How To Finance Your Rental Property
You’ve researched, narrowed your choices, and finally decided on an investment property.
But you aren’t ready to buy it just yet.
First, you need to figure out how to finance your rental property. That means finding a mortgage, analyzing interest rates, making a down payment, and evaluating the costs of your investment property and loans.
Between loan types, lenders, and budget considerations, understanding mortgages can be pretty overwhelming for new landlords. But regardless of your experience level, you can learn to finance your new rental property as proficiently and cost-effectively as possible.
Your path to financial freedom starts with your first property. This article will get you started with the basic financial steps to acquire it.
Getting a Mortgage
The first step to finance a rental property is finding a suitable mortgage. Mortgages are loans used to purchase houses or other real estate.
You, the borrower, apply for a mortgage from a lender. Your lender could be a bank, credit union, government agency, mortgage broker, etc.
The lender will approve your application if you meet their credit score and down payment criteria. During the closing, you’ll make the agreed-upon down payment, sign the mortgage documents, and receive ownership of the property. You’ll then pay off the loan in monthly installments, typically over 15 or 30 years.
During the loan term, the property you bought is considered collateral. This means if you stop making mortgage payments, the lender can foreclose on it.
Interest Rates, APR, and Discount Points
Your mortgage is the principal loan amount remaining after the down payment, plus interest. Interest is a percentage of the loan added to your debt each year. The total interest charged on your mortgage at the end of the year is known as the annual percentage rate (APR). APR varies by lender and loan, but it does not factor in compounding interest. It represents simple interest.
If your interest rate is too high, you may decide to buy discount points. Discount points lower your interest rate for an up-front fee. Consider discount points as you compare different loans—a loan with an unusually high APR might be affordable with discount points.
Mortgage Types
An array of mortgage types makes it possible to find the most advantageous lender, duration, and interest rate. Here are the five most common types:
A fixed-rate mortgage is a standard mortgage with an unchanging interest rate. Many landlords choose this type to lock in a low APR.
Adjustable-rate mortgages (ARMs) have an initial fixed rate that changes periodically after the first few years. The initial rate is often lower than fixed-rate mortgages, but expect increases over time.
Conventional loans are private mortgages offered by a bank or credit union. They tend to have fixed, but higher, interest rates and stricter requirements than fixed-rate mortgages or ARMs. A conforming loan is a type of conventional loan that meets the federal dollar limit set by the Federal Housing Finance Agency. For 2022, the federal dollar limit is $647,200.
A jumbo mortgage, or non-conforming loan, exceeds the Federal Housing Finance Agency’s dollar limit. These are most suitable for expensive, luxury properties. Larger loans are riskier for lenders, so prepare for strict requirements.
Government-insured mortgages are financed by one of three federal agencies—the Federal Housing Administration (FHA), the Department of Veterans Affairs (USVA), or the Department of Agriculture (USDA). VA mortgages are for military families, while USDA mortgages are for low- to middle-income rural families. The agency is responsible for paying the lender if you bail.
Government-insured loans are highly accessible. If you have a decent credit score, you can secure an FHA loan with a down payment as small as 3.5%.
Down Payments
What is a Down Payment?
A down payment is the portion of the total cost of a property that you pay up front.
For example, a 15% down payment on a $250,000 house would be $37,500. The remaining cost is financed with one of the mortgage loan types described above.
Down payments impact the mortgage debt you’ll take on: the loan type, monthly payments, interest rates, and your offer’s competitiveness.
How Much Money Should I Put Down?
In general, the higher your down payment, the more trustworthy of a borrower you become and the more favorable mortgage you’ll get. However, there are also benefits to smaller down payments.
Less money down means you’ll have more financial flexibility later. Your assets are liquid rather than invested in a property. However, you might appear less trustworthy to lenders and face higher APR as a less competitive applicant.
On the flip side, more money down also means your lender assumes less financial risk. You have more equity in the property and are therefore less likely to default. This means you can make an attractive offer and secure a higher mortgage preapproval amount.
