Although purchasing an investment property is a great way to enhance your income stream, the thoughts of a quick flip or easy rental income shouldn’t get in the way of due diligence. Many are drawn into investing in real estate because of the stability, high return rate and tax advantages.
But before looking into investment properties as a wealth-building or retirement strategy, you should weigh all the factors to determine if buying an investment property is a good fit, both financially and personally.
Valeria Lee, a realtor with Re/Max Supreme in the Washington, D.C. area, said consumers should consider how they plan to use the investment property. “First of all, they need to think about whether they are buying to rent and hold, or if they are buying it to flip,” she said.
The National Association of Realtors (NAR) said 45% of investment consumers purchased an investment property to keep it and turn it into rental income, as opposed to purchasing a property with the intention of flipping it or for price appreciation.
Lee said that either way, you should find out what kind of condition the property is in and how much money you’ll need to put into it in order to flip or hold it. This is especially true, she said, of investors who want to flip a house that needs a lot of work to get it to sell at market value.
“They may not make as much money as they think they’re going to make,” she said. “They’re lured by the cheap prices, then when they start adding in things like needing a new furnace, the costs add up.”
She suggested bringing in a contractor to see what it would take to get the property up to market value for it to produce income. “Otherwise, it’s not a good investment,” said Lee.
Factors to note when deciding whether to finance an investment property
There are some key differences when it comes to financing a property for investment purposes versus financing for a more traditional owner-occupied property.
Lenders see investment properties as riskier
Lenders usually have separate fees for investment properties, and the interest rates are generally higher than they are for your primary home.
Lenders are often taking a greater risk with investment properties, since homeowners are more likely to walk away from investment properties during times of financial hardships. Just how much more interest they charge all comes down to the actual down payment amount, type of investment property and your credit score.
The federal funds rate is rising
Although interest rates are still relatively low compared to previous years, they are rising. This could mean an even more expensive mortgage. One investment management firm, Principal Global, predicted four more interest rate hikes in 2019.
“With interest rates moving higher, investors are naturally worried about the potential negative impact on real estate values,” the firm noted. It added that during the next few years, investors should focus on making assets work as hard as possible to maximize rent growth and provide a cushion against higher interest rates.
But Tendayi Kapfdize, chief economist for LendingTree, which owns Student Loan Hero, wrote in December that the impact of Federal Reserve rate hikes on mortgage rates is “ambiguous.” He said there’s often a misconception that changes in the federal funds rate affect mortgage rates.
“In the last three Fed rate-hiking cycles (since 1994), the fed funds rate increased 3 percentage points on average, and the change in mortgage rates was muted at an average 1 percentage-point increase,” he said. He added that at times, mortgage rates were even falling as the federal funds rate — the interest rate that banks charge each other for overnight borrowing — increased.
Mortgages are more influenced by longer term borrowing rates. In that respect, mortgages are influenced by a different Fed action — that of reducing its balance sheet by getting rid of the treasuries and mortgages it had purchased when the economy was in worse shape. That is indeed causing mortgage rates to rise.
Investment properties often require a larger down payment
Another factor to consider when weighing whether an investment property is right for you is the amount of money you have saved to go toward the investment. You’ll typically need a higher down payment for investment properties. The NAR said 42% of investors paid all cash in 2017, but the majority needed to make a down payment of 20% at minimum.
Lee added, “From what I know from dealing with investors, it’s harder because of the down payment. That’s the big difference.”
Conventional mortgages won’t finance some multifamily dwellings
While some borrowers buy one single-family home to rent out, others who have already done that may decide to take it a step further and purchase a multifamily property to capitalize on even more rental income.
But financing an investment property is different if the you’re purchasing a building with more than one dwelling. Conventional mortgages, for example, won’t finance buildings with more than five units. In this scenario you’ll have to look at government-backed multifamily programs through Fannie Mae or Freddie Mac.
Standards for credit score, cash reserves and debt-to-income ratio may all be higher
Other important factors to note before going full steam with investment property plans are your credit score, cash reserves (sometimes up to six months is required), and debt-to-income ratio. The requirements for these may all be stricter for an investment property than for a traditional mortgage. Lee added that all are equally important and said that if none of them fit the criteria you likely won’t be able to get the loan.
“They want you to have a pretty good credit score in order to qualify because you’re buying something that you’re not going to be living in, so you don’t have as much invested in it,” said Lee.
With so much to consider, the NAR suggests meeting with lenders before seriously looking at investment properties.
Financing Options for Investment Properties
Once you’ve made the big decision to purchase an investment property, there are various types of financing options to evaluate. Below is a snapshot of some of those loan options.
Conventional loans: A conventional loan doesn’t have the government’s backing, meaning it’s not part of any government program, such as FHA loan programs.
Conforming loans are the most common type of conventional loan, according to the Consumer Financial Protection Bureau. They meet the criteria of Freddie Mac and Fannie Mae, the two largest buyers of loans. One of those criteria is that the loan must be for $484,350 or less in 2019.
The down payment is usually a minimum of 20% for investment properties. For owner-occupied properties, homebuyers can get by with providing a smaller down payment by purchasing mortgage insurance. But mortgage insurance won’t cover investment properties.
The maximum loan limit is higher if you’re buying a property with multiple dwellings, such as a duplex or a building with no more than four units. Fannie Mae and Freddie Mac loan limits for conventional mortgages in 2019 in most areas are:
For costlier purchases, there are conventional jumbo loans that offer more than the $484,350 limit. The maximum loan amount varies by county. You can use a tool from the Housing and Urban Development Department to find out limits in your county.
Your home equity is how much your home is currently worth, minus the amount of any existing mortgage on your property. A home equity loan is a lump sum installment loan with a fixed interest rate, while a HELOC is a line of credit that you use more like a credit card. It comes with a variable interest rate.
Just be aware that if you use one of these options, you’re putting your home at risk. If you can’t make payments, you could lose your home.
Lenders know that if homeowners hit hard times, they are more likely to let an investment property go than endanger their own home. That’s why they’re considered riskier for lenders and many lenders won’t offer HELs and HELOCs for investment properties. But if you do some asking around, you might be able to find one.
Lee said she’s seen some of her clients use HELs to put toward a down payment on a conventional loan to get up to the 20% needed.
Private or investor-based loans: Loans from private lenders or investors may be more flexible with the terms than other types of loans. But keep in mind that flexibility often comes with higher interest rates and origination fees.
For example, you might be able to get financing from a hard money lender. They make short-term loans based on the value of the real estate you’re looking to buy, not your credit.
Lee said such loans typically have high interest rates and are intended for investors who want to flip houses. “They only lend for maybe six months or a year for you to get the property up to speed in order for you to sell it,” Lee said.
FHA loans: An FHA loan is an option that allows for lower down payments — as low as 3.5%, but with caveats. FHA loans only work for investors looking to purchase a two- to four-unit multiple-dwelling that you also plan to live in.
When buying an investment property for the first time, industry experts say it’s probably best to start small with one home versus several homes or a multi-unit building. By having the property, you become a landlord and are responsible for much of the home’s maintenance, so it also helps to be a bit handy around the house. Some investment buyers underestimate the costs of maintaining the property.
Once you get your ducks in a row, investing in real estate could be a wise choice. Remember to take stock of your credit score, be able to prove that you have enough cash reserves available, and closely examine each of the financing options to see what suits you and your investment best.
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