Preparing Yourself for a Conventional Loan
There are many reasons to be excited about buying a rental property. It can be a fantastic investment and an exciting personal milestone. But as with any major financial decision, there are also some things you need to consider before jumping into real estate investing with both feet. For example, do you plan on purchasing the property with all cash or do you plan on financing the property and if you do plan on financing the deal what type of financing would work best for you and the deal? Many investors use Conventional financing to purchase rental properties for their lower rates and fees relative to private loans or non-qualified mortgage loans. It's important to know the terms of the loan and approval requirements by the lender in order to have a smooth path to closing on the property.
What is a Conventional mortgage loan for investment properties?
Conventional investment property loans are designed for income-producing properties. That means you can use them to buy a home that has at least one rental unit up to four units, such as a single-family home, duplex, triplex, or quadplex. Conventional mortgage loans are “conforming” loans. This simply means that it meets the requirements for Fannie Mae or Freddie Mac. Fannie Mae and Freddie Mac are government-sponsored enterprises (GSEs) that purchase mortgages from lenders allowing lenders to free up cash to issue new loans. The requirements by the GSEs cover the amount of the loan, the borrower’s credit score, debt-to-income (DTI) ratio, loan-to-value (LTV) ratio, and other factors.
Investment property loans are available from several types of lenders, including banks and credit unions, and mortgage brokers. Other types of lenders are hard money lenders and private investors. A hard money lender is someone who lends money to borrowers based on the value of the property instead of their creditworthiness alone. These investors often charge higher interest rates, provide loans with shorter maturity dates, and higher fees than traditional lenders do. To get a Conventional mortgage loan, it usually requires more paperwork, but typically they are desired by investors who want to purchase and own a rental property for the long-term and thus lock in a low fixed rate.
Be aware of your credit score
If you have a good credit score, it will be easier to get a Conventional loan and the interest rate on your loan will also be lower. If you have a poor credit score, there is a chance that you may need to pay more interest on your loan. Your credit score is based on information in your credit report and each of the three major credit bureaus produces this report. You can request all three reports for free once per year by visiting AnnualCreditReport.com.
Shop around for low interest rates and loan costs
One of the most effective ways to save money on your loan is to shop around for a competitive interest rate. Many investors are tempted to accept the first offer they receive, but it pays to be selective and look at other options before making a decision. If you feel like your initial lender has quoted you an unfair or unreasonable interest rate, don't be afraid to ask them if they can do better.
Lenders will charge some sort of processing or origination fee, which is usually in the range of $800-$1,500. This is also an area that you can negotiate and compare prices from different lenders. When times are slow for lenders they sometimes give incentives and discounts on these fees so keep an eye out or search for lenders that offer them. This is their way to entice you to take out a loan with them.
How much is required to put down
You need a down payment of at least 20% of the home's purchase price. If a home’s purchase price is $100,000 and you put down 20%, your down payment will be $20,000 and the loan amount will be $80,000.
If you don’t have 20% of the purchase price saved up, it will be more difficult for you to get approved for a Conventional mortgage. If you do get approved for a loan with less than 20% down then you will be required to pay Private Mortgage Insurance (PMI) each month on your loan until you meet the loan-to-value ratio that the lender requires. PMI is a type of insurance that protects the lender in the event you default on your loan. Keep in mind that this additional insurance will add to your monthly costs and lower your cash flow.
Your down payment can come from personal savings accounts, a Home Equity Line of Credit (HELOC), or gifts from others such as parents or grandparents. Some people form partnerships to reduce the upfront costs that are required when purchasing a rental property.
Using a HELOC for the down payment
A HELOC is a line of credit you can use to pay for your down payment and closing costs. It’s typically an option if you don’t have enough cash on hand to make the full down payment, but it obviously involves more risk.
Before going this route, it’s important that you familiarize yourself with how HELOCs work. Keep in mind though that you are borrowing money from the equity in your home to essentially borrow more money. So, it's obviously a riskier option than using your own savings to put down as a down payment. Before you decide to go this route it's best to develop a payment schedule to pay back the money you borrowed from your HELOC. Once you do that, it will be easier for you to determine whether or not this type of loan is right for your situation.
If you do decide to use a HELOC as your down-payment you are essentially using borrowed funds for the down payment. It’s then very important to disclose that information to the lender at the beginning of the underwriting process. Otherwise, it could be considered mortgage fraud.
Other costs included at closing
Now that you know how much money is required to put down to take out a loan you need to ensure you have sufficient savings to cover the down payment and additional loan and prepaid costs. The lender will provide you with an estimate of these costs to help you budget out how much you need at closing. The prepaid costs include one year of insurance and taxes for your escrow account. During the underwriting process, call up a few insurance companies and get some quotes based on the requirements by the lender. Additionally, don't forget about other expenses such as home inspections. You will most likely need an appraisal and the cost is usually included in the closing costs. These expenses can add up quickly, so make sure that you factor them into your budget!
Know how much you can afford on a monthly basis
You'll need to understand your monthly expenses, including the cost of insuring the home, taxes and insurance, property management fee, HOA, and at least three months of mortgage payments saved up. Yes, your rental income should cover all of your expenses but in the event your property is vacant as you are getting it rent-ready or while it's on the market you need to be able to pay for the mortgage, electric and water utility costs, and any maintenance involved such as lawn care. You never want to purchase a rental property without some sort of additional savings as unexpected costs, can and usually do, arise at some point of owning the rental property.
When you’re ready to take out a Conventional mortgage, make sure you have done your research and shopped around for the best rate and lowest fees. This way, you will be able to apply for the best type of loan for your rental property investment. Purchasing a rental property requires upfront costs and additional savings to cover expenses after you close on the property. The process of taking out a Conventional loan can seem daunting, but taking it step-by-step and working closely with your lender as to what is required should make the process easier. Also, a helpful tip is to ask the lender at the beginning of the process what documents are usually required so that you can gather any and all information that the lenders may require during the underwriting process.