Now could be a great time to become a landlord. Mortgage rates have been hovering near historic lows, and though recent economic uncertainty has a lot of potential homebuyers thinking twice about taking on a mortgage, rental income could be a great way to pad your finances against ongoing turbulence.
Before you commit to owning a rental property and adding another payment to your monthly expenses, find out what’s required to get financing.
Traditional Mortgage vs. Mortgage for Rental Property: What’s the Difference?
On the surface, a rental property mortgage is essentially the same as a primary residence mortgage. However, there are some important differences to understand.
“Although they follow a similar application process, it is a different process when you apply for an investment or rental property,” says Warner Quiroga, a real estate agent and investor and owner of Prestige Home Buyers in the Long Island, New York, area. “The risks are higher, and there are specific rules and requirements before getting approved by the lender.”
The increased risk comes from higher rates of default for loans on rental properties, since a borrower is more likely to focus on a primary home’s mortgage if experiencing financial difficulty. So getting a mortgage for a rental property or investment property tends to come with slightly higher interest rates.
Mike Tassone, co-founder of online mortgage marketplace Own Up, says his company aggregates daily interest rate data across more than 16,000 lenders and generally sees investment property rates at 0.375 to 0.5 of a percentage point higher than those on primary residences.
The underwriting standards also tend to be more strict. In general, Tassone says, mortgage lenders tend to focus on three primary factors when qualifying a borrower for a mortgage: the borrower’s credit score, down payment and debt-to-income ratio. That’s true whether the loan is for a primary home or an investment property. “However, qualifying for a rental property introduces a couple of nuances to these requirements,” Tassone says.
For instance, the minimum down payment to secure a mortgage for a rental property is often higher than for a primary residence. Borrowers may also be subject to stricter credit score and debt-to-income thresholds.
Your employment history and income are also more heavily scrutinized when you’re buying a rental property. “Some lenders may look for evidence of previous experience as a landlord,” Tassone says.
[Read: Best Mortgage Lenders.]How to Get a Mortgage for a Rental Property
Despite the potential financial upside, Quiroga stresses that becoming a landlord is no walk in the park. Financing a rental property might mean managing a second mortgage payment on top of your primary mortgage. Plus, rental income isn’t always consistent. Lenders know this and will require you to meet certain standards before approving you for a mortgage. Take a closer look at those qualifications.
— Credit score. In general, lenders require a minimum credit score of 620 when financing a rental property. However, in order to secure the best interest rates and terms, you should have a credit score of 740 or higher, which is considered to be in the “very good” range.
— Down payment. With a conventional mortgage for a primary residence, it’s possible to put down as little as 3%, depending on the specific lender and loan program. If your down payment is less than 20%, however, you will be required to pay private mortgage insurance, which protects the lender from some financial loss if you default on the loan. PMI doesn’t apply to mortgages on investment or rental properties, though. So you will likely be required to make a larger down payment of at least 15% to 20% in order to finance a rental property. Some properties, such as multiunit investment properties, require at least 25% down.
— DTI. Another major factor that lenders consider is your debt-to-income ratio. This measures the percentage of your monthly gross income that goes toward paying off debt. To qualify for a mortgage for rental property, your DTI should ideally fall between 36% and 45%. In many cases, borrowers can count 75% of their potential monthly rental income (as determined during the appraisal) as additional qualifying income to help reduce their DTI, Tassone says. He notes that lenders don’t consider 100% of rental income in order to account for potential vacancies. However, your lender may not consider future rental income if you don’t have a history as a landlord. If that’s the case, your ability to get a mortgage for a rental may rely on your personal income alone.
— Savings. In addition to showing that you have sufficient income compared with your debt obligations, you’ll also need to show that you have plenty of money in the bank to cover financial hiccups. It’s a good idea to have three to six months of reserves saved in a liquid bank account, including the full mortgage payment with principal, interest, taxes and insurance.
[Read: Best Mortgage Refinance Lenders.]Mortgage for Rental Property Options
Generally, the same financing options on a primary home are available on an investment property. That includes conventional fixed- or adjustable-rate mortgages with repayment terms from 10 to 30 years. However, Tassone says it’s important to note that government-sponsored programs such as Federal Housing Administration, Veterans Affairs and U.S. Department of Agriculture loans, which support low-income borrowers, veterans, active military and rural housing purchases, are not available on rental properties. The one exception is if you’re purchasing a multiunit property and plan to live in one of the units.
For example, you can secure an FHA loan for rental properties with up to four units. You’re required to live in one of the units for at least one year, after which you can move out and rent it, too. An FHA mortgage can also allow you to meet more relaxed borrower qualifications, such as a lower credit score and down payment.
Similarly, VA loans are also available for rental properties with up to four units, provided you live in one of them. These loans have no credit score or down payment requirements, though individual lenders may have their own eligibility requirements that must be met.
Quiroga says that there are some alternatives to traditional mortgage financing , as well. For example, you could use a home equity loan or line of credit to finance a rental property purchase, which usually allows you to borrow up to 80% of your current home’s value. You can also consider a private loan, which is offered by individual or group investors.
[Read: Best Home Equity Loans.]Are You Ready to Become a Landlord?
Before you sign on the dotted line, it’s important to carefully consider whether becoming a landlord is the right decision. It can be a financially rewarding experience, and owning a rental property can be a good way to generate income and long-term wealth.
“Investment property ownership is also highly tax-advantaged in the U.S., with the IRS allowing deductions for depreciation and expenses,” Tassone says. It’s also possible to defer taxes on the sale of investment property, as long as the proceeds are rolled into a “like-kind” investment (generally another property).
However, being a landlord can also introduce additional costs and headaches such as repairs, maintenance and difficult tenants, according to Tassone. If you don’t want to deal with these issues on your own, you can outsource them to a property management company for an additional cost, which may or may not be economical.
The coronavirus pandemic introduced additional stresses on landlords, who were unexpectedly subjected to a moratorium on evicting nonpaying tenants. “For some landlords, especially those who relied on rent as their primary source of income, the eviction moratorium forced them into either covering their operating costs out of pocket or considering more drastic alternatives, such as selling their properties,” Tassone says.
Of course, the pandemic’s impact on the rental market’s dynamics was unprecedented and unexpected. Still, any prospective landlord should study the tenant laws that apply to a rental property and be sure to understand a landlord’s rights and responsibilities before committing to a loan.
