Taking Out a Loan for Investment Properties? Learn How
Buying a house can be an attractive investment for everybody and not just for a professional real estate investor, but for anyone looking for an opportunity to earn passive income. Here are some of the main benefits.
- You can enjoy a predictable rental income stream.
- Your property can appreciate over time, and you can resell it at a higher price.
- Real estate investments can make your portfolio more diversified and less risk-oriented.
- Managing your investment does not require a lot of work.
- You can benefit from tax breaks or deductions.
- The property can be used as collateral to obtain a loan.
Are you considering taking out a loan for investment properties? This article will explain the different types of loans and provide you with useful tips on how to maximize your profits.
First Mortgage on Investment Properties
This is the most common loan people use when buying properties. It can be used for both houses you plan to live in or as an investment property loan. It’s usually repaid over a long period of time, which can be as high as 30 years.
Several financial institutions and specialized lenders provide this type of loan. A mortgage loan officer will usually assist you during the application process.
First mortgages require a down payment. A large one would lower the interest rate you pay on the mortgage with a positive effect on the overall borrowing cost.
Based on info provided by Freddie Mac, down payments are usually 5% to 20%, but they can be as low as 3% (or as high as 25%). For first-time buyers, it is typically around 6%. However, borrowers must purchase PMI (Private Mortgage Insurance) if their down payment is lower than 20% (until they reach 20% equity in their home).
Freddie Mac also provides interest data on how property buyers usually finance their down payment:
- 70% resort to savings (or other assets)
- 31% sell a previous property
- 23% receive a loan or a gift from relatives
- 10% apply for down payment assistance programs offered by state, county, or city authorities
- 4% ask for home equity loans or similar financing options
To be eligible for a loan, you need to have a good Debt-to-Income Ratio (DTI), that is, the percentage of your income going into debt repayment. If your DTI is 10%, it means that 10% of your monthly gross income is used to repay debt.
According to Investopedia, credit providers usually look for lenders with a DTI not higher than 36%, while 43% is the highest DTI acceptable.
Having sufficient cash reserves can also improve the likelihood of your mortgage application being accepted.
Finally, it’s wise to apply for a conventional mortgage when your credit score is in good shape. If it’s below the low 600s, it’s a good idea to take actions that improve your credit before applying for a mortgage. The best conditions are usually available to borrowers whose credit score is above the low 700s.
All these factors being equal, mortgage lenders offer different interest rates to borrowers. Therefore, it’s advisable to search for different lenders and compare their offerings to spot the most attractive ones. Don’t overlook additional fees. Sometimes they’re hidden between the terms and conditions and can significantly impact the total cost. Some of these fees may be tied to your already existing loans. Ask your mortgage loan officer for a detailed list of all the fees included in the contract.
Access to a stable supply of mortgage loans is facilitated by federally backed companies like Freddie Mac and Fannie Mae. They don’t originate loans themselves but buy them and guarantee them in the secondary mortgage market. This provides liquidity to mortgage companies, helping them provide affordable loans to borrowers.
Home Equity Loan for Investment Properties
This type of loan lets you borrow a lump amount against the equity in your home. It’s considered a second mortgage, as it allows you to borrow against an existing property’s value. The loan can then be repaid at a fixed interest rate in a period ranging from 5 to 30 years.
Based on data provided by Investopedia, most home equity loan providers will lend you up to 80% of your home’s current value. This percentage is known as the combined loan-to-value ratio.
For example, if your current home’s value is $400,000 (and you have no current debt), you will be able to borrow up to $320,000. Of course, many people have existing first and/or second mortgages on their current properties. In this case, you’ll have to subtract your outstanding debt from the amount you can borrow. In the above example, if you still owe $100,000 in existing mortgages, you’ll be able to borrow up to $220,000 when applying for a home equity loan.
Other factors, such as your current income and credit score, will also affect your eligibility, as well as the interest you have to pay on the loan.
A home equity loan can be used to finance any type of purchase. Therefore, it can also be used as an investment property loan, whether you want to resell the real estate after at a higher price or generate long-term rental income. It can be the right move when:
- you don’t have enough cash reserves
- you don’t have time to save money
- you have accumulated significant equity in your home
The obvious risk of taking out this type of loan is losing your current home if you can’t repay your debt. Another risk is the depreciation of your home’s value, meaning that you won’t be able to sell your house unless you pay the money to your creditor first.
HELOC (Home Equity Line of Credit) for Investment Properties
Unlike home equity loans, a line of credit sets an amount of available cash that you can use at your discretion. You will then have to repay the outstanding balance within a certain period of time, usually at a variable interest rate.
