How to Obtain a Loan for a Rental Property Purchase
Investing in real estate has long been a popular way to grow wealth and generate passive income.
And while the benefits of owning rental properties are clear, many aspiring real estate investors are intimidated by the process of getting a loan for an investment property.
However, there is no need to worry, as you have come to the right place.
In this comprehensive guide, we will be explaining the entire process of getting a loan as a real estate investor.
To begin, let’s go over some of the most important things investors must consider in order to get accepted for a loan.
How to Qualify For a Loan
Securing a loan for an investment property can be a daunting task, but understanding the qualifications and requirements can make the process a bit easier.
Below, we will discuss how to qualify for a loan, including the importance of credit score, down payment, income and employment, and debt-to-income ratio.
A credit score is a numerical representation of an individual's creditworthiness, based on their credit history. It is used by lenders to evaluate an individual's risk when granting a loan.
A credit score is calculated by credit bureaus using a proprietary algorithm, and it typically ranges from 300 to 850, with a higher score indicating a lower credit risk.
When purchasing an investment rental property, a credit score is of utmost importance.
A good credit score can increase the chances of loan approval and also leads to better loan terms and lower interest rates. A poor credit score can cause loan applications to be denied or lead to higher interest rates.
A good credit score may also enable you to secure a larger loan, which can mean more rental income.
Tips on Improving Credit Score
Improving your credit score is key if you want to increase your chances of getting a loan. To improve your credit score, you can:
- Pay bills on time: Late payments can significantly affect your credit score negatively.
- Pay off debts: High levels of debt can lower your credit score.
- Keep credit card balances low: High credit card balances relative to credit limits can negatively affect your score.
- Check your credit report for errors: Correcting errors on your credit report can help improve your score.
- Be mindful of applying for too many loans or credit cards at once: This can be seen as a red flag by lenders.
A down payment is the amount of money that is paid upfront by the borrower towards the purchase of a property.
It is another one of the most important things that are considered when applying for a rental property loan.
The significance of a down payment when purchasing an investment rental property lies in the fact that it shows the lender that the borrower has a stake in the property and also reduces the risk of default.
A larger down payment can also lead to better loan terms and lower interest rates.
Tips On Saving For A Down Payment
To save for a down payment, it's important to do some important things, including:
- Start a budget and stick to it.
- Consider a side hustle or part-time job.
- Set a savings goal and create a plan to achieve it.
- Cut unnecessary expenses.
- Look into down payment assistance programs.
Income and Employment
Steady income and employment are important factors when applying for a loan, as they provide evidence to the lender that the borrower will be able to make the payments on the loan.
The importance of income and employment when purchasing an investment rental property is that it can affect the lender's perception of the borrower's ability to manage and maintain the property.
A steady and stable income and employment history can increase the chances of loan approval, while a lack of stability in these areas can be seen as a risk and decrease the chances of loan approval.
A debt-to-income ratio (DTI) is a financial metric that compares an individual's total monthly payments to their gross monthly income.
It's calculated by dividing total monthly debt payments by gross monthly income and expressed as a percentage.
The importance of DTI when purchasing an investment rental property lies in the fact that it's an indicator of an individual's ability to manage their debt, and it's a measure of the individual's overall financial health.
A lower DTI can indicate that an individual is able to manage their debt and is in a better financial position to take on additional debt, making them a more favorable candidate for a loan.
It's important to keep in mind that future rental income from the rental property is not to be factored into the DTI calculations.
However, meeting the above qualifications, and having a good debt-to-income ratio, will increase the chances of being approved for a loan.
So, now that we know all about the different factors to consider to qualify for a loan, let's look over some of the different options you have in terms of loans.
Different Types of Loans
One of the most important things you need to do as a real estate investor is find out what kind of investment property loan is best for you.
To do that, you must research various investment property loan programs and make sure you make an informed decision.
Luckily for rental property investors, there are more loan options for rental properties compared to loans for a primary residence.
To help with the process, we have outlined some of the most common types of loans for investment properties, as well as some important characteristics for each.
A conventional loan is a mortgage that is not insured or guaranteed by the government. It is typically offered by private money lenders, such as banks and credit unions.
A conventional loan is a good option for a person with a good credit score and a sizable down payment.
This type of loan generally requires a higher credit score and a larger down payment than government-backed loans.
To be eligible for a conventional loan, you will typically need a credit score of at least 620, although some lenders may require a higher score. You will also need to have a down payment of at least 5% of the purchase price.
Also, depending on the lender, you may be required to have a certain amount of cash reserves, which is essentially cash on hand.
Benefits & Drawbacks
The main benefits of conventional loans include lower interest rates and more flexible terms. However, conventional loans also require a higher credit score and a larger down payment.
An FHA loan is a mortgage that is insured by the Federal Housing Administration (FHA). It is designed to help people with lower credit scores and down payments buy a home.
An FHA loan is a good option for a person with a lower credit score or a smaller down payment.
To be eligible for an FHA loan, you will typically need a credit score of at least 580, although some lenders may require a higher score. You will also need to have a down payment of at least 3.5% of the purchase price.
Benefits & Drawbacks
The main benefits of FHA loans include lower credit score requirements and smaller down payments.
