Becoming a real estate investor is a smart way to generate a steady passive income stream. Nonetheless, it does take a certain amount of cash to get started in real estate investing. Real estate investing can be a hedge against market volatility when stocks take a tumble, and there are many other perks associated with owning an income property. When you don’t have a huge bankroll, taking out loans for investment properties may be the only way to seal the deal.
Loans for investment properties can take several forms. Choosing the wrong type of loan can impact the success of your real estate investment, so it’s crucial that a real estate investor understands how the various alternatives work before approaching a lender.
In this article, we break down the 6 most common types of loans for investment properties to help you, the real estate investor, determine which option works best for your investment.
Conventional Mortgage Loans for Investment Properties
In real estate investing, taking a conventional mortgage loan is the most common investment property financing option among property investors. If you already own a home that is your primary residence, then you’re probably familiar with conventional mortgage loans. A conventional mortgage is simply a loan that private entities like banks or mortgage brokers offer for real estate investment purposes. It conforms to guidelines set by Fannie Mae or Freddie Mac and it’s not backed by the federal government.
The process of obtaining conventional mortgage loans for investment properties varies from one state to another, but there are some standard requirements for the real estate investor to qualify. For example, property investors should expect lenders to require 20% of the income property’s purchase price as down payment. This large down payment means property investors are less likely to default and tend to have a more secure financial standing.
Furthermore, your personal credit score and credit history will determine your approval for conventional mortgage loans for investment properties and what kind of interest rate applies to the mortgage. 620 is typically the minimum credit score to obtain a conventional mortgage loan, and 740 is the minimum score for a good interest rate. Another obligation is that property investors must be able to afford their existing mortgage (if they have one) and the monthly loan payments on the income property. Therefore, most lenders of conventional mortgage loans for investment properties expect the real estate investor to have at least six months of cash set aside to cover these payments.
As we said, these requirements differ from state to state. So, make sure to check other requirements for obtaining conventional mortgage loans for investment properties in your local real estate market.
Hard Money Loans for Investment Properties
You can obtain hard money loans from professional individuals or companies that lend money specifically for real estate investing purposes. The best thing about these types of loans for investment properties is that they are faster to secure than conventional mortgage loans. Moreover, hard money lenders don’t look at the real estate investor’s credit score – instead, they evaluate the value of the income property you’re planning on buying to decide whether or not to grant you the loan.
Although this is one of the common types of loans for investment properties in real estate, it does come with a list of formalities, documentation, and guarantees. Another thing to keep in mind before approaching hard money lenders is that these are short-term (up to only 36 months!) and they come with higher interest rates (up to 10% higher than conventional mortgages).
As a result, these loans for investment properties are not suitable for any type of income property. Hard money loans are a good financing option for property investors who aim to buy cheap investment properties, renovate them, and quickly sell them for a profit and pay off the loan in due time (the fix-and-flip strategy). On the other hand, you won’t possibly be able to pay off a hard money loan on a long-term residential investment property in only 3 years.
Savvy property investors evaluate the profitability and after repair value (ARV) of the targeted income property before considering these types of loans for investment properties to ensure they don’t end up in a financial bind.
Private Money Loans for Investment Properties
Private money lenders are not professionals like hard money lenders. Instead, they are individuals who have extra money and want a good return on investment for their money. Private money lenders can be within your personal network (family, friends, neighbors, co-workers, etc.) or even other property investors and people you’ve met through your real estate investing career.
These loans for investment properties are great for property investors who were turned down by banks. They come with fewer formalities thanks to the close relationship between the real estate investor and the lender. Moreover, they don’t involve strict conditions, interest rates are typically lower, and the length of the loan is flexible and negotiable.
Before approaching private money lenders, a real estate investor should keep in mind that these loans for investment properties are secured by a promissory note or the existing mortgage on the income property. Thus, if property investors don’t pay off the loan in due time, private money lenders can foreclose the investment property.
Fix-and-Flip Loans for Investment Properties
While investing in long-term investment properties has its perks, it also comes with certain headaches. Thus, some property investors find flipping a more attractive alternative because it allows them to receive profits in a lump sum after selling the investment property rather than collecting rent checks each month. If this is your preferred investment strategy, a fix-and-flip loan is a more appropriate financing option.
These loans for investment properties are short-term loans that allow a real estate investor to renovate the investment property and put it back on the market as quickly as possible. Basically, fix-and-flip loans are hard money loans – thus, they’re secured by the investment property. Hard money lenders specialize in these types of loans for investment properties, but certain real estate crowdfunding platforms offer them as well.
Just like hard money loans, the upside of this financing option is that they’re easier to qualify for and obtain compared to conventional mortgage loans. While lenders still consider things like credit score and income, the primary focus is on the income property’s profitability. Thus, the ARV also determines if property investors can apply for fix-and-flip loans for investment properties.
On the other hand, the downside of using fix-and-flip loans is that it won’t come cheap. Depending on the lender, interest rates for these kinds of loans for investment properties can go as high as 18% and your timeframe for paying it back may be short – it’s not uncommon to have terms lasting less than a year! Closing costs may also be higher compared to the conventional financing option.
Home Equity Loans for Investment Properties
Drawing on your home equity is a great financing option for a long-term income property or a flip. Home equity loans for investment properties are a type of debt that allows homeowners to borrow against the equity of their home to use towards buying a second home or an income property. The loan is based on the difference between the homeowner’s equity and the property’s current market value. In most cases, it’s possible for a real estate investor to borrow up to 80% of the home’s equity value!
Using home equity loans for investment properties has its pros and cons, depending on the type of loan you choose. The lender will run a credit check and appraisal on your home to determine your creditworthiness. This financing option provides an easy source of cash and obtaining the loan is quite simple. Moreover, interest paid on home equity loans is tax deductible.
Home equity loans for investment properties are essentially a second mortgage, but they have higher interest rates than the first mortgage. As with any mortgage, if the real estate investor doesn’t pay off the loan, the lender gets to repossess the investment property and sell it to satisfy the remaining debt. Plus, if property investors default, lenders get to keep all the money earned on the initial mortgage and the home-equity loan.
Thus, home equity loans for investment properties are a good choice for responsible property investors. If you know exactly how much you need to borrow and have a steady, reliable source of income to repay the loan, this financing option is a sensible alternative.
Commercial Investment Property Loans
If you’re into commercial real estate investing, then the above-mentioned types of loans for investment properties are not suitable for you as they are residential investment property loans. You need another financing option – a commercial investment property loan!
The main difference is that to obtain these loans for investment properties, property investors need to have a solid business plan coupled with a good credit score. Lenders are concerned with the benefits and necessary work needed to improve the investment property in order to see cash flow.
There are different types of commercial investment property loans, each with specific terms and qualifications that make them suitable for certain types of commercial properties. For example, commercial hard money loans are short-term loans to purchase and renovate an owner-occupied commercial property. When going for these types of loans for investment properties, a commercial real estate investor should expect to cover a down payment of around 15% – 35% of the purchase price. This financing option typically lasts for 1 – 3 years with 8% – 13% interest rates.
Finding the money to enjoy the perks of real estate investing doesn’t have to be an obstacle if you know where to look. As you’re comparing the different loans for investment properties, keep in mind that the best option depends on your personal financial standing, the type of income property you want to buy, and your goals as a real estate investor.