Putting A Down Payment On Investment Property: What To Know
An investment property can be a steppingstone to a brighter financial future. But before you can close, most lenders will require a relatively hefty down payment on an investment property. It’s essential to do your research on funding opportunities ahead of time to create a smooth purchase process when buying an investment property.
What Is The Minimum Down Payment For An Investment Property?
When it comes to purchasing an investment property, most lenders will require a larger down payment than you would need for a primary residence purchase.
Since this property isn’t your primary residence, the likelihood that you will default on the loan is higher. One way lenders tend to compensate for this higher risk factor is by expecting a larger down payment.
But the size of the down payment varies widely based on the type of loan you pursue. Below are some of the minimum down payment requirements for popular loan types.
Keep in mind that the government-backed loan programs included above are designed for borrowers seeking a primary residence. The loophole is that through an FHA loan or VA loan, you can purchase a property with up to four units. As long as you live in one of the units, you can rent out the other units to generate rental income.
Some borrowers can qualify for an FHA loan to procure a secondary residence. However, the secondary residence is often only possible if your household is facing housing hardship. In general, a conventional loan is preferred for an investment property because it may have less stringent residency requirements.
Getting Approved For An Investment Property Loan
If you’ve applied for a mortgage for your primary residence in the past, then you likely understand that the approval process comes with plenty of paperwork. As a borrower for any home-related loan, you’ll need to meet strict criteria determined by the lender.
But when it comes to getting approved for an investment property loan, the criteria for approval is usually stricter. Every lender sets unique eligibility requirements. But, in general, lenders will likely expect potential investment property owners to meet the following requirements:
- 15% down payment minimum: Most lenders expect a down payment of at least 15% on an investment property loan. But the exact down payment requirement will vary based on the risk tied to the loan, your experience in the industry, your income, and other financial factors.
- 680+ credit score: A higher credit score can improve the chances of getting a lower down payment and better rates on an investment property loan. But even a high credit score doesn’t guarantee approval on your investment property loan.
- 50% (or less) debt-to-income (DTI) ratio: Your debt-to-income (DTI) ratio measures how your debt stacks up against your income. For example, if you have a monthly income of $10,000 and minimum debt payments totaling $3,000 per month, your DTI would be 30%. Most lenders prefer to work with borrowers who have a relatively low DTI.
- 6 months (or more) in reserves: Cash reserves are a critical element for investors. When you own an investment property, unexpected repairs and vacancies can bleed your bank account. Lenders want to work with an investor who is prepared to cover the property’s expenses for at least 6 months. These cash reserves tend to lower the risk of foreclosure.
- Current home loans: In general, you can only hold mortgages for up to 10 investment properties through a conventional mortgage. If you already have 10 conventional mortgages, you might need to obtain a different kind of funding.
Gathering Funds To Finance An Investment Property Down Payment
The thought of coming up with a large down payment might be a damper on your investment property dreams. Many of us would struggle to quickly save enough to cover the down payment on investment property. The good news is that investors can pursue other ways of getting their hands on the cash.
Below are some strategies for investors looking to make a big down payment on an investment property purchase.
A HELOC, or home equity line of credit, is a type of revolving credit that allows you to borrow against your home equity. It’s essentially a type of second mortgage. Once you have access to the HELOC, you can pull out funds on an as-needed basis. You can use the funds from a HELOC to pay for anything, including the down payment on your investment property.
A HELOC presents a viable solution. But this adds a second mortgage payment to your budget. If you aren’t able to keep up with your HELOC payments, the lender could foreclose on your primary residence. With that, a HELOC comes with a certain level of risk.
Private lenders are able to provide loan opportunities to real estate investors. In general, private lenders secure the debt through the property as collateral. Private lenders tend to offer more flexible funding solutions for investment properties than other types of lenders. Many are even willing to offer down payment loans.
One way to find private lenders in your area is to join a local real estate group. The connections you make in this group can help you find property leads and financing possibilities.
It’s possible to hold real estate in a self-directed IRA. If you’ve been building a nest egg in a self-directed IRA, you might be able to transform that cash into a down payment for this investment property purchase.
A self-directed IRA requires more paperwork than most real estate deals. And the paperwork requirements will carry forward into the future, as the IRS requires all expenses for the property to be paid out of the IRA.
Purchasing a property as a group offers a way to pool your funds among family and friends. If you have a large network of friends and family willing to invest in a property with you, then group investing might be a viable option.