Yet just as in a home equity loan, you will need to use a current property as collateral to obtain it. Your collateral’s value also determines the amount that you will be able to borrow.
In short, a HELOC is like a credit card backed by the value of a property you own. After your line of credit has been approved and you have found an investment property to buy, there are two available options.
- You can use it to cover the down payment on a conventional mortgage (ideally, your HELOC provider will be the same as your mortgage provider).
- You can use your HELOC to finance the investment property in cash (partially or totally).
Because of its variable interest rate, opening a HELOC to finance real estate investments can be a clever option if you foresee a general decrease in interest rates. It’s also a solution to consider if you plan to renovate your investment property to increase its value. As opposed to borrowing a lump sum, opening a line of credit allows you to decide more flexibly how much you will spend on home remodeling.
Hard Money Loans for Investment Properties
These loans are also known as asset-based loans and are often used by real estate investors for short-term financing needs. This type of investment property loan is backed by hard assets like real estate and is usually provided by private or individual lenders and not by traditional financial organizations.
It has a much quicker approval process than conventional mortgages or home equity loans. That’s because using hard assets as collateral requires fewer checks on the borrower’s credit history and status.
A real estate investor or developer can use these loans to obtain quick funding to buy a property, renovate it and then sell it for a profit. Yet the easiness with which they can be obtained also translates into higher interest rates and fees. This means that the overall borrowing cost is usually higher than conventional mortgages and home equity loans.
According to Forbes, interest rates on these loans are usually between 10% and 15%. Moreover, you usually have to repay them in less than two years. This makes them a good option only if you are confident your property can be sold profitably in a short period of time.
Commercial Real Estate Loans for Investment Properties
If you are a business owner, you can also consider a commercial real estate loan. Compared to conventional mortgages, they usually require a higher interest rate than conventional mortgages, a more significant down payment, and a lower repayment period (between 3 and 30 years).
Yet like conventional mortgages, they are secured loans that require some form of collateral (usually the real estate itself).
It’s an option to consider when you are investing in a property that you plan to use as part of a larger business. This could be the case for office buildings, warehouses, or retail spaces.
Maximizing Your Profit
Using Leverage to Amplify Your Return on Investment
The best way to explain leverage is by using a practical example.
Let’s say you want to buy a $300,000 house as investment property because you predict home values in that area will increase. So you take out a mortgage with a 25% down payment ($75,000), which gives you total control of the entire asset.
You also want to use this property to generate rental income and find tenants who are willing to pay $2,000/month ($24,000/year) to live in it. Subtracting management/maintenance costs, insurance, utilities, vacancies, taxes, principal repayments, interest, and fees, your actual cash flows could be around $15,000/year.
If you had bought the property in cash for $300,000, your yearly return on investment would have been 5%. But because your actual down payment was only $75,000, your return rate is 20%, thanks to leverage.
And because your tenants are gradually paying back your mortgage, you are also building equity over time.
On top of all that, if the property does increase its value considerably, you can also repay the entire mortgage plus generate a significant capital gain by selling it at a higher price.
Investing in real estate also involves various tax benefits. Here is a summary
- You can often deduct expenses tied to the investment (e.g., property insurance, property management costs, property taxes, or mortgage interests).
- If you run a real estate investment business, you may be able to deduct office costs, legal fees, advertising costs, etc.
- You may also be able to deduct depreciation for the property’s entire expected duration (depreciation is the loss of an asset’s value due to wear and tear).
- You can be eligible for real estate tax breaks, like avoiding paying the FICA tax on the money you receive from your rental property if you are self-employed.
What About the Risks?
Finally, it’s important to highlight that buying real estate properties for a profit carries risk like any other form of investment. While eliminating risk is not possible, there are strategies to reduce it. Here are some of them.
- Analyze real estate price trends and projections in the areas you plan to invest.
- Keep up to date on macroeconomic data that can impact house prices nationally or regionally.
- Diversify your real estate investment by buying properties in different locations.
- Diversify your overall investment portfolio by including different types of assets.
Can Personal Loans Finance Real Estate Investments?
Unlike first mortgages or home equity loans, personal loans are unsecured loans that don’t require collateral. The borrowed sum can be used for any type of expense. While it is unusual to use personal loans as the main financing tool for real estate investment, they can still help you finance related expenses.
For example, you can use a personal loan to finance home renovation and remodeling costs. This can help increase the total value of your home, thus increasing the price at which you can sell it or rent it.
Level Lending offers attractive and flexible personal loans of up to $55,000. Get a free online loan offer today or contact us at 888-922-4015. We’ll be happy to explain to you in detail how a Level personal loan can help you fulfill your financial goals.