Types of Rental Property Loans for Investors
Editor’s Note: This post was originally published in November 2021 and has been completely revamped and updated for accuracy and comprehensiveness.
It's exciting when a rental investment pops up on your radar. But finding the one — that property that's going to get you on the path to making money in real estate — is actually just a part of the first step to generating rental income.
There can't be a great rental property deal without reliable funding. That means that your attention should be on finding a reliable lender to help you make things happen for a property deal that's checking all the right boxes.
In fact, knowing how to assemble the right team consisting of realty experts, inspection experts, and an agile lender often separates those who dream of buying a rental property from those who actually do it.
However, it really does all start with finding a funding source. Let's get frank about funding your project.
Getting started with financing your investment property
If you've ever purchased a home as a primary residence, you might think you've already been to this rodeo. Obtaining a mortgage for a primary home is different than getting financing for rental investment property. Traditional banks and credit unions typically handle primary home mortgages.
Once you announce your intention to buy a rental home, you may receive a lot of advice from various people. Some of that advice may point solely to a traditional mortgage.
Friends and family may give well-meaning advice, but it may not work when it comes to investing. You may need to explore specific options to get a fast and flexible loan for a property. Let's look at these financing options so you can better decide what will work for you.
Traditional mortgages are issued by banks and other financial institutions. They're usually used to buy a home for one's primary residence. While also available to real estate investors who want to purchase rental properties, the requirements for these loans are often more stringent when used for real estate investing.
There's one more thing to know about traditional home loans. Your ability to get approved actually shrinks as you purchase more properties. That's because banks and mortgage companies actually apply stricter credit requirements each time you apply for a new loan.
Additionally, larger down payments and cash reserves are required by banks when several mortgages are in play. This can be a detracting factor for investors with empire-building aspirations wanting to fund multiple deals without their lender penalizing them.
In addition, you'll find that banks are often pretty wary about giving out loans for rental investment properties. That doesn't mean you can't obtain a loan for a rental property from a traditional bank or mortgage institution. It just means that the terms of any loan you get will be designed to protect the bank.
With a traditional mortgage, real estate investors are often faced with these challenges:
- Strict qualification requirements: Traditional mortgages typically require a high credit score, a steady income, and a low debt-to-income ratio.
- Slow funding process: Traditional mortgages can take weeks or even months to fund, making it difficult for real estate investors to move quickly on investment opportunities.
- Limited flexibility: Traditional mortgages often have strict guidelines for the types of properties that can be financed, as well as restrictions on how the loan proceeds can be used.
That's why savvy real estate investors often use non-QM lending options to fund their deals. Doing so allows them the flexibility, higher leverage and faster turnaround needed to scale their real estate investment portfolios.
A look at hard money lending
Real estate investors commonly use hard money loans to finance the purchase and renovation of properties. Unlike traditional loans that banks or other financial institutions issue, hard money loans are typically issued by private investors or companies and secured by the purchased property.
Why do they prefer hard money loans? Because they offer more flexibility and faster funding than traditional loans. With them, you can finance various real estate investment projects, like fix-and-flips or rentals.
Unlike traditional bank loans, the borrower's creditworthiness doesn't determine the ability to obtain hard money financing. Instead, hard money lenders use the property's value to determine whether to make the loan. Specifically, lenders focus on the "after repair value," or ARV, which estimates what the property will be worth once the renovation or development phase is complete.
The great benefit of working with a hard money lender (also called a private lender) is they often offer different loan options tailored to the needs of real estate investors. Whether your strategy is fix-and-flip, buy-and-hold or BRRRR, a hard money lender can help you find the best financing option for your business goals.
Remember that when considering a hard money loan, it's essential to carefully review the terms and conditions of the loan, including the interest rate, fees, repayment period, and any prepayment penalties. It's also essential to have a solid plan for the investment project and a realistic understanding of its potential risks and rewards.
Let's take a look at some common hard money financing options.
Fix and Flip / Bridge Loans
Real estate investors commonly use fix and flip loans, also referred to as bridge loans, rehab loans, or residential transition loans, to acquire a property, make improvements, and then sell it for a profit. This type of loan consists of two parts — the acquisition of the property and the funds needed to cover the renovations.
Fix and flip loans are bridge loans that usually include a purchase and a renovation or construction component. However, some bridge loans don't have the renovation component. For example, real estate investors may buy properties off the market at a lower price than their market value, then sell them to another investor who will do the repairs rather than doing them themselves. To purchase the off-market property, the investor would use a bridge loan.
Fix and flip / bridge loans are popular among real estate investors. These loans help them quickly act on investment opportunities, even when they don't have the funds to make the purchase. Rather than waiting to sell an existing property or for other financing, an investor can use a bridge loan. This loan can fund a new purchase or a renovation.
These short-term loans can be obtained quickly and without the strict qualification requirements of traditional mortgages. However, they typically come with higher interest rates and fees than traditional mortgages due to the increased risk to the lender.
Fix and flip loans are specifically designed for real estate investors and come with many advantages:
- Quick financing
- Flexible terms
- Interest-only payments (low monthly costs)
- Ability to protect your other assets by financing through an entity
- Underwritten based on the investment rather than personal income
As you can see, this loan option can be a beneficial tool by providing quick access to cash and allowing you to take advantage of new investment opportunities. They can also be used to make necessary repairs on existing properties.
DSCR rental loans
Typically offered by hard money or private money lenders, a DSCR rental loan works slightly differently from most other types of loans. It's specifically designed for real estate purposes, and a few unique factors make it a great option if you want to invest in property to diversify your portfolio.
For investors with less than stellar credit or limited income, DSCR loans are often a more attractive option than traditional loans because they are based on the property's cash flow rather than the borrower's financial history. The lower risk associated with these loans makes them a viable choice for investors who want to purchase or refinance a property and an attractive option for those looking to maximize their returns.
In addition, some lenders offer adjustable-rate DSCR loans. These loans have an initial fixed rate that can adjust periodically, usually every year.
When financing your rental investment property through a bank or conventional lender, prepare for stricter guidelines. The same financial history that would qualify as a "passing grade" for one will get you denied for the other. The big thing to remember is that banks consider you a higher risk if you're seeking financing for an investment property than they would if you were buying a home to live in with your family.
Hard money loans are a good fit for wealthy investors who need to get funding for an investment property quickly, without any of the red tape that goes along with bank financing.