However, FHA loans also require mortgage insurance, which can add to the cost of the already higher mortgage payments.
Also, if you're ever in a pinch and need a lot of cash, there is a special FHA cash out refinance that can be done to get a large sum of money relatively quickly.
A VA loan is a mortgage loan that is guaranteed by the Department of Veterans Affairs (VA). It is designed to help veterans and active-duty military members buy a home.
VA loans are a good option for a veteran or active-duty military member. This type of loan generally requires a lower credit score and a smaller down payment than conventional loans.
To be eligible for a VA loan, you will typically need to be a veteran or active-duty military member. You will also need to have a credit score of at least 620, although some lenders may require a higher score. You will also need to have a down payment of at least 3.5% of the purchase price.
Benefits & Drawbacks
The main benefits of VA loans include no down payment and no mortgage insurance. However, VA loans also require a funding fee, which can add to the cost of the loan.
Now that you have gotten everything else in order for your loan, you are ready to official apply.
Since investment property loans can be very complex, you can expect the application process to be just as complex.
Below, we have outlined some of the most important steps to take when applying for rental property loans.
1. Gather necessary documents
The required documents can vary depending on the type of loan and the lender.
Generally, you will need to provide proof of income, such as pay stubs and tax returns, proof of employment and assets such as bank statements, and identification documents such as a driver's license or passport.
If you are self-employed, you may be required to provide additional documentation such as business tax returns and financial statements.
Some of the steps that you should take when gathering these important documents include:
- Start gathering the necessary documents early in the process, so you don't have to rush at the last minute.
- Make sure that the documents you provide are clear and legible.
- Keep all original documents and make copies of everything, so you can submit them to multiple lenders if needed.
- Don't hesitate to ask your lender if there are any specific documents they require.
2. Find a lender
Finding the right lender is an important step in the loan process.
A lender that is familiar with the local real estate market, has experience working with investors, and offers terms that are favorable to you, can make the process smoother and increase the chances of being approved.
Always remember to compare the interest rates and fees offered by different lenders and also check the reputation of each one by researching online.
Look into the different loan programs offered by each lender, to see which one would be best for you.
Depending on the type of loan, some lenders may have specific requirements such as minimum credit score or down payment, or limitations on the property's location.
Be sure to check with the lender to ensure you meet the qualifications and fulfill their requirements
3. Submit your application
The process of submitting an application typically involves completing a loan application and submitting it to the lender along with the necessary documents.
The lender will then review the application and determine if you qualify for the loan.
When submitting the application, you should always remember to:
- Review the documents that you have gathered, to make sure they are complete and accurate
- Review the loan application and make sure you understand the questions being asked
- Provide any documentation that the lender may request as soon as possible
Some lenders may have specific application requirements such as online submission, or in person interview while others may only require a certain format of the documents.
It is always best to check with the lender to see what their requirements are before submitting your application.
Closing on the Loan
Closing on a loan is the final step in the process of buying an investment property.
It can be a confusing and overwhelming process, but by understanding the key elements of closing on a loan, you can make sure that everything goes as smoothly as possible.
1. Reviewing and signing loan documents
Reviewing and signing loan documents is an essential step in the process of closing on a loan.
These documents are legally binding and include important information such as the terms of the loan, the interest rate, and the repayment schedule.
It is important to thoroughly review and understand these documents before signing them.
The process for reviewing and signing loan documents include:
- Read every document carefully and take the time to understand them.
- Don't be afraid to ask questions or seek help if you don't understand something.
- Pay close attention to the terms of the loan, such as the interest rate, the repayment schedule, and any fees or penalties that may apply.
- Compare the loan documents to the information provided in the loan application and disclosures.
- Take note of any contingencies that may apply, such as getting home insurance
2. Understanding Closing costs
Closing costs are the fees and expenses associated with the purchase of a property, they can be quite significant, and it is important to understand them before closing on a loan.
These costs can include things such as appraisal fees, title insurance, and recording fees.
Some tips for understanding closing costs include:
- Understand what the closing costs include and how they are calculated.
- Review the HUD-1 Settlement Statement, which is a document that lists all of the closing costs and how they are allocated between the buyer and the seller.
- Ask your lender or real estate agent for an estimate of the closing costs before you close on the loan, so you can budget accordingly.
- Be aware of any lender-specific closing costs or fees, such as origination fees or discount points.
- Compare the closing costs of different lenders to ensure you are getting the best deal.
3. Funding the loan
Funding the loan is the final step in the process of closing on a loan.
It involves transferring the funds from the lender to the seller, and is typically done through a wire transfer or a cashier's check.
Tips for funding the loan include:
- Review and sign the loan documents and closing papers ahead of time, so the process can be completed as quickly as possible.
- Make sure that you have the funds needed to cover the closing costs and any additional expenses, such as moving costs or home repairs.
- Coordinate with your lender and real estate agent to ensure that the funds are transferred on time and that the closing process goes smoothly.
Time to Purchase
You've done it!
You're that much closer to finally being able to rent out your rental property and start raking in that sweet rental income.
The final step before you're officially free is to make sure that you have all of the necessary licensing, registration, and documentation for the rental property.
Want to learn about that?
Read on to find our comprehensive guide on all the rental documents needed for a rental property.