Financing Rental Properties The Right Way
How to Finance Investment Property
You might find the perfect investment property, but before you can buy it you need to obtain financing. Many people will go to a bank and ask for a conventional loan with a repayment period of 25-30 years. Before doing so, however, you should analyze your credit history to check that you are a good credit risk. You have more options than simply relying on a conventional loan. For example, you could cash out the equity in your home or seek owner financing of the investment property.
Obtaining a Conventional Loan
Pull together a down payment.You can’t rely on mortgage insurance to cover your investment property. Accordingly, you will need a sizeable down payment, around 20-25%.
Consider a neighborhood bank.Smaller banks might be more flexible about lending to you if you don’t have a large down payment or if your credit score isn’t perfect. Local banks also may have a stronger interest in lending for local investment, so they are a good option.
- You might not know anything about smaller lenders, so you should do as much research as possible. Ask people that you know whether they have ever done business with the bank.
- You can also check online. Look for reviews.
Gather necessary paperwork.Before approaching a lender, you should pull together required paperwork. Doing so ahead of time will speed up the process. Get the following:
- two months of bank statements
- prior two months’ statements for investment accounts and retirement accounts
- last two pay stubs
- information about self-employed income, such as last two year’s tax returns or business financial statements
- driver’s license
- Social Security card
- papers related to bankruptcy, divorce, or separation (if applicable)
Work with a mortgage broker.A mortgage broker will apply for loans on your behalf with many different lenders and will compare the rates. The broker can also try to negotiate better terms for you. Using a mortgage broker is a good idea if you are too busy to comparison shop by going to many different lenders.
- Mortgage brokers don’t work for free. You typically will pay about 1% of the loan amount. For example, if you borrow 0,000, then you can expect to pay around ,500 to the mortgage broker.
- You can ask other investors or a real estate agent for a referral to a broker. Before hiring, make sure that you interview the person and ask how much experience they have and what services they offer.
Compare loans.If you don’t want to work with a mortgage broker, then you will need to educate yourself about the basics of home financing. You might be an experienced pro who has borrowed before. However, if you haven’t, then remember to consider the following when comparing loans:
- Interest rates. An interest rate is a percent of the loan amount that you pay as a privilege for borrowing the money. Interest rates can be fixed for the entire length of the loan or fixed for only a portion of the loan term.
- Discount points. For some loans, you can pay points, which will lower your interest rate.
- Loan term. This is the length of the loan. A shorter loan will cost more each month, but you will pay it off sooner and with less interest.
- Origination charge. This amount of money covers document preparation, fees, and the costs of underwriting the loan.
Seek pre-approval.You should try to get pre-approved for a loan before searching for properties. Make sure to request the pre-approval in writing because sellers might want to see that you are pre-approved.
Don’t forget other team members.Purchasing investment property requires the expertise of many different professionals. You should begin assembling your team early—even before you get financing. You will probably need the help of the following people:
- An accountant who can help you understand investment tax strategies.
- A realtor who can help you sign an appropriate real estate contract.
- An attorney who can help you protect your assets, for example by forming a limited liability company to hold the property.
- An insurance agent.
Using Other Finance Options
Use the equity in your home.You might be able to use the equity in your current home to purchase an investment property. Generally, you can borrow around 80% of your home’s value. There are different ways you can tap the equity in your home, such as the following:
- You could get a Home Equity Line of Credit (HELOC). A lender will approve you for a specific amount of credit, and you use your current home as collateral for the loan.The credit is available for a certain amount of time. At the end of this draw period, you must have paid back the loan.
- You might also get a cash-out refinance. The lender will pay you the difference between the mortgage and the home’s value, but is usually limited to 80-90% of the home’s value. For example, if you have ,000 remaining on your mortgage, but your home is valued at 0,000, then 0,000 could be available. You could get 80-90% of 0,000 (0,000-180,000). This option usually has a lower interest rate than a HELOC.
