The Complete Guide to Financing an Investment Property

Unlike investing in the stock market, which can be done for very little money, investing in real estate has a generally high start-up cost. Once you have decided that investing in real estate is right for you, done your research, and found a good deal, you need to consider how to secure financing for your investment property.

Investment property financing can take several forms, and there are specific criteria that borrowers need to be able to meet. Choosing the wrong kind of loan can impact the success of your investment, so it’s vital to understand the requirements of each kind of loan and how the various alternatives work before approaching a lender.

Why Buy Investment Property?

There are many reasons and ways to invest in real estate. It can be a hedge against market volatility when stocks tumble, and there are many perks associated with owning an investment property.

Purchasing an investment property can help diversify your portfolio of investments. Some uses for investment property include:

• Buying and holding land for future development
• Flipping a property
• Purchasing a property for an elderly relative to live in and enjoying the appreciation when it sells
• Creating a passive income stream by renting the property

When you buy an investment property, you might have the cash on hand to buy it outright. But if not, there are multiple types of financing to choose from.

Option 1: Conventional Bank Loan

If you already own a home that’s your primary residence, you’re probably familiar with conventional financing. A conventional mortgage conforms to guidelines set by Fannie Mae or Freddie Mac. Unlike a Federal Home Administration (FHA), U.S. Department of Veterans Affairs (VA), or U.S. Department of Agriculture (USDA) loan, it’s not backed by the federal government.

With conventional financing, the typical expectation for a down payment is 20% of the home’s purchase price, though many lenders will accept less depending on your credit and income. With an investment property, however, the lender may require 30% of funds as a down payment.

With a conventional loan, your personal credit score and credit history determine both your ability to get approved and what kind of interest rate applies to the mortgage. Lenders also review borrowers’ income and assets. Borrowers must be able to show that they can afford any existing mortgage as well as the monthly loan payments on an investment property.

Future rental income isn’t factored into the debt-to-income (DTI) calculations, and most lenders expect borrowers to have at least six months of cash set aside to cover both mortgage obligations.

Option 2: Hard Money Loan

A hard money loan is a short-term loan. It is most suited to flipping an investment property, rather than buying and holding it, renting it out, or developing on it.

It is possible to use a hard money loan to purchase a property and then immediately pay it off with a conventional loan, private money loan, or home equity loan. However, starting with one of the other options is more convenient and cost-effective if you are not intending to flip your property.

The upside of using a hard money loan to finance a house flip is that it may be easier to qualify for than a conventional loan. While lenders still consider things like credit and income, the primary focus is on the property’s profitability.

The home’s estimated after-repair value (ARV) is used to gauge whether you’ll be able to repay the loan. It’s also possible to get loan funding in a matter of days, rather than waiting weeks or months for a conventional mortgage closing.

The biggest drawback of using a fix-and-flip hard money loan is that it won’t come cheap. Interest rates for this kind of loan can go as high as 18%, depending on the lender, and your time frame for paying it back may be short. It is not uncommon for hard money loans to have terms lasting less than a year. Origination fees and closing costs may also be higher compared to conventional financing, which could chip away at returns.

Option 3: Private Money Loan

Private money loans are loans from one individual to another. Friends and family of the investor are the source of most private money loans. If you do not have friends or family in a position to loan money to you for an investment property purchase, a great place to start looking for private money lenders is by going to local real estate investment networking events.

Actual loan terms and interest rates on private money loans can vary significantly, from extremely favorable to predatory, depending on the relationship between the borrower and the lender. These loans are typically secured by some sort of legal contract that allows the lender to foreclose on the property if you default on payments. If you are new to real estate investing, consider carefully how your relationship with the person lending you private money may sour if you default before you sign an agreement.

Option 4: Tapping Home Equity

Drawing on your home equity is a fourth way to secure an investment property. You can do this through a home equity loan, home equity line of credit (HELOC), or cash-out refinance. In most cases, it’s possible to borrow up to 80% of the home’s equity value to use toward the purchase, rehabilitation, and repair of an investment property.

Using equity to finance a real estate investment has its pros and cons, depending on which type of loan you choose. With a HELOC, for instance, you can borrow against the equity the same as you would with a credit card, and the monthly payments are often interest-only. The rate is usually variable, however, which means it can increase if the prime rate changes.

A cash-out refinance would come with a fixed rate, but it may extend the life of your existing mortgage. A longer loan term could mean paying more in interest for the primary residence. That would have to be weighed against the anticipated returns that an investment property would bring in.

The Bottom Line

Investing in a rental property or tackling a house-flipping project are risky ventures, but they offer the potential for a big payoff. Finding the money to take advantage of an investment opportunity doesn’t have to be an obstacle if you know where to look. As you compare different borrowing options, keep in mind the short- and long-term costs and how each one can affect the investment’s bottom line.