Rental properties can be a great way to diversify your income and your long-term financial situation.
Understanding rental property loans and how to qualify will position you for success as you set out on your passive income journey.
No doubt you have expectations of what you want out of owning rental properties, and lenders also have expectations of you as a potential borrower. The post will summarize what to expect and how to prepare.
Here are the four main areas covered in this post:
- Getting your personal finances ready
- Planning for the purchase of the rental property
- Understanding the loan programs
- Additional resources
Let’s get started
Getting your personal finances ready
Being proactive and making yourself an attractive borrower can increase your credit score which could get you a lower interest rate, saving you a lot of money.
You should set a goal of having a credit score of at least 620 before you seek a loan for a rental property. If you’re currently below that number, here are some tips for increasing your score:
- Pay off your outstanding debt. Not only will this help to increase your credit score, it will also put you in a far better financial situation.
- Pay your bills on time. This sounds obvious, but make sure you’re in the habit of doing this and automate your payments as much as possible.
- Keep your credit utilization below 30%. If you have a total credit limit across all of your card of $10,000, and have a total balance of $5,000, your utilization is 50%. Bringing your balance to $3,000 or lower will bring your utilization to 30%.
Save up six month’s worth of potential mortgage payments in a cash emergency fund. You’ll estimate what the mortgage payment is going to be on the rental property you’re going to buy. Having six months worth of payments saved in a checking or savings account will not only give you a cushion, it will also improve your creditworthiness in the eyes of the lender.
Plan to make a down payment of 25%. Doing this will help you qualify for a conventional mortgage which will save you money, and it will reduce your overall loan.
Create an entity such as an LLC and set up bank accounts. From a legal perspective, it makes sense to keep a rental property separate from your personal assets. Having an LLC own the rental property is an effective way to go about this.
Planning for the purchase of the rental property
If you’ve ever obtained a residential mortgage, you’ll find this process to be similar.
Understand the total cost of the property. Too often, people underestimate the total cost of owning real estate. Here are the costs to be aware of:
- Mortgage payment. You’ll know what this will be as you go through the process. If you’d like to speak with someone, you can get in touch here.
- Homeowner’s insurance. If you’d like to speak with someone, you can get in touch here.
- Property tax. You’ll know what this will be and can find out what it is in your state.
- HOA fees. This will be an important factor in your home buying process.
- Utilities. You’ll be able to estimate what these will be when you’re looking at homes.
- Maintenance and repairs. Landscaping, cleaning, pool service, air conditioning, pest control; the list goes on. Basic and recurring services can be estimated. Major problems like an AC unit breaking, roof leak or electrical problem can be very expensive. These are some of the reasons an emergency fund is so important.
Do you intend to manage the property yourself? If not, will you hire a management company and what will the costs of that be?
Project rental income and total costs. This is a sound practice for your personal finance needs and the lender will also ask to see a pro forma of what the property you intend to purchase.
Have all of your documents ready. The lender will want to see documentation such as tax returns, W2s, account statements and other documentation of assets. Having these ready will streamline the loan process.
Understanding the loan programs
Lenders are interested in making loans to borrowers who they believe will pay them back. This may seem obvious, but I tell you that because they will ask you for a lot of information. It’s important to keep that in mind as you go through this process.
It’s common for lenders to ask for a 25% down payment. Because financing a rental property is riskier than a primary residence, some costs will be higher.
You should expect to pay a higher interest rate than you’re paying for your home loan. The reasoning here is the same as for the higher down payment.
Single-family, small multifamily, condos, and townhomes are the property types you can purchase with a conventional rental property loan.
The lender will probably ask you to have six months of cash reserves equivalent to the mortgage payment.
The lender will expect your debt to income ratio (DTI) to be less than 36%.
The lender will ask you for a pro forma income statement if the property is not currently rented. This should include gross rental income potential and an accounting of total potential costs.
You could also explore a home equity loan or cash-out refinance to purchase the rental property.
- A home equity loan is a second loan where you’re borrowing against your home’s equity.
- A cash-out refinance is a new first mortgage which is greater than the mortgage it is replacing.
A rental property can be a great way to diversify your portfolio and create passive income, but there are also many people who have negative experiences.
You’ve heard the saying “the devil’s in the details” and that certainly applies here. If you’re not careful with your planning, your margins will be eroded and your rental property won’t be as profitable as you’d like. Worse yet, you could lose money.
Following the steps we’ve talked about here can position you for success as you apply for a rental property loan.
Resources to help you on your journey
I’ve mentioned some of the no-cost resources which are available. Here they are again
- Goals Course
- Values Course
- Get Out of Debt Course
- Improve your Credit Course
- Buying your Next House course
- If you’re ready to take control of your financial life, check out our DIY Financial Plan course.
If you’d like more, you can access our Courses page.
If you’d like additional help with any part of this process, we have Certified Partners who can help you with your home purchase process.
- RPI for real estate coaching and education
- Tiller for help with budgeting
- Dovly can help clear up your credit
- Coaches to help you succeed in every aspect of your life
Here are some applicable episodes of LifeBlood podcast:
Good luck on your rental property loan journey!
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