Financing real estate investments can be tricky. There are several types of lenders that make loans on investment properties, and the requirements to finance an investment property can be significantly different than they are for a primary home.
Having said that, there are a ton of financing options out there, and it isn’t terribly difficult to find a loan for your next real estate investment. However, finding the best possible loan for your investment requires a bit more work. Here are five suggestions that can help you make sure that the process goes smoothly, and that you’re financing your investment property with the best possible terms you can get.
5 tips to get the best loan possible
If you are a reasonably qualified borrower, you can typically find someone to loan you the money for your real estate investments. However, you don’t want just any loan -- you want the best investment property loan you could possibly get.
To do that, you need to be the most attractive applicant possible in the eyes of lenders. With that in mind, here are five suggestions to help you find the best loan for your next investment property.
1. Work on your credit score
Whether you’re applying for a conventional mortgage for your investment property or for a commercial asset-based loan, you can be sure that your credit score will come into play. Lenders generally check your FICO credit score from all three major credit bureaus and use your middle score to determine your eligibility, your down payment requirement, and your interest rate.
The average American has a FICO® Score of about 700. Scores range from 300 to 850, and higher scores are better. If you aren’t familiar with how your FICO® Score works, our sister website The Ascent has an excellent guide to FICO scores that's definitely worth a read.
Here’s the point: You can get an investment property mortgage with a credit score in the low-to-mid 600s. However, you may be asked to put more money down than you want to, and your interest rate might be significantly above average.
You may also be surprised by the difference a seemingly small change in interest rate, or APR can make. For example, let’s say that a lender is offering 30-year investment property mortgages with fixed 4.50% APRs to the most qualified borrowers. However, because your credit score is good but not great, they offer you a rate of 5.25%. On a $250,000 mortgage, you would pay nearly $41,000 in additional interest over the life of the loan when compared with a top-notch borrower.
A FICO® Score of 740 or higher will generally qualify you for a lender’s best terms, so working on your credit score can be an extremely smart move.
2. Get your income and employment documentation in order
There are asset-based lenders who don’t care about your personal income or employment history when you apply for an investment property loan, and to be clear, they can be great options. However, conventional lenders generally offer better terms than asset-based lenders, and they will certainly consider your income and employment situation when making loan decisions.
If you’re applying for a conventional loan, you generally can’t have a debt-to-income ratio of more than 45%, including the expected payment on your new investment property loan. You can include three-fourths of the property’s expected rental income for qualification purposes, but you’ll still need to be able to document your other sources of income.
So, before you begin shopping for a loan, it’s a good idea to gather all of your income documentation. This includes your last couple of tax returns, W-2s and/or 1099s, and a few recent pay stubs won’t hurt. It’s also worth having a contact number for someone (like your employer’s HR department) who can verify how long you’ve been at your job.
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3. Pay down some other debts
Even though asset-based lenders won’t consider your personal debts in the way conventional lenders will, debt reduction can boost your qualifications for any type of loan.
For conventional loans, debt reduction will obviously improve your debt-to-income (DTI) ratio. Even if you’re already within your lender’s limit, a lower DTI can help you get better loan terms.
Debt reduction can raise your credit score, which, as I’ve discussed, will help your chances of approval and improve your loan terms with any type of lender. Unfortunately, there’s no way to know how much a specific amount of debt reduction or debt payoff will affect your score. However, we do know that the amounts you owe on your various credit accounts make up 30% of your FICO® Score, and so a substantial debt reduction could have a big impact.
4. Make sure your target property will produce enough cash flow
This is more of a factor when it comes to asset-based lenders. When you use one of these lenders to finance an investment property, the good news is that they generally don’t care about your personal debts, your income, or how long you’ve been with your employer. You won’t have to dig up your old tax returns or produce W-2s or other income documentation.
The caveat is that because the loan is only based on the property, the property needs to be able to justify the loan and then some. In other words, the cash flow from the property needs to be more than sufficient to cover your mortgage payments, including taxes and insurance.
Many asset-based lenders use a metric known as the debt service coverage ratio, or DSCR. This is the property’s expected income divided by your monthly expenses. For example, if a property is expected to rent for $1,200 and your mortgage payment will be $1,000, this implies a DSCR of 1.2.
A DSCR of 1.2 tends to be the absolute minimum an asset-based lender wants to see. Higher is better, and many lenders have different tiers of DSCR that determine your interest rate. For example, one particular lender offered me interest rates that were roughly 50 basis points lower on properties with DCSRs of above 1.3.
5. Apply with as many lenders as you can
As a final tip, perhaps the most common mistake I see investors make when trying to finance a property is to apply for just one mortgage and accept whatever terms they’re given.
You might be shocked by the differences among interest rates and other loan terms you can get when you comparison shop. A lower origination fee or a lower APR can make a big difference in your property’s profitability, so this is an important step.
Plus, you don’t have to worry about too many mortgage applications hurting your credit score. There’s a special provision in the FICO credit scoring formula that says that as long as all of your applications take place within a two-week window, they’ll count as a single inquiry for credit-scoring purposes.
So, apply to at least a handful of lenders before deciding. This should include conventional lenders as well as asset-based lenders. The more the merrier.
The bottom line on investment property loans
If you have a down payment of 20% or more and a good credit score, it isn’t too difficult to find financing for an investment property. However, finding the best possible loan can make a big difference in your property’s cash flow, as well as your long-term equity. So take the time to make yourself the best applicant you can be and make sure you explore all of your options.