Funding Investment Property
- 31 Jan 2022
What’s an Investment property?
It is a piece of real estate that’s purchased to be a source of income or provide a return on investment for the buyer. Popular investment properties include multi-family homes such as apartment buildings and duplexes as well as single-family homes.
Investment properties are usually profitable due to the cash flow they provide each month. If you purchase an investment property and rent it out to a tenant, the profit is the rent each month above and beyond costs involved in owning and maintaining the home. Investment property can also provide a capital gain if it appreciates in value while you own it.
The difference between a primary or secondary residence and an investment property is that you live in a primary residence most of the year and it generally does not provide a source of cash flow each month. If it is a multi-family unit, the property can serve as both an investment property and the investor’s primary residence.
Investment properties also differ from primary residences with regards to lending requirements. While you are often able to purchase a home with as little as a few percent down (or even 0 percent for some specialty loans), investment properties usually require a down payment of anywhere between 15 and 20 percent along with significantly larger cash reserves. There are different types of property investment loans.
Traditional Bank Loans
Similar to traditional mortgages for primary residence, lenders also offer traditional loans for investment properties. Such loans have similar requirements as other traditional loans that Fannie Mae and Freddie Mac set.
The fact that a larger down payment is required is perhaps one of the key differences between investment and primary-residence loans. You typically can buy a primary residence with as little as 3 percent down. Fannie Mae-backed loans for investment properties usually require a 15 percent down payment for single-family units as well as up to 30 percent down for multi-family units, depending on the type of loan.
The other difference is the income required for you to qualify for a traditional loan on an investment property. Just like when you buy a primary residence, you can qualify for a mortgage using your personal debt-to-income ratio. In the case of investment properties, however, you can also qualify using the expected future rental income.
Rental income can only qualify you for a mortgage if it is verifiable through either a signed lease for the property or the seller’s tax returns.
Fix-and-flip loans are designed for real estate investors that plan to quickly renovate and resell a property. Investors that flip homes have very different needs from those that buy property to rent out for many years, which is why their loan requirements might also be different.
First, while a traditional mortgage is aimed at covering the cost of the property minus down payment, fix-and-flip loans also consider the repair costs incurred by the investor. As a result, they may well be borrowing more than the property is worth currently.
The other feature of fix and flip loans is that they usually have higher rates of interest than traditional loans. The rate accounts for the fact that the financial institution is lending more than the property is actually worth and the fact that the borrower will likely pay off the loan within a shorter time period. For instance, a fix-and-flip loan may have a term of just 12 to 18 months.
Fix-and-flip loans sometimes come with interest-only repayment periods, during which time the investor isn’t required to make any payments towards the principal.
It is worth noting that while fix-and-flip loans have some benefits, which include the fact that they are customized to house flippers, they also have some risks. If you are unable to sell the property as quickly or for as much as you hoped, you may find yourself underwater on a high-interest loan and unaffordable payments each month.
Financing on the Basis of Home Equity
Using the equity that you have built up in your primary residence or another property you own is another option to finance an investment property. With home equity lines of credit, home equity loans, and cash-out refinance, lenders will allow you to use this equity for other purposes.
Home Equity Line of Credit (HELOC)
A home equity line of credit is a revolving line of credit that can be used by homeowners to borrow against their home’s equity if and when they need it. HELOCs come with a maximum amount that you are allowed to borrow, but you can continue borrowing that amount as long as you repay it.
HELOCs usually have an initial “draw” period whereby you are allowed to borrow against your equity, and a repayment period where you are required to make fixed payments. You may only be required to pay interest on your line of credit at a variable rate of interest during the draw period.
Home Equity Loan
A home equity loan is a fixed lump sum that’s borrowed from a financial institution with a predefined interest rate and repayment period. You are often able to borrow as much as 85 percent of your home’s equity for any purpose.
A cash-out refinance is a type of refinance loan where you take out a new mortgage larger than the one you are refinancing. The difference between the original mortgage and your new one is paid to you in cash for you to do what you deem fit.
A cash-out refinance acts just like any other type of mortgage refinance loan with regards to repayment – you just take out a larger loan. You can then use the extra cash for financing your investment property.
Pros & Cons of Equity-Based Loans
The fact that you can leverage an asset that you already own is one of the key advantages of using your home equity to finance an investment property. Still, there’s a major downside you need to consider.
If you use your home equity to finance the purchase of a second property, it is your original property that serves as collateral. If the investment property fails to pan out as expected, you will be unable to make loan repayments and you may end up losing your primary residence.
The other major risk in the case of HELOCs is that there’s usually a variable rate of interest. So, loan repayments that seem affordable today may easily become unaffordable if there’s a significant rise in interest rates.