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Financing a Rental Property: What to Know


Written by
Sunday, September 20, 2020

With interest rates flirting again with historic lows over the past couple of months, many are looking to invest in real estate. Rates are low and as such the situation offers the opportunity for monthly cash flow as well as long term appreciation. If you’re looking to expand your portfolio and get beyond stocks, bonds and mutual funds, adding real estate might be an option. When financing a rental, there are some things you need to know about before moving much further along.

The first is how much cash you’ll need at the closing table. Conventional loan programs ask for a minimum of 20% for a down payment and can offer slightly better terms with a 25% down payment. Owner-occupied loan programs can ask for a minimum down payment of 5%, with certain targeted areas qualifying for a 3% down option. One of the drivers behind the difference in down payment requirements for the same type of property is private mortgage insurance, or PMI. Down payments of less than 20% of the sales price require PMI but PMI is not available for rental properties.

Next, interest rates for non-owner occupied homes will be slightly higher compared to owner-occupied properties. How much higher? It depends upon the program you can expect a traditional 30 year fixed loan for a rental to be anywhere from 0.375% to 1.00% higher. This obviously impacts qualifying because higher rates equate to higher monthly payments.

Another important item to note is the income generated from the unit. Lenders will factor in a vacancy rate of around 25%. This means the property will be unoccupied and not generating any income as tenants come and go. When someone moves out of a rental, the landlord will begin preparing the property for the next round of renters. Repairs are made, paint, maybe updating the appliances…all take a bit of time. As well, it can take some time to properly market the property for rent. Depending upon the area and the real estate market, it might take a couple of months to find and qualify new tenants.

And speaking of income, savvy real estate investors typically only look at properties that provide a positive cash flow each month. Otherwise, the asset turns into a monthly expense instead of monthly income. It’s relatively easy to discover how much rent a unit is currently generating. An appraiser can also help. The appraiser will also perform a market rental survey. This survey researches other rentals in the area of the same property type. Using this information, an average rent will be calculated and listed as such in the appraisal report. It is this number lenders use to determine monthly rental income, not necessarily what is listed on a rental agreement.

And finally, in order to use that income, there needs to be a record of at least two years of owning investment real estate. Lenders want to make sure the new owners can responsibly manage the rental property over an extended period of time. Even though the unit may be generating cash each and every month, while the lender recognizes the cash coming in, it can’t be used to help qualify for the new home. This obviously means qualifying with at least two mortgage payments along with associated property taxes, insurance and maintenance.

However, once that two year milestone has been reached, subsequent purchases can use the generated income each month to offset the new monthly payments. For this reason, it’s not uncommon for real estate investors to own multiple properties and not just one or two. The new mortgage payments are no longer an expense, but an asset that appreciates over time and pays the owner a monthly salary.



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