Real Estate Investing

How To Finance Rental Properties

Article Summary

This article tells you why you should make rental real estate a part of your investment strategy and how you can go about doing so. You’ll learn how to finance your first then multiple purchases of rental property. You’ll also learn what you need to do to prepare for real estate investment, such as getting your credit in order and saving money for down payments. And we’ll direct you to various resources to help you on your way to success.

Stock, bonds, and mutual funds may be great investments, but you may be missing out on a huge return if you don’t also consider real estate investments.

According to Zillow, the value of homes in the United States is expected to increase by over 10% in 2021, with the current median value at $266,222.

Also, the U.S Census Bureau reports that the median asking rent in the U.S. rose by 2.5% to around US$1,033 per month in Q2 2020.

Buying or financing your first rental property might be easy, but it gets tougher as you try to buy more properties and increase your investment portfolio.

And that’s why we created this article. By the time you’re done, you’ll have learned how to handle investment property financing properly and how to buy multiple rental properties.

Let’s begin with some advantages of real estate investing.

Owning multiple properties: Advantages for real estate investors

Become a landlord with increased cash flow

Your investment property makes you a landlord and positions you to rake in a steady rental income from property rentals.

Even if you take a money loan to increase your real estate portfolio, you’ll see that property investment is low-risk once you find tenants to occupy your rental property. Over time, rental income from your tenants will pay off the entirety of the property’s mortgage or loan and ease your cash flow. This will allow you to recoup pure profits when you sell the home.

Enjoy tax and inflation benefits with your rental property

Real estate investors can gain tax benefits from rental properties, especially when they choose to scale their real estate investment.

Say, for example, you have an expensive investment property in Area A but want to shop around and switch over to Area B, where you’ve found 3 smaller rental properties. You can easily do so with the 1031 tax-deferred exchange. This allows you to exchange one property for another, or for several others, without having to pay tax on the expensive property’s accrued home equity.

What is more, you can use the tax savings you make along the way as a source of funding for another rental property and bring in additional rental income.

Challenges of funding more than one real estate investment property

Along with the benefits that come when you want to buy a property are some challenges. Here are some of them.

Lenders consider financing multiple properties high risk

As mentioned earlier, getting a loan from a lender when you want to improve your real estate portfolio is harder than when you’re getting a loan for your first rental property.

Why?

Lenders are used to investors treating their purchases as investment properties and not as places they’ll live in or even consider their second home. This makes lenders believe that investors might not be eager to pay back the loan they take out. And, they reason, with each additional rental property comes more risk.

Since mortgage insurance doesn’t cover the purchase of an investment property, you’re unlikely to find a lender willing to underwrite 100% of an investment home’s purchase price. As well, most lenders require borrowers to have at least six months’ worth of cash reserved after making a down payment.

The paperwork may be brutal. Lenders will want to pore over your tax returns — particularly Schedule E, which covers rental property income and expenses. They’ll also want to know how much your monthly mortgage payment costs for your primary residence.

Investors with high mortgage debt and hard money loans should expect higher mortgage rates and stiffer loan terms from a lender.

Each property will have its set of mortgage documents. You’ll have to produce W-2s and other financial data so that mortgage brokers can calculate your debt-to-income ratio, which changes with each new property you buy.

If you’re having trouble keeping tabs on your loans, you can hire a mortgage broker to help out.

Higher down payment requirements

Lenders require borrowers to have plenty of cash in the bank, with more on the way. Investment home buyers in 2016 had a median household income of $95,800 — up from $87,680 the year before (Source).

When making a down payment, you won’t be able to use gift funds as freely as you can when buying your first home and residence. And if you’re borrowing under Fannie Mae guidelines, you won’t be permitted to use any gift funds for your down payment (Source).

High credit score requirements

You’ll need a credit score higher than 720 if you want to get good interest rates and loan terms for your rental property loans. So always keep your credit card(s) safe, monitor your credit reports to ensure you know and can report any errors quickly, and review our article on how to improve your score.

Higher interest rate

Interest rates tend to be around 4% for fixed-rate loans or slightly lower for adjustable-rate mortgages. Some lenders will tack on extra fees to finance multiple properties.

Although the interest rate and loan terms are usually unique to each lender, the rate on home loans is generally 0.5–1% lower than the rental property’s interest rate. When compared long-term — over, say, 30 years — you’ll find out that the interest rate difference is significant.

Advantages & Challenges: Recap

To review, these are the advantages and challenges of owning not just one but multiple rental properties as an investment.

Advantages
  • Your cash flow will increase
  • You’ll benefit from inflation
  • You’ll get tax benefits
Challenges
  • Lenders think more properties means higher risk
  • You’ll need higher down payments
  • You’ll need a higher credit score
  • The interest rate will likely be higher

How many rental properties can you finance?

As a real estate investor, you can finance as little as 1 investment property or make more than 10 property investments at a time.

