So you want to buy an investment property? Well, how do you finance said investment property? How do you go about getting a loan to buy that first investment property? While you're not playing with Monopoly money, it's similar to the boardgame in that it's all about collecting rent.
Because there are various types of mortgage loans for you to choose from, you might wonder which one is best for you. Take several factors into consideration before making the final decision on a mortgage to finance your investment property. Make a list, addressing the following criteria:
- the length of the loan
- how much flexibility you want
- how much money you are going to put down
- how much you can afford to pay now and in the future
- your overall plan, i.e. when you will be moving if you buy a duplex for instance
- when you would like to sell the property
- take a look at these examples of investment property deals to better understand the finances of buying an income generating property
- will you hire a property management company
- what are current interest rate levels for investors
- what is the your loan to value ratio?
- how to finance the purchase of a property
Reminder: If possible, one of the best things to do if you're just starting out as a real estate investor, is to purchase your property and live in it for one year and then rent it out - turn it in to an investment property. If you buy as an owner occupant, use the property as your personal residence, you can qualify for a better interest rate and not have to put down as much money for the down payment.
Through the Federal Housing Administration (FHA) or U.S. Department of Housing and Urban Development (HUD), you should be able to qualify for a lower interest rate and not have a large down payment to make. Yes, you will have to live in the house for one year though, there is no getting around this.
Try this mortgage calculator to help you with this decision too. And below are some tips and suggestions for how to finance your real estate investment:
Once you apply answers to the above issues, you’ll be able to find a loan that best fits your needs, capabilities, and overall plan. But before you go shopping for a mortgage, it’s a good idea to be familiar with the two major types.
- Fixed Rate – This is the loan that most people think of when they consider a mortgage. Here, you owe a percentage of the loan amount as interest to the lender. Like the name suggests, this amount remains the same for the life of loan, and your monthly payments will never change either. You can get either a 15 or 30 year fixed rate mortgage.
- 30-year - Because your monthly payments are spread across so many years, the amount you pay will be lower than they would be with shorter term loans. Also, you will be paying thousands more in interest, but luckily this interest is tax deductible.
- 15-year – This variation is becoming more common because people generally pay lower interest rates but at the cost of larger monthly payments. Generally, the interest rate is between one-quarter and one-half percent lower than a 30-year mortgage but in the long run amounts to significant savings.
- Adjustable Rate Mortgage (ARM) – Unlike fixed rate loans, the interest rates here fluctuate up and down. The first year rate (also called a teaser rate) is usually a couple of percentage points below the market rate. After that, there will be limits (called caps) that prevent the rates from exceeding a certain amount. For example, if your teaser rate is 5%, and you have a 5-point cap, then your interest rate cannot exceed 10%. A few more facts about ARMs you should know:
- The degree to which the interest rate rises each year is usually limited to 1 or 2 percentage points.
o Keep in mind that interest rates might skyrocket and cause your ARM to adjust to its maximum. Can you make these payments?
- Most ARMs come with caps that protect you from large payment increases. A lifetime cap limits how much your interests rate rises throughout the course of your loan. A periodic rate cap limits how much the rate can rise at one time. A payment cap limits the amount of payment over the loan’s lifetime.
TIP: Ask the mortgage lender if you can convert an ARM to a fixed rate mortgage if you know you're going to have trouble once the rate increases - don't wait. This will grant you more financial freedom. Also, make sure to ask that when you sell your home if the new owner can assume the loan’s payments.
Now that you’re comfortable with those two, let’s take a look at other types of mortgages.
- Balloon Payment Loans – These are short term, fixed-rate loans where you pay a smaller amount during the beginning of the term but then pay a larger lump sum towards the end. Hence the name, balloon. For example, if you have a 7-year loan, the loan will be amortized as if it were a 30-year loan. During this period, your payments are low, but towards the end of the loan period, you will owe the remaining principal in large sums. These are ideal if you want to stay in a home for a short period of time and then sell quickly. You can save thousands in interest and make low monthly payments. However, these loans aren’t for people who don’t know how long they’ll stay in the house.
- COFI (cost of funds index) – This is a type of ARM that adjusts each month and doesn’t have any caps. Essentially, it is the most adjustable ARM because it is never fixed at any given point. Its index is tied to the rate that banks pay their customers (i.e. depositors) to hold their money (e.g. checking accounts, savings, etc.). Also, you can change your monthly payments as you wish.
- Hybrid Loan – A hybrid loan is fixed for a certain number of years (such as 1, 3, 5, 7, or 10) and then converts into an ARM after this period is over. This affords you some stability for a while until your payments become reliant upon fluctuating interest rates.
- Two-Step Loan – Tries to give you the stability of a fixed loan and the lower rates of an ARM. These loans are usually seen as 5/25 or 7/23—and if you’ve noticed, the two numbers on either side of the slash add up to 30 (as in 30-year loan). This means your loan will be fixed for the first 5 or 7 years, and then becomes either an ARM or a fixed rate loan.
- Interest Only Loan – You pay only the interest on the mortgage for a certain amount of time, usually 5 or 7 years. Then, you transition to an ARM or make a balloon payment. The advantage to this is that you can save money for the first few years to pay for more pressing needs and then finish off the payments with larger sums. These are not recommended to regular wage workers or to people who don’t have a strategy to work with the saved money. If you rely on huge sums of money coming your way (e.g. commissions, bonuses, etc.), these are for you.
- Exotic Loan – These are non-traditional loans (i.e. they are not the long term, fixed rate loans discussed above) that allow you put down a very small down payment and still make low monthly payments. These are popular in high-cost markets where non-traditional loans make it possible to afford a home.
Once you secure a mortgage loan, you should regularly keep in close contact with the bank who is managing your loan. Have them contact you if there’s a way you can refinance the loan if the interest rate has dropped.
Additionally, contact other banks and brokers to see if there’s a way for you to make more money by refinancing. You can use this as leverage with the bank who is currently managing your loan because they'll want to keep you happy and on board with them. Learn more at About.com: Financial Planning.
TIP: Don’t let a pre-approved notice get you too excited. Often, these approvals don’t take into account your goals as an investor: future earnings, type of property you want, and other assets you own. It’s wise to use this approval as a starting point but not to make it your guide—it may actually narrow your choices.