Investment in real estate property can be tricky. There are several types of lenders making loans on investment properties, and the requirements for financing an investment property may differ considerably from those for a primary home.
That being said, there are a ton of financing options out there, and finding a loan for your next real estate investment is not terribly difficult. Finding the best loan for your investment however requires a little more work. Here are five tips that can help you make sure the process is going smoothly, and that you are funding your investment property with the best terms you can find.
5 Tips on Getting the Best Possible Loan
When you are a fairly eligible investor, you will usually find someone to lend you the money for your investment in real estate. You don’t just want any loan though — you want the best investment property loan you might find.
For that to happen, in the eyes of lenders, you need to be the most attractive applicant possible. Here are five suggestions with that in mind to help you find the best loan for your next investment property.
1. Work on Your Credit Score
You can be sure that your credit score will come into play, whether you are applying for a conventional mortgage for your investment property or for a commercial asset-based loan. In general, lenders check your FICO credit score from all three major credit offices and use your middle score to determine your eligibility, down payment requirement and interest rate.
The average American has an approximate 700 FICO® Score. The scores range from 300 to 850 and the higher scores are better. If you’re not familiar with how your FICO® Score works, our The Ascent sister website has an excellent FICO scores guide that is definitely worth reading.
Here’s the point: In the low-to-mid 600s, you can get a mortgage on investment property with a credit score. You may be asked to put more money down than you want, however, and your interest rate may well be considerably above average.
You may also be surprised by the difference that an apparently small interest rate (APR) change can make. Let’s assume, for example, that a lender is offering the most eligible lenders 30-year investment property mortgages with fixed 4.50 percent APRs. However, since your credit score is good but not great, they offer you a 5.25% rate. On a $250,000 mortgage, when compared with a top-notch borrower, you would pay nearly $41,000 in extra interest over the life of the loan.
A FICO® score of 740 or higher would usually qualify you for the better terms of a loan, so it can be an incredibly wise decision to focus on your credit score.
2. Get Documentation on Your Income and Employment
When you apply for an investment property loan, there are asset-based lenders who don’t care about your personal income or job history and, to be clear, they can be great options. Generally, however, traditional lenders give better terms than asset-based lenders, and they will definitely take into account your income and job situation when making lending decisions.
In general, if you apply for a traditional loan, you can not have a debt-to-income ratio of more than 45%, including the estimated interest on your new investment property loan. You can use three-fourths of the rental income required of the property for qualified purposes, but you would also need to be able to disclose the other sources of income.
Therefore, it’s a good idea to collect all of your income paperwork before you start shopping for a loan. It covers the last couple of tax returns, W-2s and/or 1099s, and is not going to damage any recent pay stubs. It is also worth getting a contact number for someone (like the HR department of your employer) that is able to check how long you have been at your place of employment.
3. Pay Off Other Debts
Even though asset-based lenders will not consider your personal debts in the way conventional lenders will, debt reduction may boost your credit rating for any type of loan.
The debt reduction will obviously improve your debt-to-income ratio (DTI) for conventional loans. Also if you are still within the limits of your lender, a lower DTI will help you get better terms for a loan.
Debt reduction will raise your credit score, which, as I have mentioned, will boost your approval chances and enhance your terms of credit with any form of lender. Unfortunately there is no way to determine how much the performance would be impacted by a certain amount of debt reduction or debt repayment. They do note, however, that the sums you owe on your various credit cards make up 30 percent of your FICO® score, and a significant debt reduction may have a major impact.
4. Make Sure Your Target Property Will Produce Enough Cash Flow
When it comes to asset-based lenders that is more of a consideration. The good news when you use one of these lenders to finance an investment property is that they generally don’t care about your personal debt, your income, or how long you have been with your employer. You won’t have to dig up your old tax returns or produce W-2s or any other documentation about your income.
The property needs to be able to justify the loan, and then some, because the loan is based only on the property. In other words, the property’s cash flow needs to be more than enough to cover your mortgage payments including taxes and insurance.
A metric known as the debt service coverage ratio, or DSCR, is used by many asset-based lenders. It is the estimated profit of the property divided by your monthly outlays. For instance, if you want a property to rent for $1,200 and your mortgage payment would be $1,000, this implies a DSCR of 1.2.
A 1.2 DSCR tends to be the absolute minimum which a lender based on assets wants to see. Higher is better, and many lenders have different DSCR levels which determine their interest rate. For example, one particular lender offered me interest rates on properties with DCSRs above 1.3 which were about 50 basis points lower.
5. Apply With as Many Investors as Possible
As a last tip, maybe the most common mistake I see investors make when trying to finance a property is to apply for only one mortgage and accept whatever terms they are given.
You may be shocked by the differences between interest rates and other terms of loans you can get when you compare shop. A lower origination fee or a lower APR can make a big difference in the profitability of your property, so this is a significant step forward.
Besides, you don’t need to think about damaging your credit score with so many mortgage applications. There is a special provision in the FICO credit scoring formula that says they will count as a single inquiry for credit-scoring purposes as long as all of your applications take place within a two week window.
So, apply before making a decision, to at least a handful of lenders. That should include both conventional lenders and lenders based on assets. The more the merrier.
When you have a 20 percent or more down payment and a decent credit score, obtaining funding for an investment property is not too difficult. Finding the best available loan, however, will make a big difference in the cash flow of your house, as well as your long-term equity. So take the time to be the best candidate you can be, and make sure you’re considering all your choices.