Real Estate 101 – Financing an Investment Property
Investing in real estate can be an incredibly rewarding and lucrative way to put your money to work. But, unless you have tons of cash sitting around, you’ll need to get financing when you buy an investment property. Even if you can afford to buy in cash, borrowing could be the best way to go.
However, financing an investment property is different than financing your primary home or even a vacation home. With that in mind, here’s a guide to what you need to know about your various financing options to help decide which is best for you.
Before we get into a discussion of how to finance an investment property, it’s important to clearly define what an investment property is.
There are three different categories a residential property can fall into:
These are listed in order of the easiest to finance to the most difficult. While it’s not quite this simple, investment properties typically represent more of a risk to a lender than a second home, which in turn represents more of a risk to a lender than a primary residence.
Different types of lenders consider different things when making decisions.
Investment properties represent a generally higher level of risk to lenders. One of the smartest things you can do before trying to get investment property financing is to make yourself as attractive a buyer as possible.
Your credit score is a good place to start. Different lenders and loan programs have varying credit score requirements, but I’ve never encountered an investment property lender that didn’t perform a thorough credit check.
I won’t get into a thorough discussion of how to improve your credit score, but there are a few important concepts to mention.
First, when you check your credit score, make sure you’re looking at a FICO credit score, as this is the type that virtually all lenders use. Many of the “free credit score” services provide a credit score that’s based on your actual credit information, but the FICO Score can be significantly different than these.
Some credit card companies have started to provide a FICO Score for free as a perk to their customers, but you may have to pay for it.
Another reason you might want to pay for your credit score is that you have three different FICO Scores — one from each of the major credit bureaus. And there are several different versions that can be generated from each bureau’s credit file. In fact, most mortgage lenders use different versions than other consumer lenders.
In all, there are actually 28 different FICO Scores lenders could see. It could be worth it to buy access to these if you’re serious about maximizing your credit score. I’ve used myFICO.com for the past 12 years, and I have nothing but great things to say about it.
While the FICO scoring formula is a closely guarded secret, we know that it’s made of five weighted categories of information:
FICO Scores range from 300 to 850. Higher scores are better. Different lenders have different cutoffs, but a FICO Score of 740 or higher should qualify you for virtually any loan program you want. A score of 760 or above should get you a lender’s best rates.
Your personal debts and income only matter for certain types of investment property loans. But, when trying to finance investment properties, it’s a good idea to give yourself as many options as possible.
The lower your monthly debt obligations are as a percentage of your pre-tax income, the stronger your application will be. For example, if your mortgage, auto loan, student loan, credit card, and any other monthly obligations on your credit report add up to $3,000 and you earn a pre-tax income of $10,000 per month, you have a debt-to-income (DTI) ratio of 30%.
Lenders may consider two different DTI ratios. Your front-end DTI ratio is your mortgage payments as a percentage of your income. Lenders place more weight on this factor when financing a primary residence. Your back-end DTI ratio is all of your monthly obligations, including your mortgage payments.
Most lenders want borrowers to have a certain amount of money in liquid reserves. This is usually expressed as a certain number of months’ worth of mortgage payments, including taxes and insurance.
Different lenders have different guidelines, but don’t expect to get investment property financing without three months’ worth of liquid reserves. Some lenders want at least six months’ worth. Even more will make your application stronger.
The short answer is that you’ll need at least 20% down to finance an investment property. It’s not uncommon for lenders to require 25%, 30%, or even more in certain circumstances. You may have read other articles and books on financing investment properties with “creative” methods to buy properties with no money down. But you should plan to put at least 20% down unless one of the following exceptions apply:
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