- Both a HELOC and a cash-out refinance put your home at risk if you can’t make repayments. For this reason, you should think carefully before tapping the equity in your home to finance investments.
Obtain a fix-and-flip loan.You might be able to get this type of loan if you want to purchase a property in order to renovate and then quickly sell. The loan will be short-term and is secured by the property. Fix-and-flip loans have high interest rates, so you need to renovate and sell quickly.
- You might find it easier to qualify for a fix-and-flip loan compared to a conventional loan. However, lenders will still look at your credit history and income.
- The lender will also want to know the estimated value after repair, which can impact whether they extend you a loan and the terms.
Research peer-to-peer lending sites.Peer-to-peer lending connects investors with lenders who are willing to lend. Two of the more well-known peer-to-peer lending sites are Prosper and LendingClub.
- Peer-to-peer lenders will require that you complete an application. They look at your credit score and credit history.They may also have minimum credit scores in order to qualify.
- You might not be able to get a large personal loan through peer-to-peer lending. However, small businesses can typically borrow more, so if you create an LLC then you might be able to borrow up to 0,000.
Find a business partner.You might not be able to secure a loan on your own, in which case you will need to consider other options. One option is to find a business partner who you can invest with.
- You will want to screen any potential business partner, just as a bank would screen you. If you are counting on the partner to help pay for the loan, then you will need to check their credit history and employment.
- You also need to consider how you will hold the investment property. For example, it might be best to create an LLC and to both be owners of the LLC. The LLC will then hold title to the investment property.
Consider owner financing.With owner financing, the owner lends you the money that you use to buy the property. Sometimes the owner will lend only a portion of the price, which you then supplement with a conventional loan.You should analyze the pros and cons of owner financing.
- A benefit of owner financing is that an owner might be willing to lend if you don’t have perfect credit or a huge down payment available. You and the owner can work out loan terms that are acceptable to both of you.
- Typically, the seller’s loan will be for a short period of time (such as five years). At the end of the term, you are obligated to pay off the loan with a “balloon payment.” This usually means you need to get a conventional loan to make this balloon payment.You should analyze your credit to see if you can qualify for a conventional loan in the near future.
- See Owner Finance a Home for more information.
Analyzing Your Credit Score
Obtain a free copy of your credit report.Your credit score will have the largest impact on your ability to get a loan, so you should obtain a copy of your credit report.You are entitled to one free credit report each year from the three national Credit Reporting Agencies (CRAs). You shouldn’t contact the CRAs individually. Instead, you can get your free copy from all three using one of the following methods:
- Call 1-877-322-8228 and request a report.
- Visit and submit the requested information.
- Complete the Annual Credit Report Request Form, which is available here: . Once completed, submit the form to Annual Credit Report Request Service, PO Box 105281, Atlanta, GA 30348-5281.
Find errors on your credit report.You should closely look at you credit reports to find any errors that might lower your credit score.If your score is below 740, then you will probably have to pay more to borrow.For this reason, you should do whatever you can to increase the score. Look for the following errors:
- credit information from an ex-spouse
- credit information from someone with a similar name, address, Social Security Number, etc.
- incorrect payment status (e.g., stating you are late when you aren’t)
- a delinquent account reported more than once
- old information that should have fallen off your credit report
- an account inaccurately identified as closed by the lender
- failure to note when delinquencies have been remedied
Consider whether you should fix certain problems.There may be negative information on your credit report that you want to fix. For example, you might want to pay an old collections account. However, you should think carefully before fixing certain problems.
- Negative information must fall off your credit report after a certain amount of time. For example, an account in collections should fall off after seven years.If the account is six years old, you might want to wait and let it fall off rather than pay it off.
- If you need help considering what to do, then you should consult with an attorney who can advise you.
Fix errors.You can correct errors by contacting each CRA online or by writing a letter. To protect yourself, you should probably do both. Mail your letter certified mail, return receipt requested.
Video: 4 Rental Property Financing Options
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