Are you considering purchasing an investment property? It can be an excellent source of passive income, but financing an investment property is very different from financing a primary residence. You may consider yourself a mortgage pro because you've gone through the process already, but investment property mortgages have additional steps, higher rates, and additional borrower scrutiny.
Let's go over a few things to keep in mind before you make the jump and apply for an investment property loan.
1. Your down payment will probably be higher
Primary residences and investment properties both have similar kinds of mortgages, such as conventional loans, FHA loans, and VA loans. However, qualifying for these mortgages is more challenging for investment properties than they might be for a primary residence or even a second home.
One of these higher associated costs is your down payment. Homebuyers searching for primary residences can sometimes qualify for mortgages that require as little as 3–5% down. But most investment property loans require at least a 15-20% down payment to secure a favorable rate.
One reason for this increase is because there’s more risk involved for lenders. Lenders like security, so you'll need to pay a higher down payment to give them confidence that you won't default on the loan. You’re not going to live in this property, so you presumably have less stake in maintaining it. And there’s financial risk, because your ability to pay for the loan is dependent on whether or not you can reliably rent out the home—which is not always something you can control.
With a primary residence, a homebuyer can often get a loan with a lower down payment in exchange for getting private mortgage insurance, or PMI. However, PMI does not cover investment properties, which is another reason those down payments tend to be a bit higher. The more you put down, the more confidence lenders will have and the more likely you’ll be able to secure a favorable rate. Purchasing an investment property through a personal loan is also an option, but often comes with different terms and higher rates.
2. Your interest rates will be higher, too
Mortgage interest rates for investment properties are even higher than those for a second home—which is a property you intend to live in for only part of the year. You can typically expect investment property rates to be at least .5–.75% higher, or even as much as 1% more, than your primary residence. When a lender purchases an investment property loan, Fannie Mae and Freddie Mac charge higher fees because these loans are considered higher risk. So the lenders raise the interest rates to help cover these fees.
3. You’ll need a solid credit score
As mentioned above, if you want to buy an investment property, lenders will want to see that you’re a reliable borrower with a low risk of default. A high credit score is another way you can prove that to them.
You’ll most likely need a credit score of at least 720 if you want to qualify for a conventional loan. It's still possible to obtain a loan with a lower score, but it will require higher fees and interest rates, as well as a lower required loan-to-value ratio (LTV). For example, Fannie Mae borrowers can acquire a rental property mortgage with a credit score of 640, as long as they make a down payment of at least 25%.
If you’re looking to refinance your investment property, you’ll need at least a 620 score to qualify at all. If you’re curious, learn about how your credit score affects your mortgage.
4. There will be ongoing costs
If you're thinking about buying an investment property to rent, you need to remember that there are additional and ongoing costs to factor into your budget. Procuring a mortgage is just the first step.
You’ll need a financial cushion
What will you do during the months no one is living in your rental property? You'll still need to make monthly loan payments, so it's in your best interest to have a financial cushion to protect you in case you hit any dry spells.
In fact, having a sufficient financial cushion is often a requirement to qualify for an investment property mortgage in the first place. Lenders will want to see at least 6 months worth of cash reserves or assets you could convert into cash, if necessary.
Be aware of operating expenses
One of the first things you should do when hunting for an investment property is to calculate operating costs. Besides paying your mortgage, how much will it cost to keep the lights on? Fix any problems that arise? Pay property tax? Cover management fees if you hire someone to help maintain the property? Pay home insurance? While many of these monthly payments are calculated by your lender in your debt-to-income (DTI) ratio, there are other considerations.
Many landlords underestimate how expensive their operating costs will be. The truth is that these costs are usually between 35% and 80% of your gross operating income (GOI), so don't assume you’ll make enormous profit margins from charging your tenants rent. It’s important to calculate your realistic costs upfront so that you don't overcharge your tenants or fall behind on any necessary payments.
5. Investment properties come with a lot of responsibilities
When you buy an investment property, congratulations! You’re a landlord. However, this new title comes with a broad range of responsibilities, like:
- Repairing property and appliance damage
- Complying with state codes
- Ensuring pests are eliminated
- Ensuring heat, electricity, and water are present
- Supplying garbage receptacles
You’ll also need to provide habitable living conditions and collect monthly rent. You might also want to consider looking into landlord insurance, which helps cover damages to your rental property and other financial liabilities.
If you don’t have the skills or the time for all of these tasks, you have the option of hiring a third-party property manager. But just keep in mind that a property manager will be an additional operating cost to account for.
Now that you’ve learned about investment property loans, there are many options available to you. These investments can be lucrative if you qualify for financing—and ever more so if you’re willing to put in the work. We recommend that you do your research in terms of property values and vacancy rates. Then, you’re ready to take a look at rates to start outlining a budget, see if you prequalify for an investment property mortgage with Better Mortgage today.