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Landlords Guide to Financing Rental Property Purchases

Financing Rental Property

Investors know that owning real estate is potentially lucrative, but financing rental property is another story. While there are many moving parts to the process, financing is a step that can trip up even the most seasoned individuals. Most lending institutions require higher down payments and stricter approval criteria for the property that is not a primary dwelling. So, many landlords wonder what the best way to fund these purchases is? To help make your goal of investing a reality, check out these tips below for financing a rental property.

Top 5 Options for Financing Rental Property Investments

Before even looking for listings, future landlords must take a hard look at their personal finances. Take an inventory of your personal assets, cash on hand, and financial data from any investment partners. Let’s take a look at the top 5 most popular options for financing rental property.

  1. Cash
  2. Private Money Lenders
  3. Home Equity Loan
  4. Conventional Mortgage
  5. Cash-out Refinancing

Using Cash for Financing Rental Property Acquisitions

This is the best way but not always an option. For seasoned investors with the available capital, consider a cash purchase. Keep in mind, coming to the negotiating table with cash is very appealing to sellers and could give you the edge over a competitive market of buyers with traditional loans. Additionally, offering cash could incentivize sellers to give an overall better deal.

However, while there are certainly benefits to a cash purchase, there are also a few drawbacks. Before jumping into this option, consider the benefits of cash versus the benefits of financing.

Using Cash for Financing Rental Property Acquisitions

Pros for Financing Rental Property with Cash

  • Less Chance the Deal Will Fall Apart – When you have cash, you have control. Investors do not need to rely on lenders coming through or processing as they would with a conventional loan. So, less chance of losing the deal.
  • Less Risk – The higher percentage of the purchase price you finance, the more risk you face of “falling underwater” if the market trends down. However, with cash, investors avoid this risk.
  • Favorable Negotiations – “Cash Offer” is music to a seller’s ears. Cash buyers can settle faster, which alleviates the seller’s concern of financing falling through last minute. In many cases, sellers are willing to accept a reduced offer that is backed by cash.
  • No Interest – Avoiding the interest that adds up over the course of a loan can save an investor thousands of dollars.
  • Skip Lender Fees – Origination fees, among others, can add up to thousands of dollars. Paying cash helps a buyer avoid these costly fees that lenders tack on.
  • Improved Cash Flow – When you do not have a mortgage payment to account for each month, monthly cash flow is better.

Is a Cash Sale Better Than Financing Rental Property?

Cash is indeed king, but that does not mean financing is not a great option. The key to determining which is best for you is to weigh all of the facts. Check out these reasons below why financing is better than cash.

  • Improved Liquidity – Real estate is not known for its liquidity. Therefore, investors who tie up large amounts of cash in a property could find it difficult to convert back to cash quickly. Many investors choose financing as a way to hang onto cash on hand.
  • Diversification – Even with the best due diligence, buying property is a risk. By financing, an investor can spread their cash across several properties. For example, you could purchase one property for $100,000 or divide that sum across several down payments. This allows for cash flow to come from several different avenues.
  • Quicker Scaling – If you plan on building a portfolio, financing is the way to do it. Typically, investors financing rental property grow their portfolio faster than those who opt for cash purchases.
  • Tax Advantages – Property investors can take advantage of deductions for depreciation, mortgage interest, and loan-related costs on their yearly taxes. Doing so can greatly benefit your bottom line.

Private Money Lenders as a Financing Option

Private funding comes from a non-institutional lender who provides financing in exchange for a secure interest in the property.  The benefit for investors in this scenario is speed. Typically, the process for private funding is faster than a conventional mortgage tract. That said, interest rates for this type of loan are higher than other available options. However, if the property has excellent rental income potential, the overall numbers may still work in the investor’s favor. Investors have several options for financing rental property; private money lenders might work for your situation. Below we examine a few scenarios where private money lenders are beneficial.

When Should an Investor Consider Financing Rental Property with Private Money Lenders?

When Should an Investor Consider Financing Rental Property with Private Money Lenders?

