Demand from tenants for good rental property has been growing by leaps and bounds over the last few years, sending rents and home values soaring. As more people become interested in investing in real estate, one of the common questions that comes up is how much of a down payment is needed.
In this article, we’ll discuss how a down payment for investment property works, along with five places to find funds for a down payment that many buyers overlook.
- A down payment for investment property generally ranges from 15% to 25%.
- House hacking is a technique used by some real estate investors to reduce the down payment amount to as little as 3.5%.
- Loans backed by Fannie Mae and Freddie Mac are two options for financing an investment property.
How much down payment do you need for an investment property loan?
As a rule of thumb, buy-and-hold real estate investors normally make a down payment of around 20-25% when financing an investment property, although some loan programs offer investment property financing with down payments as low as 15%.
However, the answer to this question really depends on what a lender’s requirements are and the credit history, experience, and general risk profile of a borrower.
From the point of view of the lender, the smaller the down payment is – or the higher the loan-to-value (LTV) ratio is – the greater the potential level of risk. That’s because a borrower making a small down payment does not have a lot of “skin in the game” and may be more willing to walk away from the property if the investment doesn’t perform as expected.
Investment property loans with a higher loan-to-value (LTV) ratio generally come with a higher interest rate and larger loan fees to compensate the lender for taking on more risk.
On the other hand, loan fees and mortgage interest rates on investment property loans with bigger down payments tend to be less costly. Investors with a good credit score and significant down payment may also find more options available for getting a loan on a rental property.
One of the more creative options for investing in real estate is through house hacking. Investors who house hack buy a house or small multifamily property as a primary residence, then rent out a spare room or extra units and use the monthly rental income to pay down the mortgage as quickly as possible.
House hacking can also be used to reduce the amount of the down payment needed to buy a home. As a rule of thumb, investors use a down payment of 25% to finance an investment property. However, FHA loans allow down payments as low as 3.5% for a single-family home used as a primary residence or a multifamily home where one unit is occupied as a primary residence.
Traditional ways to finance an investment property
Traditional lenders, such as banks and credit unions, offering investment loans backed by Fannie Mae and Freddie Mac are a source investors may consider for financing an investment property.
Mortgage brokers often have access to alternative sources for financing a rental property, like portfolio lenders, while Stessa Mortgages is a good place to obtain a competitive mortgage quote for purchasing or refinancing a property.
The most recent Fannie Mae Eligibility Matrix is used by conventional lenders who offer financing for an investment property. Eligibility factors lenders consider when underwriting an investment property loan include credit score, minimum reserve requirements, debt-to-income (DTI) ratio, and loan-to-value (LTV) ratio.
Fannie Mae’s maximum LTV and down payment standard eligibility requirements for financing an investment property using a fixed rate or adjustable mortgage are:
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Investment property mortgages backed by Freddie Mac are another potential option for financing a rental property. Qualified borrowers may find flexible financing options for investment opportunities to address individual cash flows and financial situations.
The LTV ratios and down payment amounts that Freddie Mac requires for an investment property loan are similar to Fannie Mae:
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Rather than originate conforming loans to sell to Fannie Mae and Freddie Mac, portfolio lenders offer investment loans to keep on their own books. According to a recent report from Bankrate, about 30% of all mortgages are typically underwritten through portfolio lenders (also known as direct lenders).
Portfolio lenders are able to create their own approval standards because they do not resell the investment property loans they originate. For example, a portfolio lender may be willing to accept a borrower with a lower credit score or higher debt-to-income ratio than a conventional lender would.
In exchange for taking on more potential risk, interest rates and loan fees from a portfolio loan may also be higher. But if an investment property appears to be a good deal, paying more for portfolio financing may be better than losing the home to another buyer.
Sometimes, traditional lenders also offer portfolio financing and title companies and investor-friendly real estate agents may be able to recommend a good portfolio lender.
