Financing Your Rental Real Estate Purchase

Thinking about investing in rental real estate? It’s a great way to diversify your portfolio, and generally, real estate is an investment that keeps paying dividends for years to come.

The big question for you is likely how you’ll pay for the purchase. Let’s look at your options for financing rental real estate purchases and what you need to do to build a smart financial strategy.

Understanding Rental Property Loans

While you may have taken out a residential mortgage before, there are some differences when it comes to rental property loans.

These loans may come with higher interest rates because lenders view rental properties as higher risk than primary residence loans. If you’re living in a property, you’ll be sure to pay the mortgage since you’d lose your home otherwise. But if renters don’t pay, lenders run the risk that you won’t pay the mortgage.

Rental property loans may have a higher down payment requirement, ranging from 15 to 30% of the purchase price. Loans for rental real estate may have stricter terms and conditions, including higher credit score requirements and income verification.

Unlike primary residence loans, you aren’t required to live in the property that you’re financing. When it comes to taxes, interest on real estate loans is tax-deductible, as are other expenses like maintenance, repairs, and property management fees.

Types of Rental Property Loans

Now, let’s look at your options for financing your rental property purchase.

Conventional Bank Loans

For investors with decent credit (sometimes 660 or higher), commercial real estate loans from a bank can offer lower interest rates and favorable terms. 

Keep in mind that the property you’re purchasing will be the collateral for the loan. That means that should you be unable to pay the mortgage, the bank has the right to seize the property to cover your debt.

If you’re looking for fast financing, however, know that conventional loans can take 30 days or more to process.

FHA Multifamily Loans

The Federal Housing Administration offers a program that helps finance multifamily real estate. This covers properties with five or more units. There are lower requirements for credit scores to qualify (580), and the program requires as little as 3% down.

However, you may be required to have higher mortgage insurance, and there may be occupancy requirements.

Veterans Affairs (VA) Multifamily Loans 

Another option for financing your rental property is available if you’re a veteran or active-duty service member. Interest rates are low, and in some situations, you won’t need a down payment and there’s no mortgage insurance requirement. 

However, you are required to live in one of the units. There may be funding fees and property restrictions.

Portfolio Loans

Rather than taking out a large loan for an entire multifamily property, a portfolio loan provides separate mortgages for each unit, offered by the same lender. There may be a discount for multiple loans.

These loans may have higher fees and prepayment penalties.

Hard Money Loans

In cases where you can’t easily qualify for more conventional loans, maybe because you can’t meet credit score requirements, consider a hard money loan. 

With hard money loans, qualifications are based on the value of the property, not your financial situation.

Another benefit is that hard money loans can often be processed quickly, in as little as a few days. This is ideal if you need to jump on a great real estate deal and don’t have time to wait.

The drawbacks of hard money loans include potentially higher interest rates, shorter repayment times, and higher down payments.

Group Investing

One other financing option is a private loan offered by a group of investors who pool their money to invest in rental properties. Rates and terms can be customized for each property.

Private Loan

If you have a friend, family member, or colleague interested in loaning you the money you need to buy an investment property, this may be an easier option, especially if you don’t qualify for others on this list. You may be able to negotiate low interest rates and long repayment terms.

However, be careful when borrowing money from people you have a personal relationship with. If things don’t go well, that relationship may be jeopardized. Treat it as a business transaction. Write up a loan agreement that outlines the terms, and be on time with your payment, like you would if you borrowed money from a bank.

Seller Financing

It’s less common, but you may find a seller who’s willing to finance the purchase of the investment property. You might make a large down payment and then monthly payments until the agreed-upon selling price is reached.

Keep in mind that the seller may want more interest than other financing options, and if they still have a mortgage and the bank or lender has a due-on-sale clause, you will be required to pay the remaining balance on the mortgage as soon as you buy the property. You can save yourself from this problem by getting the lender’s agreement to waive the clause or by only accepting seller financing if the seller owns the property free and clear of any mortgage. 

Home Equity Loan

This is not an ideal financing solution, but if all other options aren’t available to you, consider taking out a home equity loan if you own your own home. You can use the equity (up to 80%, typically) for the down payment on the investment property, and your home will serve as collateral for that loan.

Keep in mind that if you aren’t able to pay back the home equity loan, your house could be foreclosed on. It’s a great personal risk, so consider it carefully.

Evaluating Financing Options: What to Consider

So, how can you decide which of these financing options is best for you when buying a rental property? Here’s what you need to look at.

Interest Rates and Loan Terms

Interest rates may vary wildly from one financing option to the next, and your financial history and credit score will determine the rates and terms you qualify for.

Generally, a traditional loan or one backed by the government will offer the best rates and terms, though, in the case of a conventional bank loan, you may need a higher credit score.

Down Payment Requirements

As mentioned, rental real estate loans may require a larger down payment (up to 30%). Though there are those multifamily loan options from the FHA and VA you may qualify for with lower down payment requirements.

Credit Score and Financial Health

Before applying for a loan, know your financial situation. Review your credit report and credit score. If there are discrepancies on your credit report, get them cleared up.

You may be able to get pre-approved for financing so you know what rates you’ll qualify for without your credit being impacted. Do this to shop around for the best rate.

Cash Flow and Return on Investment (ROI)

It’s important, too, to consider what your return on investment will be with the rental property. Create a budget for your upfront costs to renovate the property, as well as to hire a property manager if you need one. You can estimate how long it will take for you to break even and then reach profitability.

When considering financing, take into consideration your ability to repay the loan. Biting off more than you can chew could cost you dearly, as the lender will have the right to take the property if you’re unable to make your monthly payment.

Final Thoughts

It’s important to carefully explore each financing option available to determine which ones you qualify for and offer the best terms. 

You should also make sure you have a strategy for your rental real estate purchase so you will reach profitability faster and not take on more financing than you can afford to pay back. Always assess your financial situation and long-term investment goals when making financing decisions like purchasing rental real estate.