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How Much Should You Have in Reserves Before Buying a Rental Property?

[Updated: Dec 11, 2020 ] Feb 25, 2020 by Matt Frankel, CFP
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If you obtain a mortgage to buy an investment property, you'll have to come up with funds for your down payment, closing costs, and prepaid taxes and insurance expenses. Your lender will almost certainly require you to document that you have sufficient cash in the bank on top of all of those costs before they'll let you close on the loan.

With that in mind, here's what you should know about reserve requirements when buying a rental property, how much you should expect your lender to require, and why you might want to set even more aside.

What are reserves?

When a financial institution loans you hundreds of thousands of dollars to buy a property, the last thing they want is for you to run out of money immediately after closing. At the very least, they want you to be able to cover your first few mortgage payments, even if you can't find renters, lose your job, or face other financial hardship.

For this reason, lenders always have some sort of reserve requirement, which means that you'll have to have a certain amount of money in cash that you can potentially tap into if needed. You do not need to deposit your reserves with the lender or leave them in any specific account. Technically, after you close on the property, you can do whatever you want with your reserve funds.

Reserves don't actually have to be kept in cash. Typically, "cash reserves" are held in readily accessible and safe places such as a savings account, checking account, or money market fund, but it can also include liquid investments held in a brokerage account. Typically, banks don't want you to use retirement assets for reserves, especially for investment property mortgages, although many guidelines (including Fannie Mae's) specifically allow vested retirement account balances to be included.

How much will your lender require?

Unfortunately, there's no set answer. The minimum level of reserves you'll be required to demonstrate depends on a few factors, such as the property type, your credit score and debt-to-income (DTI) ratio, your down payment, and your lender's specific rules. In general, the riskier your loan is perceived to be, the more you'll be expected to have in reserves. And the reserve requirements for investment property loans are almost always higher than the requirements for similar primary residence mortgages.

If you plan to obtain a conforming investment property loan -- meaning that it meets the lending standards of Fannie Mae or Freddie Mac -- you'll generally be required to show six months' worth of expenses in reserves, although there are a few situations where you'll need 12 months.

Since reserve requirements are generally quoted in terms of months, it's important to note that this refers to your entire monthly PITIA, which stands for principal, interest, taxes, insurance, and association dues. In other words, if your monthly PITIA payment on the property would be $1,000, you can expect to need at least $6,000 in reserves when buying an investment property.

Most other types of investment property loans also require the borrower to have six to 12 months' worth of expenses in reserves, so it's reasonable to expect a figure in this range.

Why the minimum might not be sufficient

To illustrate why you should err on the side of caution when it comes to reserves, I'll share a personal story. One of my investment properties is a triplex that I bought with partners. The plan was to find out how much we needed for the down payment and closing costs and the lender's required reserves, and then contribute exactly that much capital into an operating account for the property.

Our lender required six months' worth of mortgage payments in reserves, which worked out to about $9,000. Shortly after we closed on the triplex, we discovered that one of the rental units had extensive damage, plus we would need to replace all three water heaters to make the property rentable. These unforeseen expenses made our "sufficient reserves" disappear before our first mortgage payment was due.

Of course, this isn't a common situation. As I've written before, I made a rookie mistake with that property and didn't personally view one of the rental units before closing. However, there's always the potential for unforeseen expenses, even if the property appears to be in top-notch condition. The property could sit vacant longer than expected, and if it's an older property, there could be hidden (costly) problems that even a thorough home inspection might not find.

While there's no specific number I suggest in reserves, keep in mind that having a bit of extra cushion is a good thing and that the minimum reserves required by your lender might not truly be enough. I won't buy an investment property anymore without at least a year's worth of expenses in reserve, and I'll keep all of the extra money set aside until I've owned the property for a few months and know exactly what I'm dealing with.

Prepare for the unexpected

The bottom line is that while it's clearly not desirable to have too much of your investment capital tied up, it's better to overprepare when it comes to reserves. If you end up not needing them before your investment property starts generating reliable cash flow, great. But if you do need the cash, you'll be glad you considered your lender's minimum as just that -- a minimum.

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