The down payment on investment property is different from buying a primary residence. Before investing in a rental home, it’s important to understand the differences between the two.
In this article, we’ll discuss how much of a down payment on investment property to expect, the factors affecting a down payment amount, and surprising ways to raise money for the down payment on an investment property.
- Minimum down payment amounts on investment property range from 0-15%.
- The down payment on an investment property is affected by factors such as a borrower’s credit score, type of rental property, and debt-to-income ratio.
- An investor may choose to make a larger down payment to obtain a better interest rate and loan terms.
- Ways to raise the down payment for an investment property include house hacking, group investing, and using a self-directed IRA.
How much is the down payment on investment property?
The down payment requirements on investment property varies on a variety of factors, including a borrower’s credit score, type of rental property being financed, debt-to-income ratio, and loan program.
These are the minimum down payments for an investment property, according to LendingTree:
|Loan program||Minimum down payment|
In general, the minimum credit score required for an investment property loan is 680, provided a borrower’s debt-to-income ratio is 36% or less.
The debt-to-income ratio is calculated by dividing all monthly debt payments by gross (pre-tax) monthly income. For example, if a borrower has a gross monthly income of $5,000 and total monthly debt payments are $1,800, the debt-to-income ratio would be 36%.
While the FHA and VA loan programs come with a low minimum down payment, borrowers are required to occupy one unit as a primary residence.
Oftentimes a borrower will purchase a small multifamily property with 4 units or less, and live in one unit while renting the other units out. Rental income from the tenants is then used to pay for the mortgage and the cost of owning and maintaining the property.
Why some investors make more than the minimum down payment
Another key factor affecting the down payment amount for an investment property is the amount of risk a borrower and lender are willing to accept. For example, a borrower may make a smaller down payment – with a higher loan-to-value (LTV) ratio – in an attempt to boost the cash-on-cash return.
However, from a lender’s viewpoint, the lower the down payment on a rental property is, the greater the risk is that a borrower may give back the keys and walk away from the property if the investment doesn’t perform as planned.
As a rule of thumb, a buy-and-hold investor seeking a balanced blend of risk and potential reward may make a down payment of between 20%-25%, even if a lender allows a smaller down payment. So, if the purchase price of a single-family rental (SFR) house is $135,000, a 25% down payment would be $33,750.
In addition to having a lower monthly mortgage payment, making a larger down payment on an investment property may help lower the mortgage interest rate and amount of lender loan fees.
6 ways to raise an investment property down payment
The down payment amount to finance an investment property can be a challenge for some investors, especially when housing prices in many of the best real estate markets keep rising.
But life can be full of challenges, and the most successful real estate investors find creative ways to raise money for an investment property down payment:
House hacking uses part of a primary residence to generate rental income. The extra income is used to save money for a down payment or pay down the existing mortgage faster until there is enough equity to qualify for a cash out refinancing.
Examples of house hacking include renting out a spare bedroom, using a garage as a storage rental, or obtaining a 0% down payment VA loan to purchase a 2-, 3-, or 4-unit multifamily property and living in one of the units while renting the other ones out.
Some people invest in real estate by offering private loans to other investors, similar to what a bank or credit union does. In exchange for loaning a fellow investor money for a down payment, a private lender accepts a second-position loan and receives a monthly payment of principal and interest until the down payment loan is paid off.
Although a private loan may carry a higher interest rate and a shorter loan term, it’s an option for raising a down payment that an investor may find worth considering.
Group real estate investing
Family, friends, and other investors can be another way to raise an investment property down payment. One popular way of group real estate investing is to form a limited liability company or LLC. Instead of owning an investment property as individuals, the LLC owns the rental property and each investor owns shares of the LLC.
Depending on how the operating agreement is written, a member may choose to be reimbursed for the down payment from the property’s monthly cash flow. Or, a member may opt to remain a silent partner in the real estate venture in exchange for a percentage of any net operating income and profit when the property is eventually sold.
An IRA or 401(k) is another option for finding money for an investment property down payment, although making a withdrawal before retirement age may result in hefty penalties.
However, an investor may convert an existing retirement account into a self-directed IRA to buy an investment property. There are some hoops to jump through, and a retirement account should have enough available cash to pay for the property and have excess funds available if cash flow is negative or capital repairs need to be made.
Withdrawals from a retirement account can also be made penalty-free when buying a home. However, the property must be a first-time purchase and the maximum withdrawal limit is $10,000.
Home equity line of credit
A home equity line of credit (HELOC) is a line of credit tied to the equity in an existing property. A HELOC works similar to a credit card, except that a loan is secured by a primary residence.
Unlike a cash out refinance where funds are received right away, money can be withdrawn by a borrower when and if it is needed, such as for the down payment on an investment property. Once a HELOC is drawn on, a borrower may be able to make interest-only payments for the first 10-15 years.
At the end of the draw period, a borrower must make monthly principal and interest payments on a HELOC and will be unable to make any further withdrawals. Some real estate investors use a HELOC like a revolving loan. After money is pulled out, the HELOC is paid off as quickly as possible, and the funds are available all over again until the draw period expires.
Some lenders may also offer a line of credit on an existing rental property that is similar to a HELOC. However, interest rates on a rental property HELOC are generally higher, and repayment terms more strict, because lenders generally view a rental property line of credit as having a higher level of risk.
Sometimes a seller may be willing to lend a buyer money for a down payment in exchange for a second mortgage on the property being sold. Why would a seller offer to help a buyer out with the down payment?
If a property requires a significant amount of repairs, qualified buyers may be few and far between. So, a seller financing a down payment serves as an incentive for a buyer to purchase the property. As with a private loan, the interest rate on seller financing may be higher than a traditional loan, and the repayment period may be shorter.
Bonus tips for buying an investment property
Finding money for the down payment on investment property is only part of the process of buying a rental home. Here are some other tips investors may wish to consider:
- Pay off any existing high-interest debt, such as credit cards or car loans.
- Ensure that contributions to any retirement account are maxed out for the current year.
- Crunch the numbers of understanding financial metrics such as return on investment (ROI), cash flow, cash-on-cash return, net operating income, and cap rate.
- Explore the options for investing in real estate in a different city and state, where property prices may be lower and ROI potentially greater.
There are a surprising number of ways to raise money for the down payment on investment property by being creative and thinking outside of the box. An investor may borrow money from family and friends, create an LLC to invest in real estate, or convert an existing retirement account into a self-directed IRA.
While housing prices in many markets are reaching all-time highs, there are still markets that are affordable to buy single-family rental property in. The money used for a down payment can go much farther without an investor running the risk of using too much leverage.