Alternative ways to come up with a down payment for an investment property
Although a down payment of 25% for an investment property may seem like a lot of money, there are actually several options for finding funds to buy a rental property:
A home equity loan or line of credit (HELOC) is one way to fund the down payment for an investment property by using the equity in a primary residence or an existing rental property.
Loan fees and interest rates are relatively affordable, and HELOCs typically have to be repaid over a period of 15-20 years. However, as a rule of thumb lenders only allow around 80% of the equity in a home to be borrowed, depending on income level and credit score.
Another option for coming up with an investment property down payment is by using a private lender. While many investors focus on the equity side of real estate investing, private lenders invest in real estate debt by making loans to investors looking for a down payment.
For borrowers with good credit and a successful track record of investing in real estate, interest rates and loan terms from private lenders may be comparable to those offered by a traditional bank.
Most retirement account investments are limited to publicly-traded stocks, bonds, and mutual funds. By converting a traditional IRA or 401(k) into a self-directed IRA (SD-IRA) savers are able to purchase rental property. A custodian is normally used to set up an SD-IRA to help ensure compliance with tax laws.
Income or losses generated from the rental property stay within the self-directed IRA until retirement withdrawals begin, and the account must have sufficient funds to pay for operating expenses and CapEx (capital expenses) without needing to add extra cash beyond normal annual contributions. Consult your tax advisor or professional for additional details.
There’s no rule that says a real estate investor has to purchase a property all on his or her own. Forming a joint venture or LLC to invest in rental housing is one way to raise the down payment for investment property.
Today, many people would like to invest in real estate but don’t know how. An investor willing to put in the time and effort could identify good deals in the best rental property markets, then bring in other partners willing to contribute cash for the down payment in exchange for a share of any monthly cash flow and future potential profits.
Getting approved for an investment property loan
In addition to the size of the down payment, lenders also consider factors such as credit score, debt-to-income ratio, and cash reserves when an investor applies for a rental property loan.
According to LendingTree, the chances for getting approved for a conventional investment property loan strengthen when borrowers meet the following loan criteria:
- Minimum of 15% down payment, although some investors use house hacking to reduce the amount of money needed to put down.
- Minimum credit score of 700, although the loans with the best terms and rates are available to borrowers with a credit score of 740 or higher.
- Maximum debt-to-income (DTI) ratio of 45%, which means that the percentage of gross monthly income used to pay monthly debt can not be higher than 45%.
- At least 6 months in cash reserves is required to buy an investment property, to have funds available to pay the mortgage if the home is vacant for an extended period of time.
Tips for buying an investment property
The down payment for an investment property loan is just one of the things to think about before buying a rental home. Other important considerations include:
Attractive housing markets for investment
Local market characteristics that make some housing markets better than others include job and population growth, change in housing prices and affordability, growth in rent prices year-over-year, percentage of renter-occupied households, median household income, and median age of residents.
State property tax & income tax rates
Both property tax rates and state income tax rates can vary wildly from one place to another. Although taxes aren’t the only factor to consider when investing in real estate, many investors overlook the advantages of investing in a place where tax obligations are low. States where investors may have no income tax include Florida, Nevada, South Dakota, Texas, Washington, and Wyoming.
Professional property management
The best property management companies take care of day-to-day details such as rent collection and lease enforcement, tenant communication, and repairs and maintenance. Well maintained property generally has higher occupancy rates, leading to more robust cash flow and better potential ROI.
Tracking income and expenses
There are numerous tax benefits that come with owning an investment property, including operating expense deductions and depreciation expense to help reduce taxable net income. Investors use Stessa to automate income and expense tracking, and claim every tax deduction they are entitled to. When the end of the year rolls around, the Stessa Tax Center helps make tax season a breeze.
The down payment amount for an investment property varies based on a number of factors. Investors typically are required to make a down payment of about 25% to help get the most favorable loan terms and interest rates. In addition to the down payment amount, buying a rental property generally has closing costs of between 1% to 3% of the purchase price, plus fees for due diligence such as property inspection and appraisal.