There are a lot of similarities between a rental property loan and a mortgage on your primary residence, and also some big differences as well.
Lenders follow a similar loan application process: You’ll need to provide documentation of your income, assets, and debt, and the lender will check your credit score.
However, lenders view a rental property loan as having a higher level of risk because the property is not owner-occupied. They know from experience that some investors may simply walk away from the loan if times are tough and the property doesn’t generate positive cash flow.
Rental property loans vs regular home loans
Some of the biggest differences between a rental property loan versus a regular home loan include:
- Larger down payment, often 20-25% or more, depending on the property and the borrower
- Higher interest rates and fees to compensate the lender for the additional risk of making a rental property loan
- Credit score of 620 or more
- Debt-to-income ratio (DTI) of less than 36%
- Sufficient cash reserves to pay the mortgage for up to six months if the vacancy rate is higher than anticipated
- Higher interest rates and fees to compensate the lender for the additional risk of making a rental property loan
- Qualifying property types must fit into typical categories of single-family, small multifamily, townhome, or condominium
- Private mortgage insurance (PMI) doesn’t apply when the loan-to-value ratio (LTV) is less than 80%
Rental property loan options
There are plenty of good options available for taking out a rental property loan. Borrowing options range from traditional banks and credit unions to lenders who specialize in making blanket or portfolio loans to real estate investors who own 10 rental properties or more.
These rental property loan options can be used when you’re buying your first income property, adding to your rental property portfolio, or refinancing an existing mortgage:
1. Conventional loans
- Also known as “conforming loans”
- Offered by mortgage brokers and traditional lenders such as banks and credit unions
- Guaranteed by Fannie Mae or Freddie Mac and must meet the government-sponsored enterprise (GSE) guidelines
- Lowest interest rates and fees with a good credit score
- Down payment requirements of between 15% and 25% (depending on the property)
- Up to 10 mortgages, although most lenders have an in-house limit of no more than four
2. FHA multi-unit financing
- Multi-family loan backed by the Federal Housing Administration (FHA)
- Offered by mortgage brokers and traditional lenders
- Good for new construction, substantial property rehabilitation, and purchases
- Down payment and credit score requirements lower than with conventional loans
- Can use existing property rental income to help qualify
- Must reside in one of the units for one year or more
3. VA multi-unit financing
- Multi-family loan backed by the U.S. Department of Veterans Affairs (VA)
- Offered by mortgage brokers and traditional lenders
- Available to active-duty service members, veterans, and eligible spouses
- No minimum down payment or credit score
- Purchase up to seven units and borrower must reside in one of the units
4. Blanket mortgage loans
- Finance multiple rental properties under a single loan
- Can be used for any type of income-producing property
- Offered by mortgage brokers or private lenders
- Properties are ‘cross-collateralized’ with each property serving as collateral for the others
- Down payment, credit scores, interest rate, and loan terms vary based on the lender and the specific properties
- Possible to refinance existing individual property loans under one blanket mortgage
- Release clause can be negotiated that allows you to sell one or more of the properties within the blanket loan
5. Portfolio loans
- Finance single or multiple rental properties with the same lender
- Offered by mortgage brokers or private lenders
- Portfolio loans are held by the lender and are a good option for ‘creative financing’
- Down payment, credit score, interest rate, and loan terms can be customized to fit the needs of the borrower
- Less stringent borrower requirements also mean higher fees, prepayment penalties, and balloon payments where the entire loan balance is due at the end of a short-term loan
6. Private money loans
- Offered by private investors or groups who make loans to real estate investors
- Good source for funding future investments based on current property performance
- Loan terms and fees can be customized for each individual investor
- Some private lenders may ‘take a piece of the action’ by participating in the project in exchange for lower interest rates or fees
7. HELOC and Home Equity Loan
- Home equity line of credit draws on the accumulated equity in one property as a source of funds to buy another
- Works similar to a credit card, with monthly payments and loan amount secured by the property
- Home equity loan is a type of second mortgage with the funds paid in one lump sum
- Loan is usually at a fixed rate with payments made over a certain amount of time
