Using other people’s money by getting a loan on a rental property can be a good way to increase potential returns as long as you conservatively balance risk with reward.
In this article, we’ll look at the options for getting a rental property loan and discuss how to analyze cash flow and property value to help you make the best investment decision.
How Rental Property Loans Work
As a rule of thumb, loans for a residential rental property come with slightly higher interest rates and require larger down payments. Rental property loans are still fully amortized over 30 years so that the payment amount is the same every month, which makes putting together an accurate pro forma for cash flow easier.
Interest rates are higher and down payments are bigger because lenders view investment property loans as being more risky compared to a mortgage for an owner-occupied home. That’s because banks know from experience that if the investment doesn’t go as planned, an investor-borrower is more likely to walk away and give the keys back to the bank.
However, the slightly more restrictive terms on a rental property loan can work in favor of the real estate investor. Interest payments can be completely expensed as a tax deduction by investors. A bigger down payment creates a lower loan-to-value (LTV) ratio, with a lower mortgage debt service payment amount and potentially increased cash flow.
Although every lender is different, these are some of the typical requirements to expect when applying for a residential rental property loan:
- Minimum credit score of 620
- Maximum of 36% debt-to-income (DTI) ratio
- Down payment of 25% or more based on the property type and borrower credit
- Interest rates and loan fees slightly higher to compensate lender for additional risk
- PMI (private mortgage insurance) is not applicable when the down payment is 20% or more (LTV is less than 80%)
- Borrower must have cash reserves to cover six months of mortgage payments
- Single-family, small multifamily, condos, and townhomes qualify for residential rental property loans
Options for a Rental Property Loan
It’s much easier and less expensive to find a loan option for a residential rental property like a house or a duplex compared to a large apartment building or commercial property. If you’re shopping around for a rental property loan online, you can get a free rate quote from an experienced mortgage professional on Stessa.
Here are some of the options to look at when you need a loan for buying a rental property or refinancing an existing mortgage:
Conventional or conforming loans are mortgages that most people are familiar with. They are offered by traditional lenders like banks or credit unions, and also by mortgage brokers who work with a variety of lenders and can help you find the best deal.
Interest rates are usually lower than other options provided you have a good credit score, and down payments may be less than 25%. Conforming loans must meet Fannie Mae or Freddie Mac guidelines. While Fannie and Freddie allow up to 10 mortgages by the same borrower, banks often set a lower limit of around four loans total.
Federal Housing Administration (FHA) loans are also offered by traditional lenders and mortgage brokers. Credit score requirements and down payments are usually lower than a conventional loan, and income from an existing rental property can be used to help qualify.
FHA loans are a good option for multifamily property investors looking for a rental property loan for a new purchase, new construction, or renovating an existing property. To help qualify for an FHA multifamily loan, the investor will need to use one unit as a primary residence for at least one year.
Veterans Affairs (VA) multifamily loans are a third option for rental property loans offered by banks, credit unions, and mortgage brokers. Mortgages backed by the U.S. Department of Veterans Affairs are available to active-duty service members, veterans, and eligible spouses.
There are several benefits to using a VA loan for a rental property if you qualify. There is no minimum down payment or minimum credit score, and you may be able to purchase up to seven units. However, one of the units must be your primary residence.
Portfolio loans are mortgages on individual single-family or small multifamily properties by the same lender. Although each property has its own loan, the mortgage brokers and private lenders who offer portfolio loans may offer the borrower a ‘group discount’ for multiple loans.
Loan terms such as interest rate, down payment, credit score, and loan length can be customized to fit the specific needs of the borrower. However, because portfolio loans can be easier to qualify for when an investor has multiple properties, there may also be higher fees and prepayment penalties.
A blanket loan is a good option for real estate investors who want to purchase several rental properties and finance all of them using a single loan or refinance a portfolio of existing rental homes. Mortgage brokers and private lenders are two sources for finding a blanket mortgage loan for any type of income-producing property.
Interest rate, length of loan, down payment, and credit score vary from lender to lender, and loan terms can often be customized to meet the needs of the borrower and lender.
Rental properties in a blanket loan are usually cross-collateralized, which means that each individual property acts as collateral for the other properties. However, you can ask for a release clause that allows you to sell one or more of the group of properties under the blanket loan without having to refinance the remaining properties.
Private loans are offered by experienced real estate investors and business people pool their capital and offer debt financing to rental property owners. Because these private investors know how the real estate business works, they often offer loan terms and fees customized to match the deal potential and the experience of the borrower.
Some private lenders may even take a small equity position in the project and accept future potential profits in exchange for lower fees or interest rates. If the investment performs according to plan, private lenders can also be an excellent source of funding for future rental property investments.