You’ll also have a lower Loan-to-Value ratio (LTV). LTV assesses borrower risk by comparing the loan amount to the appraised property value. The lower the ratio, the lower your interest rates and the fewer fees you’ll pay; an LTV over 80% might require you to pay extra for personal mortgage insurance. The downside is that you’ll have less money available for expenses like taxes, maintenance, or insurance.
Traditionally, 20% is a good benchmark for down payments. However, it’s possible to secure a property with much less if you cannot meet that benchmark.
BiggerPockets, Investopedia, and NerdWallet each have mortgage calculators that can help you determine the monthly payment you can afford while accounting for property expenses.
Refinancing Your Property
Refinancing is the process of replacing your current mortgage with a new, better one. You might refinance your mortgage to get a lower interest rate, pay it off sooner, convert it from adjustable to fixed or vice versa, or liquidize your assets for another purchase.
Refinancing a rental property typically costs 3-6% of the loan’s principal. This means it can potentially add to your debt if you aren’t careful. However, if you know what you’re doing and why, refinancing is a lucrative endeavor. With a careful strategy, you can refinance and save 1-2% in interest, quickly build equity in your property, and decrease your monthly payments.
How it Works
What kind of loan makes a good replacement for refinancing?
In general, shorter-term loans save you money in interest but result in higher monthly payments. Longer-term loans lower monthly payments but accrue more interest over their life.
Here’s an example. Let’s say you have a 30-year fixed rate mortgage on a $190,000 property. The interest rate is 6.5%, and you’re paying about $1,200 per month. You decide to refinance and find two potential replacement loans: Option 1 is a 15-year fixed-rate mortgage at 4.5% interest, while Option 2 is a 30-year fixed-rate mortgage at 5.5% interest. Which one should you choose?
Option 1 increases your monthly payment by about $200 per month. However, it saves you over $50,900 in interest for the first five years and halves the term length.
Option 2 reduces your monthly payment by $160 per month and saves you almost $5,000 in interest for the first five years. It still takes 30 years to pay off.
Between these loans, only Option 2 reduces both monthly payments and APR. Sticking with the 30-year term means you’ll have more cash for monthly expenses or rehabbing. However, there are some reasons you might choose Option 1—for instance, if your priority is to pay off the loan as quickly as possible and you don’t have an urgent need for cash.
Option 2 doesn’t come without its risks. Although it’s convenient to access your home equity for large expenses, you could slide further into debt. You should only use refinancing if you can lower interest rates, shorten the term, or consolidate debt. Also, if you don’t consider the 3-6% fee, you might accumulate more debt than when you started. It’s your job to consider your circumstances, do the math, and identify the best option.
The BRRRR Method
The BRRRR method is an investment cycle recommended by Brendan Turner on Bigger Pockets. His idea is to borrow against the property to improve its value, then refinance to recover the costs and continue buying.
Here are the five steps, simplified:
Buy – Find a below-market value property with low competition.
Rehab – Make improvements that add more value than they cost. For instance, try installing hardwood flooring, remodeling bathrooms, or adding bedrooms.
Rent – Seek renters and collect rent. Don’t neglect tenant screening.
Refinance – Find a lender willing to refinance the property. The trick is to borrow on the appraised value, not the amount you invested. If you rehabbed well, you should achieve a substantially higher appraisal because you added value.
Repeat – Repeat to continue building your investment portfolio.
While you would traditionally leave your down payment in the property as equity, the BRRRR method uses that capital to acquire more investment properties. You need cash to grow a large portfolio quickly. BRRRR frees the funds to helping you finance your first rental property and keep buying. BRRRR method real estate investing is an excellent way to propel your business forward.
Conclusion
No landlord is a perfect investor, especially when buying their first property. And that’s okay. In fact, many have little previous experience navigating financing. But even a little preparation could mean the difference between a manageable loan and prolonged debt. Passive income is within your grasp—if you take the time to research and fully understand how to finance your rental property first.
