How To Finance an Investment Property
You have saved money for investing. The question is how do you make your hard-earned money deliver the highest rate of return?
Do you sock it all away in a mutual fund or do you want to generate a higher return by investing in a rental property or some other type of real estate opportunity? If you want one of the highest rates of returns on your hard-earned money, going the investment property route is a solid option. However, you should know that most investors of properties, whether the properties are residential or commercial, have to do much more than dive into their saving accounts to finance the transaction.
You will probably have to gain approval for some type of investment property financing.
Overview of an Investment Property
There are numerous “How to invest in real estate” informercials online and on television where an astute realtor explains his or her property investment tips during a webinar. Real estate investing can be a lucrative full-time job or a financially rewarding strategy for making the money you save work for you.
Unless you just won the lottery, saved for investing like there was no tomorrow, or just became the beneficiary of a generous relative, you will need to borrow at least some money to finance the purchase of an investment property. Before we dive into how to get finance an investment property, let’s take a closer look at what defines such as property.
There are three broad categories for defining what constitutes a residential property:
- Primary residence
- Secondary residence
- Investment property
Yes, you can consider a first or second home as a type of investment property, since you want the liquidity built in both types of residences to grow into a financial windfall when it comes time to sell the property. However, unlike a first or second home, a true investment property is a home that you never call home. It is strictly a way to generate profit, which is the same goal you have for investing in stocks, bonds, and mutual funds.It is all about investing in a residential property that you want to earn long-term capital appreciation.
Steps Required for Mortgage Application Approval
Although different lenders consider different factors when analyzing the financial strength of a mortgage application, you can expect most lenders to refer to several similar factors. Because financing investment properties involves a much higher risk than other types of lending programs, financial institutions that finance mortgages for investment properties apply a strict standard of criteria to ensure full payment of a loan
It Starts with Your Credit Score
You can save a substantial amount of money for several years to bring in a hefty down payment on a mortgage to finance an investment property. Yet, the first factor most lenders look at when analyzing a mortgage application is the applicant’s credit score. Although lenders have different minimum credit score standards, one thing remains constant across the lending world.
You need to know your credit score, before you set foot inside of a lending institution.
Your FICO score determines your creditworthiness in the eyes of the professionals that are responsible for vetting your mortgage application. A federal law passed by the United States Congress allows you to request a free credit report from each of the three major credit reporting bureaus (Equifax, Experian, and TransUnion). Make sure you refer to your FICO credit score, as many free credit score services provide credit scores that differ from your FICO score.
Although this is not an introductory course that teaches you how to improve your credit score, you should be aware of how your FICO credit score is calculated.
35%-Credit payment history
30%-Total amount of debt
15%-Duration of your consumer credit history
10%-Diversity of credit
10%-Number of recently open credit accounts
What is the Ratio for Your Debt to Your Income?
Your debt to income ratio answers one important question: How capable are you financially to pay back a mortgage used to finance an investment property? The lower your personal debt is to how much you earn annually before taxes, the more likely a lender will look favorably on your mortgage application
Let’s say you have total debt amounting to $10,000 and your annual pre-tax income is $50,000. Your debt to income ration is 20%. A generous raise bumps your income before taxes to $60,000 and you are able to reduce your personal debt to $6,000. Now, your debt to income ration sits at 10%, which gives you a much stronger case for mortgage approval on an investment property.
There is not an optimal percentage for establishing a lending-friendly debt to income ratio. Nonetheless, you should work hard to maximize your pre-tax income and minimize your personal debt long before you complete a mortgage application.
Worth of Your Assets
Your mortgage application for an investment property will include a section that asks you to list your most significant assets, as well as associate a monetary value for each asset listed. Lenders want to know how much your assets are worth in case you need to liquidate some, if not all of the assets to cover the costs of financing an investment property.
