You are financially secure and decide you want to try your hand at real estate investments. How do you make your first rental home purchase happen, though? The options may seem overwhelming and complicated at the same time. We break down your options here so that you can decide what works best for you.
Cash Isn’t the Only Option
First, let’s debunk a myth. You can buy a rental home with financing. Many people think you can only buy investment real estate if you can pay all cash. While in a perfect world that would be amazing, it’s not necessary. There are many options out there using conventional, subprime, and even FHA financing.
How to Use FHA Financing
You may already know that FHA financing is strictly for owner-occupied properties. However, did you know there is an exception to the rule? If you purchase a multi-unit property with FHA financing, you can live in one unit and rent out the others. It’s that simple!
For example, let’s say you buy a 4-unit property. You must live in one unit. This automatically makes it an owner-occupied property for you. The remaining three units do not have to remain vacant nor do you have to live in all four units. Instead, you can rent them out, using the money to offset your mortgage payment. This way you get your taste of real estate investing but with favorable loan terms.
The FHA offers the same flexible financing options for a single-family home as they do on a four-unit property. You can secure low interest rates, low closing costs, and as long as a 30-year term. Even better, you only have to put 3.5% down on the home as long as you have a credit score higher than 580.
How to Use Conventional Financing
Conventional financing is often the most popular option. Lenders don’t require you to live in one unit of the property. You can even purchase a single-family home strictly for investment purposes. However, conventional lenders have stricter guidelines for rental properties, such as:
- Higher down payments – You may have to put down as much as 20-30% on the rental home purchase
- Rental income – You cannot count ‘future’ rental income in your qualifying income
- Debt-to-income ratio – Your debt ratio must include the mortgage on your primary residence and your investment properties to qualify
- Down payment funds – All funds must come from you for a rental purchase; they cannot be a gift
Conventional financing is often the hardest to secure for investment properties for beginners. Once you are an established landlord, however, it gets easier. Once you have proof of receiving rents successfully, you can use the money to offset your debt ratio, helping you qualify for conventional financing.
How to Use a Home Equity Loan for a Rental Home Purchase
If you have equity in your primary residence, you may be able to tap into it to buy a rental home. This could be the stepping stone you need to qualify for conventional financing. Let’s say your primary residence is worth $300,000. You have an outstanding balance on your mortgage of $175,000. This gives you $125,000 in equity. Many lenders will allow a HELOC up to 80% of the home’s value. In this case, 80% of $300,000 is $240,000. Since you have $175,000 outstanding already, you have $65,000 available for your home equity line of credit.
If a lender gives you a HELOC, you can then use the funds as the down payment on your rental home purchase. Of course, you’ll still have to qualify for financing on the rental home, but having the down payment can help give you more options.
How to Use a Cash Out Refinance
Lastly, you may use a cash-out refinance on your primary residence. Again, this is just like the HELOC. You need equity in your primary residence. Most lenders allow up to 80% for the cash-out refinance as well. You’ll need great credit and a low debt ratio to qualify for this option.
Because the cash-out refinance can provide you with the same results as the HELOC, you should compare your options. Which loan provides the lower interest rate and lower APR? This takes into consideration the closing costs and the cost of the loan over its entire term. Since the goal of an investment property is to make money, this is a decision you must make carefully.
How to Use Subprime Loans
If all of the above methods don’t work out for you, subprime loans are always a viable choice. Subprime doesn’t mean ‘bad.’ It’s just a portfolio loan or a loan a lender holds onto rather than selling on the secondary market.
The lenders writing the loans get to make their own rules. This is a large benefit for you. They can grant exceptions and even have more lenient rules than conventional and FHA loans. They may allow lower credit scores, lower down payments, and higher debt ratios, as a few examples.
Talk with several lenders to see what options are available for you. You might be surprised to see what each lender has to offer. The programs will likely be different from lender to lender, so make sure you read the fine print and understand the full implication of each loan.
Buying your first rental purchase doesn’t have to seem impossible or overwhelming. There are many options available to you. Consider each of them and look at what they cost you over the entire term. Then you can decide which loan offers you the best option.