A growing number of people today are interested in investing in real estate to generate extra income and increase net worth over the long term. But in order to purchase a rental property, financing often has to be arranged.
While financing a rental property is similar to a primary residence, there are some unique differences between the two. Keep reading to learn more about how to finance a rental property, including what lenders look for and 7 options for finding a rental property loan.
Key takeaways
- Rental property loans are used to purchase income-producing real estate such as single family rental homes and small multifamily properties.
- Financing a rental property typically requires a larger down payment than a primary residence.
- A lender will consider a borrower’s credit score, debt-to-income ratio, and existing qualified rental income from the property being purchased when underwriting a rental property loan.
- Options for financing a rental property include conventional and FHA loans, VA loan programs, private money lenders, group investments, and portfolio lenders.
How is a rental property loan different?
Rental property loans are used to finance income-producing real estate such as a single-family rental (SFR), small multifamily building with 4 units or less, along with townhouses and condominiums.
Since loans for rental property are used to finance investment real estate, the loan terms and conditions are generally stricter than with a mortgage for a primary residence. That’s because a lender views a rental property loan as having more risk when a borrower is not living in the home.
Rental property loan requirements
While the process for financing a rental property is similar to a primary residence, there are key differences a borrower should be aware of. Here are things to expect when applying for a rental property loan.
Down payment
Unlike financing a primary residence where down payment requirements are low, a lender generally looks for a rental property down payment of between 15%-25%.
Sometimes a lender will use the term LTV or loan-to-value, which is another way of describing the required down payment amount. If a lender says the maximum LTV is 75%, that means the maximum loan amount is 75% of the property purchase price, and the required down payment is 25%.
For example, if an investor is purchasing a single family rental home for $120,000 and the maximum LTV is 75%, the down payment amount would be $30,000 ($120,000 x 25%).
Existing rental income
One of the advantages of purchasing a rental property with a tenant already in place is that the existing rental income may be used to help qualify for a rental property loan.
As a rule of thumb, a lender will apply 75% of the property’s reported rental income to a borrower’s total income. For example, if a borrower earns $100,000 per year and a rental property generates $18,000 per year in gross rental income, a lender will add $13,500 to a borrower’s total income used to qualify for a rental property loan.
According to Fannie Mae (November 3, 2021) guidelines:
- There must be a 1-year history of receiving the rental income
- Rental income is likely to continue
- Income must be properly documented
- Rental property being financed must be a 1-4 unit investment property
If the rental property is vacant and waiting for a new tenant, some lenders will count 75% of the potential rental income as part of a borrower’s total income, based on a rent analysis performed by an appraiser.
Credit score
The better a borrower’s credit score is, the more attractive and flexible a lender may be when offering a rental property loan. In general, the minimum credit score required to finance a rental property is 620.
Borrowers with a credit score above 620 may be eligible for a down payment of less than 25% and a more attractive mortgage interest rate. However, the interest rate on a rental property loan may still be higher than the interest rate for a primary residence.
Debt to income ratio
Debt-to-income-ratio (DTI) compares a borrower’s monthly gross income to the monthly debt payments and is expressed as a percentage. A lender will normally look for a maximum DTI of 45%.
For example, assume a borrower’s total income (including qualified existing rental income) is $113,500 per year or $9,458 per month. The maximum debt payment would be $4,256, including the monthly mortgage for the rental property being financed:
- $4,256 monthly debt payments/$9,458 gross monthly income = 45% DTI
Cash reserves
An investor applying for a rental property loan will usually be required to have enough cash in reserve to pay for 3-6 months of operating expenses and mortgage payments.
Even though investors do their best to forecast income and expenses, sometimes repair costs are higher than expected or it can take longer than anticipated to find a qualified tenant. Having cash reserves lets a lender know the money is there to maintain the property and pay the mortgage even if there is no rental income being received.
7 options for financing a rental property
An investor may find that there are actually more financing options for a rental property than there are for a primary residence. Here are 7 options for obtaining a loan on a rental property:
Conventional
Conventional loans offered by banks and credit unions follow guidelines set by Freddie Mac and Fannie Mae. Depending on a borrower’s credit score, down payments range between 15%-25%. Loan costs and mortgage interest rates are usually competitive, and many will consider qualified rental income from the property being financed when calculating a borrower’s debt-to-income ratio.
FHA multifamily
Available for properties with 2-4 units, these loans are backed by the FHA and may be a good option for a borrower trying to raise a down payment or with negative markets on a credit report.
Down payments are as low as 3.5% for a borrower with a credit score of 580, and just 10% if the credit score is between 500-580. However, a borrower will be required to live in one unit as a primary residence for at least the first 12 months to qualify for an FHA multifamily loan.
VA multifamily
VA multifamily loans are available for active-duty services members, eligible spouses, and veterans. Down payment is 0% and there is no minimum credit score. A VA loan can be used to purchase a multifamily property with 2-4 units, although a borrower must live in one of the units as a primary residence.
Portfolio lender
Portfolio lenders and small, local community banks keep the mortgage loans they originate on their own books instead of selling them to agencies like Fannie Mae or Freddie Mac. Loan terms and conditions may be more flexible and designed to meet the needs of both the borrower and the lender. A portfolio loan for a rental property may be a good option for a borrower with a lower credit score or a high debt-to-income ratio.
Private lender
Private lenders are fellow real estate professionals who prefer to invest in debt instead of equity. Rather than owning real estate directly, they provide funds for investors seeking to finance a rental property. A borrower looking for creative financing, such as acquiring a property to rehab and rent, may wish to speak to a private lender to learn more about approval requirements and faster funding timeframes.
Group investing
Some investors bypass banks altogether and form a real estate limited partnership (LP) or limited liability company (LLC) to raise money to invest in real estate. Instead of an individual borrower owning a rental property, the LLC owns the real estate and investors own shares of the LLC as members.
An LLC operating agreement can be structured to make monthly principal and interest payments to members who contribute capital, similar to the way a mortgage loan works from a conventional or private lender.
Home equity line of credit
A borrower with a primary residence or other rental properties may be able to turn accrued equity into cash with a home equity line of credit (HELOC). A HELOC is a second-position mortgage on a property and works similar to a credit card.
A lender will generally allow a borrower to access up to 80% of the equity in a property to use for the purchase of a rental property, including any needed repairs. A credit line from a HELOC does not have to be used right away, giving an investor access to funds when and if they are needed. Monthly repayments are often interest-only at first, with either fixed for variable interest rates.
Closing thoughts
Investing in a rental property may be a good way to generate monthly rental income while building equity over the long term. However, as with any other type of debt, financing a rental property does come with some risk.
A real estate investor may wish to shop around for the best loan terms and conditions, make a large enough down payment to keep LTV and DTI ratios low, and take the time to research different real estate markets to find a rental property that meets an investor’s goals and objectives.