7. Seller Financing
Sellers who own a property free and clear (or with very little mortgage debt) are sometimes willing to act as a lender. By offering owner financing or a seller carryback, property owners who finance a sale to the buyer can generate interest income and earn a regular monthly mortgage payment instead of receiving the sales proceeds in one lump sum.
Seller financing can be a good option for owners who want to spread out capital gains tax payments over the life of the loan as an alternative to conducting a 1031 tax-deferred exchange. However, because the seller is offering the mortgage, borrowers should expect similar underwriting requirements such as credit checks and minimum down payment.
A home equity line of credit (HELOC) and a home equity loan are two options for pulling money out of an existing property to use as a down payment for another rental property loan. This strategy is an example of the waterfall technique where investors use the cash flow and equity build-up from existing rental properties to fund future purchases.
A HELOC acts as a line of credit secured by the equity in an existing property that an investor can tap into at any time, and repay the loan with monthly payments similar to the way a credit card works. On the other hand, a home equity loan is a second mortgage that provides funds to the borrower in one lump sum.
With both a HELOC and a home equity loan lenders generally set a borrowing limit of between 75% – 80% of the property equity. Interest rates and fees may also be higher compared to doing a cash-out refinancing using a conventional loan.
Reduce Rental Property Loan Costs
The lower your loan costs are, the larger your cash flow could be. Here are some of the best ways to keep your loan costs low when applying for a rental property mortgage:
- Research the best loan terms and conditions by speaking with lenders and mortgage brokers who know the local real estate market.
- Maintain a good personal credit score and use a conservative LTV with a down payment of around 25%.
- Prepare your mortgage application docs ahead of time – items such as W-2s, bank statements, and tax returns – to show the lender you’re a serious real estate investor.
- Generate income statements, net cash flow, and capital expense reports for any existing properties by automatically tracking income and expenses on Stessa.
Estimate Cash Flow Accurately
When you apply for a rental property loan the lender will want to see an existing cash flow statement or a pro forma income statement if the property currently isn’t rented to a tenant. When you calculate potential cash flow be sure to take these income and expense items into account:
- Gross potential rental income
- Vacancy allowance (to account for lost rental income during the time the property is vacant)
- Leasing and property management fees
- Operating expenses (repairs, maintenance, CapEx, etc. usually 20% of the gross rental income)
- Utilities (usually if the property is multifamily with a master gas or water meter)
- HOA fees
- Property taxes
- Mortgage payment (principal and interest)
Rental Property Performance Matters
There are a number of different ways to forecast the potential financial performance of a rental property before you apply for a loan. Analyzing cash flow from several different angles lets a lender know you’ve done your due diligence and also helps to avoid making a bad investment decision:
Capitalization rate (cap rate) compares the property’s net operating income (NOI) to the property purchase price or value and is a way of measuring potential return. NOI includes operating expenses but not the mortgage payment debt service.
Because cap rates vary from market to market, the cap rate calculation should only be used to compare similar properties in the same market or submarket. If a rental property that costs $150,000 generates an NOI of $9,500 per year the cap rate would be 5.7%:
- Cap rate = NOI / Property value
- $9,500 NOI / $150,000 property value = 0.063 or 6.3%
Cash-on-cash return (CoC) is a ratio that measures the cash returned as profit (pre-tax) to the amount of cash invested. Unlike the cap rate formula, cash-on-cash return factors in the debt service from a mortgage payment.
If you purchased a $150,000 rental property using a 25% down payment ($37,500) and your annual cash returned was $3,500 (pre tax including debt service) your CoC would be 9.3%:
- Cash-on-cash return = Cash returned / Cash invested
- $3,500 cash returned / $37,500 down payment cash invested = 0.093 or 9.3%
Loan-to-value (LTV) compares the amount of the mortgage loan to the property value.
Although using a smaller down payment may increase your cash-on-cash return, investors also run the risk of not having enough cash flow to pay the operating expenses and mortgage if vacancy is higher than expected or repairs costs run higher.
That’s why most lenders look for an LTV of no more than 75%:
- LTV = Loan amount / Property value
- $112,500 loan amount / $150,000 property value = 0.75 or 75%
Debt Service Coverage Ratio
Debt service coverage ratio (DSCR) compares the net operating income (NOI) available for the mortgage payment (P&I or principal and interest) to the overall mortgage debt.
The DSCR indicates the amount of cash remaining after the mortgage and operating expenses have been paid. If the annual NOI on a rental property is $9,500 and the annual mortgage payment (P&I) is $5,772 the DSCR would be 1.65 :
- DSCR = NOI / Debt payments
- $9,500 NOI / $5,772 debt payments = 1.65
Lenders usually look for a DSCR of between 1.25 and 1.40 on a rental property loan.