- Can borrow between 75% or 80% of the property equity, depending on the borrower and lender
- Interest rates may be higher than with a long-term, cash-out refinancing
- Good source for funds when and if they are needed
8. Seller financing
- Also known as a seller carryback, owner financing, or a purchase-money mortgage
- Offered by sellers who own property free and clear
- Good option for buyers investing when the real estate market is in a down cycle or for property that is difficult to qualify for conventional financing
- Loan terms can be completely customized based on the needs of the buyer and seller
- Sometimes used by sellers as a way to spread out capital gains as an alternative to conducting a 1031 tax-deferred exchange
How to keep rental property loan fees low
Although rental property loans can be more expensive than getting a loan on your primary residence, there are several things you can do to keep rates and fees low:
- Maintain a good credit score, ideally of at least 740 or higher
- Make a bigger down payment of between 20% and 25% for a lower LTV
- Use a local bank or lender who knows the local real estate market and can take the time to learn about you and your business
- Having your loan application docs prepared ahead of time shows the lender you’re a serious investor and improves your chances of getting your rental property loan approved
- Document the successful financial performance of your existing rental properties with profit and loss statements and cash flow reports
- Shop around for the best loan terms and conditions
- Think outside of the box and consider alternative loan solutions for rental property such as private lending or seller financing
- Consider forming a small joint venture (JV) or partnership for bigger projects that require capital-intensive updating or are outside your field of investment expertise
Rental property operating expenses to remember
In addition to the principal payments of the mortgage, there are several other operating expenses investors need to consider before buying a rental property.
All of these can be deducted as normal expenses to reduce taxable net income:
- Mortgage interest payment
- Property taxes
- Rental taxes
- Property management fees
- Leasing fees
- Repairs and maintenance
- Capital reserve account contributions (a fund used to pay for future major repairs and upgrades)
- HOA fees (if the property is in a homeowners association)
- Utilities (although tenants in single-family rental property usually pay their own utilities, owners of small multifamily property sometimes pay utility fees like water, sewer, and trash and include those charges as part of the tenants’ rent)
How to measure rental property performance
When you use a conservative LTV (loan-to-value) of 75% or less with a rental property loan, the gross cash flow should cover all of the above expenses and more. At the end of each month, you’ll still have cash profit left over to put into your bank account.
Before you apply for a rental property loan, consider these three income property ratios to help ensure your intended purchase has solid, positive cash flow:
Cap Rate
The capitalization rate – cap rate for short – compares the property’s net operating income (NOI) to the property purchase price:
- Cap rate = NOI / Purchase price
- $6,000 NOI / $100,000 Purchase price = .06 or 6% Cap rate
Although the NOI doesn’t include the mortgage payment, cap rate is a good way to screen out properties that may not cash flow. That’s because the lower the cap rate is without the loan payment, the greater the odds cash flow will be negative.
Rent Ratio
Rent ratio – also known as the “1% Rule” - compares the gross monthly rent to the total cost of the property (including acquisition and financing fees, and rehab expenses):
- Rent ratio = Monthly rent / Property cost
- $1,200 Monthly rent / $100,000 Property cost = .012 or 1.2%
A rental property with a very low rent ratio is a red flag that the investment will have negative cash flow. As a rule of thumb, the higher the rent ratio the better. Real estate investors who use the rent ratio usually look for a minimum ratio of between 1% and 2%.
Cash-on-Cash Return
Cash-on-cash return compares the amount of cash received to the amount of cash invested:
- Cash-on-Cash = Cash received / Cash invested
- $3,000 Cash flow received / $25,000 cash invested as down payment = 12%
The cash-on-cash return calculation is a good way to analyze how different financing options affect cash flow, because the cash received includes the mortgage payment expense.
Final thoughts
Buying rental property is one way to diversify your investment portfolio that may generate monthly income, especially during troubled economic times. Income-producing real estate generates dual revenue streams of monthly rental income and long-term appreciation and qualifies for tax benefits that other assets don’t offer.
Best of all, there’s a low correlation between real estate prices and the stock market. You may find yourself sleeping better at night knowing you own an asset that isn’t subject to the whims of Wall Street.
