How to Get a Mortgage to Buy Rental Property
Point of Interest
Purchasing a rental property offers the potential for long-term revenue and substantial return on investment, but finding and securing the right mortgage financing is different than it is for other types of residences.
While the current rental market is a bit uncertain due to the pandemic, Bloomberg recently noted that the eventual end of the public health crisis will lead to an uptick in rental demand. Combine that with lower-than-average interest rates and this could be the ideal time to take the plunge and make your move on a rental property.
But while rental properties may be a smart investment, it can be tougher to get a loan for them. Getting a mortgage for a rental property involves a different process than getting a mortgage for a regular home, and you’ll probably need to make a bigger down payment in return for a home loan with a higher interest rate.
Getting a mortgage to buy a rental property vs. a home
The rules for rental property lending are much stricter than they are for a regular home mortgage — and with good reason. Unlike a primary residence, which is your legal residence during most or all of the year, rental properties don’t come with guaranteed occupancy. As a result, rental properties are considered riskier investments by banks and other lending agencies. After all, what happens if you purchase a multi-unit property but aren’t able to find tenants?
To help offset this risk, lenders start by increasing the down payment requirement for prospective buyers. While residential homebuyers typically put down about 12% of the property’s total price, it’s also possible to find government-backed loans that offer down payments of just over 3%. This is because any residential mortgage with a down payment of less than 20% requires borrowers to carry private mortgage insurance (PMI) to help lenders recoup part of their cost if buyers default.
When it comes to rental properties, PMI doesn’t apply. You won’t have to pay PMI on a rental loan, and as a result, lenders will often want at least a 25% down payment for single-family homes and 30% for multifamily units, although you can often bring down this cost if you choose to live in one of the units on the property.
Rental property buyers must also be prepared for higher interest rates on their mortgages. While there’s no hard and fast rule for how much higher the interest rate will be, rental property mortgages typically come with rates that are 1% to 3% higher than the rates for residential loans. Again, this speaks to the potential risk involved for lenders with rental properties. Lenders want to ensure they receive the highest return on investment possible, even if you’re not able to secure tenants.
What kind of mortgages can you use to buy rental property?
Unlike residential properties, rental purchases aren’t covered by government-backed funding such as FHA or VA loans, unless you qualify for an FHA or VA loan for a multi-family unit that you’ll also reside in. As a result, most rental buyers have two basic options:
- Conventional mortgages — Conventional loans are provided by banks or credit unions and are not backed by a government agency. These loans typically require a credit score of at least 620 and a debt-to-income ratio of less than 43%.
- Jumbo mortgages — If you’re purchasing a property and need a loan of more than $510,400, you’ll probably need a jumbo mortgage. Because these loans are larger than the amounts the government is willing to guarantee, they cannot be sold to either Fannie Mae or Freddie Mac if you default.
Both of these mortgage types can be conforming or non-conforming. While jumbo loans are typically non-conforming thanks to their large loan amount, conventional rental property mortgages may also be considered non-conforming if they don’t meet the guidelines of government-sponsored entities around down payments or credit requirements.
If you’d prefer not to go the convention or jumbo mortgage route you also have other options, such as:
- Home equity loans — If you own a home and have already paid down a significant amount of your mortgage principal, you may be able to secure a home equity loan, which is effectively a second mortgage based on the amount of equity in your home. The lump-sum cash available is usually calculated as 80% of the market value of your home, minus whatever mortgage amount remains.
- HELOCs — Home equity lines of credit also leverage your existing home equity. In this case, though, they provide a revolving line of credit you can draw on as needed to support the purchase of your new rental property. The downside is that these lines of credit may come with higher interest rates than traditional home equity loans.
- Cash-out refinancing — In the case of cash-out refinancing, the equity in your home is converted to cash and the new loan amount is added to your existing mortgage to create a new, larger mortgage. This is a great option if residential mortgage rates are low and you’re able to secure cash for a rental property while still keeping mortgage repayments under control.
How to get approved to buy a rental property
Getting approved for a rental property mortgage requires specific financial criteria, including:
- Higher than average credit ratings — While residential property mortgages often require credit scores in the 580 range for government-backed mortgages, rental property loans generally require a much higher score.
- Proof of income — To ensure that lending risks are minimized, banks and credit unions will often ask for at least two years of income documentation, including W-2s and tax returns.
- Evidence of liquidity — Given the inherent instability in rental markets, lenders will want evidence of your liquid reserves. In some cases, lenders will require confirmation of either cash or easily-convertible assets to cover at least several months’ worth of mortgage payments.
It’s also a good idea to provide documentation about your plan to ensure a profitable rental after the purchase. This could include relevant market data, demographic information and rental rate trends for your area.
The final word
Rental properties offer substantial income-earning potential but also come with higher risk. As a result, the criteria for loan approval is far more rigid for rental property purchases. Borrowers should be prepared to make larger down payments, demonstrate strong credit ratings and have substantial assets on-hand. If you’re able to meet these qualifications, you should be able to get a rental property mortgage without a problem.