowners can use to borrow against their home’s equity if and when they need it. HELOCs come with a maximum amount you can borrow, but you can continue to borrow that amount as long as you pay it back. HELOCs often have an initial “draw” period, during which you can borrow against your equity, as well as a repayment period where you make fixed payments. During the draw period, you may only be required to pay the interest on your line of credit at a variable interest rate.
Cash-Out Refinance
A cash-out refinance is a type of refinance loan where you take out a new mortgage that is larger than the one you’re refinancing. The difference between the original mortgage and the new one is paid to you in cash for you to do whatever you want. A cash-out refinance acts just like any other type of mortgage refinance loan when it comes to repayment—you simply take out a larger loan. Then, you can use the extra cash to finance your investment property.
Pros and Cons of Equity-Based Loans
The advantage of using your home equity to finance an investment property is that you’re able to leverage an asset you already own. But there’s also a major downside to consider. When you use your home equity to finance the purchase of a second property, your original property serves as collateral. If the investment property doesn’t pan out as you expected and you can’t make your loan payments, you could lose your primary residence. Another risk is that in the case of HELOCs, there’s often a variable interest rate. So a loan payment that seems affordable today could easily become unaffordable if interest rates rise significantly.
Tips for Financing an Investment Property
Getting financing for an investment property has a few hurdles you can clear if you know how to prepare ahead of time.
Plan for a Large Down Payment
Conventional loans for investment properties require anywhere from 15% to 30% down, depending on the number of units in the home and loan type. The more you can save, the more flexibility you’ll have when it comes to shopping for properties.
Use Cash if Possible
While there are financing options available, there are also some advantages to paying cash. First, you reduce your risk of foreclosure if you can’t bring in the rental income you expected. You’re also a more competitive bidder when it comes to finding investment properties, especially in a seller’s market. In fact, December 2020 data from Realtor.com found that all-cash deals made up about 36% of real estate deals nationwide, as these offers can be more attractive to the seller.
Improve Your Credit Score
Your credit score is an important factor in determining whether you qualify for a home loan, how much you qualify for, and what interest rate you can get. A good credit score may allow you to buy a home with a smaller down payment and lower interest rate, which can help you save tens of thousands of dollars in interest.