  1. Time is of the Essence – In the fast-paced and competitive real estate market, time is money. When investors need to secure funds fast, private money lenders are the best option. By securing capital, investors have the ability to close the deal faster and gain an edge over the competition.
  2. Credit is Not the Best – Banks require excellent credit for investment property purchases. So, if your credit needs some work, private lenders are beneficial. Private money lenders do charge higher interest, but they do not have the same strict credit requirements. That said, they do have additional fees, so research options carefully before selecting a lender.

Using Home Equity Loans to Purchase Investment Property

Coming up with the down payment is a challenge in any real estate transaction. Investors can utilize equity in their existing homes as a way to finance investment ventures. An equity loan is like a mini mortgage. It utilizes an existing home you already own to secure the new loan while investors make monthly payments over a 15 to 20-year period.

Typically, investors can use a home equity loan to borrow up to 90% of their primary home’s value. While this is a viable option for many, some investors hesitate to put their own homes on the line. So, weigh this option carefully to make sure it fits into your long-term financial plan, and you have ample funds set aside for unexpected circumstances.

Another option is via a home equity line of credit or HELOC. This allows you to access funds on an as-needed basis instead of the lump sum from a home equity loan. However, keep in mind that a HELOC will likely come with a variable interest rate. So, depending on how you plan to use the funds, a fixed rate home equity loan is more favorable.

Is a Conventional Mortgage Best for Financing Rental Property?

For this type of mortgage, the property you intend to purchase is the collateral for the loan. This is a great option for investors to spread the cost over a 15 to 30-year term for a decent interest rate. However, a mortgage for investment property is different than an owner-occupied home. Many lenders require anywhere from a 20% to 30% down payment along with excellent credit. Remember, lenders are looking to ensure the investor can afford both their own mortgage and the one on the investment property. In addition to conventional loans, individuals can also use government loans. Let’s take a look at some options below.

Is a Conventional Mortgage Best for Financing Rental Property?

Other Mortgage Loan Options for Investment Property

  • FHA Loan – Using an FHA loan for investment property is possible under certain circumstances. The benefit is investors have a lower down payment, and the loan has more lenient qualifications. However, because of restrictions, this option will not work for every investor. There are two ways an FHA loan can purchase an investment property; if investors buy a one-unit primary residence and live in it for several years before renting to a tenant, or if investors purchase up to a four-unit multi-family property with the intent to occupy one of the units.
  • VA Loan – Investors can consider this type of loan if they are a veteran, active-duty military, reservists, members of the Coast Guard and the National Guard, or surviving spouses of an eligible service member. Offering similar conditions to an FHA, owners must occupy a part of the property for a time. However, a VA loan requires a credit rating above 620 and a less than 41% debt-to-income ratio. That said, if you meet these qualifications, you can take advantage of up to 100% financing with no mortgage insurance.

How to Use Cash-out Refinancing to Purchase Rental Property

Using a cash-out refinance option, investors can borrow up to 80% of their home’s value. It works by paying off the existing debt on the property, establishing a new mortgage, and then giving investors the difference. However, the lender is still using the home you currently own to secure the loan. So, investors must be comfortable putting their property on the line. Additionally, this process is similar to applying for a standard mortgage, so plan on 30 to 45 days to complete the transaction.

The Pros of Cash-out Refinancing

  • Take advantage of low-interest rates
  • Use leverage to potentially increase cash-on-cash return and ROI
  • Increase return by making upgrades that justify higher rents
  • Grow your portfolio by investing in additional properties

The Cons of Cash-out Refinancing

  • Risk of over-leveraging and high monthly payments
  • Cash-out fees add up, such as origination, application fees, appraisal, inspection, title search, and insurance fees.
  • Agreeing to an adjustable-rate mortgage may not agree with your long-term strategy

 

In Conclusion

Investors have the benefit of several options for financing rental property. Which path you choose depends on your financial situation and long-term goals. Part of being a successful real estate investor is understanding the need for support staff around you. Ambitious investors chasing deals cannot be bogged down with the day to day running of their portfolio. So, why not turn to a professional rental property management company? Bay Property Management Group understands these challenges and our focus on attention to every detail ensures comprehensive service for our clients. From marketing to maintenance needs, give us a call today to see what professional rental management can do for you.