Lenders have different requirements as to how much borrowers should have in reserve for asset liquidation, but you should expect to need at least six months of debt payments in the form of liquid reserves. You will list hard assets, such as the value of your car or how much your jewelry is worth. Softer assets like a retirement plan or a mutual fund used for generating profit can also become part of the equation used by lenders to determine the likelihood that you will pay back a mortgage.
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How Much Money Will You Need to Make a Down Payment?
Lenders want to know about your liquidity, from calculating the worth of your most prominent assets to determining how much personal debt might prevent you from keeping up with mortgage payments. The most important factor that determines whether you receive approval for a mortgage to finance an investment property is how much you can afford for a down payment.
The amount of a down payment does two things. First, it gives lenders a glimpse into your financial strength. Second, a down payment determines the amount of your loan, as well as the terms accompanying the mortgage.
How do you maximize your down payment for a mortgage financing an investment property? You can take small steps like saving money on meals or advance in financial leaps and bounds by dramatically increasing your income. You should know that standard mortgages require at least a down payment that is worth at least 20% of the loan. Some lenders bump up the minimum down payment to more than 30%.
A Quick Review of the Lending Process for an Investment Property
The lending process for financing an investment property follows the same financial path for most lending institutions. Before you do anything else, you should find the right lender to finance your loan.
Find the Right Mortgage Lender
Online banking has taken some of the personalization out of the borrower-lender relationship. For a mortgage loan financing an investment property, you want to have as much personal contact with a lender as possible. The financial stakes are much too high for you to complete the mortgage process mostly online. This means you will have to perform extensive research not only to read customer reviews, but also to compare interest rates and the terms typically set for investment property mortgages.
Pre-Approval Shortens the Mortgage Application Process
After you decide on the right mortgage lender, try to get pre-approved for a loan. The pre-approval process is a fairly quick process that determines whether you meet the lending guidelines established by the lending institution. Before you fall in love with an investment property, you have to know that you are financially capable of financing the property. Just remember that pre-approval for a mortgage is not a guarantee that you will be approved for a mortgage to finance an investment property. Pre-approval for a mortgage is similar to getting your foot into the door of an employer after completing a successful job interview.
Start Searching for an Investment Property
Now that you have been pre-approved for a mortgage loan, the next step in the process involves conducting the research required to find the right investment property. Resources to use include participating in virtual tours of different properties and meeting with real estate agents to discuss investment property options. One important rule of thumb: The likelihood of you gaining approval on a mortgage application increases if you can demonstrate a high rate of return on the investment property you want to buy. You are not looking for a first or second home; you are looking for the most profitable way to use you hard earned cash to generate revenue.
Getting the Mortgage Approved
Right after you make an offer on the right investment property, the time has come to initiate the second part of the mortgage approval process. Your lender will want all the information pertaining to the investment property, which comes in the form of the P&S agreement. An appraiser working for the lender will conduct a thorough review of the property to determine its fair market value. Your lender will want to know the condition of the investment property, as well as ensuring the financial institution does not grant approval for money than you actually need.
When all the information is gathered by your lender, the underwriting department for your mortgage loan will decide if you meet every requirement for mortgage approval as established by the lending institution. If approved, your lender will give you a Closing Disclosure statement that includes the date of the closing on the investment property.
Do you need a financial advisor to come with you to the closing table? If the terms of the mortgage are clear and the lender has not included any additional stipulations for the mortgage, then you should be able to consummate the closing of the loan on your own. Make sure to ask questions to clarify the terms of the loan and have the information you need to make a down payment to ensure closing the mortgage goes off without a hitch.
When it comes to financing your investment property, we'll leave you with a few tips. First, do not limit your lending options for large institutions. Second, make sure you have all the documents you need for every step of the mortgage approval process. Third, always remain responsive with the lender. Nothing irks a lender more than a customer who is slow to return emails, phone calls, and text messages.
Getting approved for an investment property is a major step in your journey towards financial freedom and with the right preparation, many people can do it. Make sure that your credit and income are in line to better your chance of getting approved for investment property financing.