But a question remains:

How can you afford multiple rental properties?

Here’s what you need to know about residential rental property financing, depending on how many properties you want.

Financing four or fewer homes

If you have a credit score of at least 630, have liquid assets equal to three months of your desired mortgage payment, and can make a 20% down payment, you have a decent chance of getting a loan.

Major institutions like Bank of America or U.S. Bank choose borrowers cautiously. But smaller banks are hungrier for business and are thus more flexible in their terms. If you’re interested in financing your mortgage with a traditional loan, consider applying to a local bank.

You can also try tapping into your home equity with a home equity loan, cash-out refinance, or HELOC.

When choosing a bank, you also need to consider its closing costs.

Financing five to ten homes

In this situation, a bank often originates your loan but shunts ownership (and risk) to Fannie Mae under its 5-10 Financed Properties program. This program applies even if some of your five to 10 properties were not financed by Fannie Mae.

To qualify, you’ll need six months of reserves to buffer against vacancies. You’ll have to pay 25% in down payments for single-family properties and 30% for properties with up to four units. If you’ve been late on mortgage payments in the past 12 months, you’ll be disqualified. You’ll also be disqualified for any bankruptcies or foreclosures within the past seven years.

To finance the seventh to tenth home under this program, you’ll need a 720 or higher credit score.

More than ten homes

In this bracket, you’re at the mercy of the big bank portfolio lenders. Lenders in this category are especially wary of the risk of default.

U.S. Bank and Wells Fargo both offer investment property loans. They suggest using current home equity as a financing tool in certain situations.

You could also try a blanket mortgage, a loan that funds multiple property purchases. However, this option comes with risks. It isn’t easy to unload properties under a blanket loan since you’ll have to sell every home that the loan covers at once.

Other “creative” financing exists, but these options are riskier. For example, you could seek financing from the property’s previous owner rather than from the bank holding your mortgage. However, you’d likely see higher interest rates or other forms of resistance from the seller.

Hard money lenders (rich individuals or small banks that offer funds in exchange for high rates) can also seem appealing. But their terms often require you to pay back the loan quickly or face foreclosure.

Bottom line: Don’t rush these kinds of investments. Think more than two years ahead instead of thinking short-term. And do your research to make sure you find the best mortgage lender for your investment loans.

Financing by borrower type

Solo 401(k)

If you’re a self-employed business owner without full-time employees, you can flesh out your retirement fund with investment properties. Sign up for a Solo 401(k) and then opt for “checkbook control.” This allows you to bypass a plan custodian and serve as your own trustee. You can then use the plan to purchase property, which will be owned by your Solo 401(k).

This option comes with one major limitation: any rental income your properties earn must be deposited back into your 401(k). You must also tap into your 401(k) to cover all rental expenses and repairs.

This plan also allows you to finance property purchases via a non-recourse loan or mortgage, which treats only the home and not the plan as collateral. Solo 401(k) participants can borrow up to $50,000 or 50% of their account value.

1031 exchange

A 1031 exchange allows you to postpone taxes on gains from the sale of an investment property by reinvesting the equity from that property into a new property.

To set up a 1031 exchange, you’ll have to identify a replacement property within 45 days of the sale of your original property. This replacement house will have to be of equal or greater value than the original, and you’ll have to close on the purchase within 180 days.

The properties can’t be for personal use like a second home or primary residence. Here’s an extensive field guide to 1031 exchanges from the National Association of Realtors. And here’s a list of tax deductions for rental property owners.

Self-directed IRA

With a self-directed IRA, you can buy a property through a custodian while tapping the tax benefits of a traditional IRA. Participants can also apply for non-recourse loans.

Other ways of financing multiple rental properties

  1. Seller financing. In this case, you can buy a property from a seller directly. It’s great because not only is it less stressful, but you can also pocket some short-term savings on capital gains tax if the seller chooses to make a 1031 exchange.
  2. Home equity loans. You can use a home equity loan to offload accumulated equity on other rental properties.
  3. A joint venture (JV). With a joint venture, you can combine resources with other borrowers to make either a monthly payment or a down payment. Since it’s not only one borrower in a joint venture, there’s lower risk involved for a lender.

Additional considerations

While juggling multiple properties, keep an eye on expenses such as property taxes and damages. Otherwise, you have to look for loans to cover unanticipated expenses or reckon with sinking property values.

Consider forming a limited liability company (LLC), which can shield you from vulnerability to lawsuits. Going this route involves more paperwork, but it offers more protection and flexibility in splitting ownership of the property.

Going it alone? End-to-end services like HomeUnion can help you identify investment properties to buy. These services will vet properties based on your needs and risk tolerance. They’ll also streamline your purchase process and suggest good times for you to sell.

If enjoying steady cash flow sounds like a life you’re looking forward to then you can learn how to get started with SuperMoney’s Ultimate Guide to Real Estate Investment.