The housing market crash has become a distant memory, and home prices are looking healthy again. And a stronger economy has helped bring out new investors who are looking to make real estate a part of their investment portfolio.
While selecting a great investment property is difficult enough on its own, once you’ve found that perfect house or apartment, how do you go about financing it? A little creativity and preparation can bring financing within reach for many real estate investors.
Here are five tips to finance investment property:
- Make a sizable down payment
- Be a “strong borrower”
- Turn to a local bank
- Ask for owner financing
- Think creatively
If you’re ready to borrow for a residential investment property, these tips can help improve your chances of success.
1. Make a sizable down payment
Since mortgage insurance won’t cover investment properties, you’ll generally need to put at least 20 percent down to secure traditional financing from a lender. If you can put down 25 percent, you may qualify for an even better interest rate, according to mortgage broker Todd Huettner, president of Huettner Capital in Denver.
A larger down payment gives you “more skin in the game” and therefore more to lose if the investment doesn’t work out. That can be a powerful incentive, and a larger down payment also provides the bank greater security against losing its investment. If the investment goes poorly, you’ll lose your whole stake before the bank begins to lose any money in the property.
If you don’t have the down payment money, you can try to get a second mortgage on the property, but it’s likely to be an uphill struggle.
[READ: How much house can you afford?]
2. Be a “strong borrower”
Although many factors — among them the loan-to-value ratio and the policies of the lender you’re dealing with — can influence the terms of a loan on an investment property, you’ll want to check your credit score before attempting a deal.
“Below [a score of] 740, it can start to cost you additional money for the same interest rate,” Huettner says. “Below 740, you will have to pay a fee to have the interest rate stay the same. That can range from one-quarter of a point to 2 points to keep the same rate.”
A point is equal to one percent of the mortgage loan. So a point on a $100,000 loan would equal $1,000. (Here’s when it’s worthwhile to buy points.)
The alternative to paying points if your score is below 740 is to accept a higher interest rate.
In addition, having reserves in the bank to pay all your expenses — personal and investment-related — for at least six months has become part of the lending equation.
“If you have multiple rental properties, (lenders) now want reserves for each property,” Huettner says. “That way, if you have vacancies, you’re not dead.”
3. Turn to a local bank or broker
If your down payment isn’t quite as big as it should be or if you have other extenuating circumstances, consider going to a neighborhood bank for financing rather than a large national financial institution.
“They’re going to have a little more flexibility,” Huettner says. They also may know the local market better and have more interest in investing locally.
Mortgage brokers are another good option because they have access to a wide range of loan products — but do some research before settling on one.
“What is their background?” Huettner asks. “Do they have a college degree? Do they belong to any professional organizations? You have to do a little bit of due diligence.”
4. Ask for owner financing
In the days when almost anyone could qualify for a bank loan, a request for owner financing used to make sellers suspicious of potential buyers. But now it’s more acceptable because credit has tightened and standards for borrowers have increased.
However, you should have a game plan if you decide to go this route.
“You have to say, ‘I would like to do owner financing with this amount of money and these terms,’” Huettner says. “You have to sell the seller on owner financing, and on you.”
This game plan shows the seller that you’re serious about the transaction and that you’re ready to make a real deal based on the practical assumptions that you’ve presented.
5. Think creatively
If you’re looking at a good property with a high chance of profit, consider securing a down payment or renovation money through a home equity line of credit, from credit cards or even via some life insurance policies, says Ben Spofford, an Ohio home remodeler and former real estate investor.
Financing for the actual purchase of the property might be possible through private, personal loans from peer-to-peer lending sites like Prosper and LendingClub, which connect investors with individual lenders.
Just be aware that you may be met with some skepticism, especially if you don’t have a long history of successful real estate investments. Some peer-to-peer groups also require that your credit history meet certain criteria.
“When you’re borrowing from a person as opposed to an entity, that person is generally going to be more conservative and more protective of giving their money to a stranger,” Spofford says.
Use real estate to create retirement income
Real estate is a popular way for individuals to generate retirement income. In fact, it’s now Americans’ favorite long-term investment, according to a recent Bankrate study. Real estate’s popularity is at its highest level since Bankrate began conducting the study seven years ago.
That popularity partially relies on real estate producing a steady stream of income, as investors collect a regular monthly rent from their tenants. For retirees, a steady income is exactly the kind of security that they’re looking for when not fully employed.
And retirees have upside on that income. Over time a well-managed property can increase its rents, putting more money into investors’ pockets each month. The property can also increase in value, so when it comes time to sell or even invest in another property, there’s equity that can be tapped. Of course, investment property has other advantages, especially around taxes.
If you don’t want to get into managing property directly, you can buy it via real estate investment trusts (REITs) in the stock market and let a professional manager deal with all the problems. REITs are tremendously popular with retirees because of their steady dividends.
[READ: 5 ways to invest in REITs]
Real estate is usually a long-term game where the gains tend to come over time. But however you invest in real estate, you can make money if you follow smart principles of investing. When financing property, make sure you can afford the payments when you take out the loan. Then as you pay down the loan over time, consider how you might be able to reduce the interest expenses still further based on your solid borrowing history and lower outstanding loan balance.
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— Jennifer Acosta Scott wrote the original version of this story.