There are many reasons and ways to invest in real estate. It can be a hedge against market volatility when stocks tumble, and there are many perks associated with owning an investment property.
Whether you are buying and holding land for future development, flipping a property, purchasing a property for an elderly relative to live in and enjoying the appreciation when it sells, or creating a passive income stream by renting the property, purchasing an investment property is a great way to diversify your portfolio.
Unlike investing in the stock market, which can be done for very little money, investing in real estate has a generally high start-up cost. Once you have decided that investing in real estate is right for you, done your research, and found a good deal, you need to consider how to secure financing for your investment property.
Investment property financing can take several forms, and there are specific criteria that borrowers need to be able to meet. Choosing the wrong kind of loan can impact the success of your investment, so it’s vital to understand the requirements of each kind of loan and how the various alternatives work before approaching a lender.
Option 1: Conventional Bank Loans
If you already own a home that’s your primary residence, you’re probably familiar with conventional financing. A conventional mortgage conforms to guidelines set by Fannie Mae or Freddie Mac, and unlike a Federal Home Administration (FHA), U.S. Department of Veterans Affairs (VA), or U.S. Department of Agriculture (USDA) loan, it’s not backed by the federal government.
With conventional financing, the typical expectation for a down payment is 20% of the home’s purchase price. With an investment property, however, the lender may require 30% of funds as a down payment.
With a conventional loan, your personal credit score and credit history determine both your ability to get approved and what kind of interest rate applies to the mortgage. Lenders also review borrowers’ income and assets. And obviously, borrowers must be able to show that they can afford their existing mortgage and the monthly loan payments on an investment property.
Future rental income isn’t factored into the debt-to-income (DTI) calculations, and most lenders expect borrowers to have at least six months of cash set aside to cover both mortgage obligations.
Option 2: Hard Money Loans
A hard money loan is a short-term loan that is most suited to flipping an investment property as opposed to buying and holding it, renting it out, or developing on it.
While it is possible to use a hard money loan to purchase a property and then immediately pay off the hard money loan with a conventional loan, private money loan, or home equity loan, starting out with one of the other options is more convenient and cost effective if you are not intending to flip your property.
The upside of using a hard money loan to finance a house flip is that it may be easier to qualify for compared to a conventional loan. While lenders still consider things like credit and income, the primary focus is on the property’s profitability.
The home’s estimated after-repair value (ARV) is used to gauge whether you’ll be able to repay the loan. It’s also possible to get loan funding in a matter of days, rather than waiting weeks or months for a conventional mortgage closing.