The downside of this approach is that mixing money and friendship can become a disaster. That’s especially true if the deal doesn’t go exactly according to plan. Weigh the potential cost on your relationships before moving forward.
A bridge loan is a short-term financing solution that can help you come up with the funds you need for a down payment. It’s a relatively common way for real estate investors to obtain the property.
Once the deal is done, an investor can seek a more favorable loan for the long term. For someone looking for a primary residence, this long-term loan is usually a new mortgage after they are able to sell their first property. But as an investor, the secondary loan might be a conventional loan for an investment property.
Seller financing, sometimes called owner financing, presents an opportunity for buyers with limited upfront cash. The owner of the property essentially decides to act as the lender in this type of agreement. A real estate investor can negotiate the terms of the loan agreement with the seller.
In many cases, this type of financing agreement might look like a regular mortgage. For example, you might agree to monthly payments stretching out for a 30-year term. But the seller might be able to give you a break on the down payment requirements.
House hacking is a strategy that involves living in a property with multiple units or extra space. After you obtain the property, you can rent out this extra space to turn a profit. Depending on the situation, you could more than cover the mortgage payment.
The real beauty of house hacking is that you can obtain the property through a mortgage designed for a primary residence. In most cases, this means you can put down significantly less than 20%. For example, you may be able to purchase a property with just 3% down.
Although house hacking involves living near your tenants, it could be the way to get your foot into the world of real estate investing.
Can I Avoid Paying 20% Down On My Investment Property?
There are strategies available to reduce the down payment amount when financing an investment property. A 20% down payment can be avoided by considering alternative financing options like group investing.
But most investors will need to find a way to put down at least 20% on their investment property purchase. If your credit score is 680 or higher, you may be able to put down a minimum of 15%.
Considerations Before Buying An Investment Property
A down payment isn’t the only thing to consider when purchasing an investment property. As you consider this significant purchase, make sure to take every factor into account. Some of the factors you should consider include the following:
- Property taxes and income taxes: Obtaining an investment property will increase the complexity of your tax situation. Not only will you have to face property taxes, but generating a profit from your investment property often leads to more income taxes. It is highly recommended that you work with a finance professional to help you navigate your new tax situation.
- Mortgage rates: If you are taking out a loan to purchase an investment property, mortgage rates will likely have an impact on what you can afford. Monitor interest rates throughout your investment property search. As rates change, you may need to adjust your search accordingly.
- Closing costs: When finalizing the purchase of a property with a mortgage, you will have to deal with closing costs. In general, these costs range from 3% to 6% of the home’s purchase price. Be aware of these costs as you navigate the purchase process.
- Housing market trends: The housing market undergoes change on a regular basis. These changes can have an impact on your strategy as a real estate investor. Keeping a close eye on local trends can give you an edge as you search for a good deal.
- Potential return on investment (ROI): ROI measures how much of a profit your investment is making. Before you close on the deal, it’s important to understand the potential ROI. Calculate this number by subtracting the cost of investment from the gain on investment, then divide this number by the cost of investment, and finally, multiply it by 100.
- Local restrictions: Many local governments impose restrictions on investment property usage. For example, many cities do not allow landlords to operate short-term rentals. It’s critical to be aware of any of these limitations before buying the property. While your real estate agent can help you find out about these restrictions, it’s usually a good idea to track down this information from your city yourself to avoid any miscommunications.
- Hiring a property manager: A property manager can take some of the hassle out of managing your rental property. The downside is that a property manager will take a cut of the profits. As an investor, you must weigh the pros and cons of your unique situation.
- Insurance costs: The cost of insuring an investment property may be higher than the insurance costs attached to your primary residence. Before you move forward with a property, explore your insurance options. Comparing quotes from multiple insurance companies can help you lock in the best deal.
- Tracking income and expenses: Managing a rental property involves keeping careful track of your income and expenses. Without a clear understanding of these numbers, it’s difficult to handle tax time and generate a profit. Consider using a software platform to streamline this process.
The Bottom Line
Real estate investors usually need to put down at least 15% to obtain a property. But some financing options, like seller financing and house hacking, offer a way to tap into lower down payment requirements.
As you explore your options for obtaining an investment property, make sure to run the numbers carefully and talk to a financial advisor. If you’re ready to jump into the financing process for your investment property, start the mortgage application process.