For a real estate investment to be successful, you will need to start by finding an adequate source of financing. While some people (about 1 in 7) might simply use cash to pay for an investment property, most will choose to apply for a loan from an outside lender.
However, as you’d probably expect, there are many different lenders available for you to choose from. The lender that’s right for you will depend on your specific circumstances, which is why it is important to take some time to clarify your ongoing financing needs.
Whether it is your first time applying for a loan as a real estate investor or you’ve made an investment before, be sure to keep the following things in mind:
1. Your Goals as an Investor
Before making any major investment, it will be critical to define your underlying investment goals. These goals, ultimately, will impact the type of financing that is right for you, as well as the type of financing partner you want to work with.
When identifying these goals, you’ll want to think about more than just your target ROI. You’ll also need to consider your target investment timeline, the type(s) of property you hope to invest in, and any laws that apply in your target market.
2. Your Personal Financial Strengths
Identifying your personal financial strengths (and potential weaknesses) will also make this market significantly easier to navigate. For example, if you hope to refinance in the future or create a more complex financing package, you might need to be willing to explore additional options. The current state of your already existing portfolio—and even your credit score—could also affect which investment strategies will make the most sense for you.
3. The Type of Underwriting Process that Will Be Used
When investing in a rental property, there are two primary types of underwriting that might be used: debt-to-income-ratio (DTI) and debt-service-coverage-ratio (DSCR).
With DTI financing, underwriters will look at your current personal or household (if jointly) income in order to determine the amount they are willing to lend you. Ideally, your DTI ratio will need to be 45% or less.
With DSCR underwriting, on the other hand, the underwriters will look at how much income the investment will generate in the future and will not underwrite based on how you earn your personal income. All they require is that the property can generate more income than the property’s expenses, such as taxes, insurance, HOA fees, or property management fees. Nothing more and nothing less.
With some exceptions, DTI financing is more common for primary resident investments and DSCR is more common for commercial investments.
4. The Type of Loan You Want
There are four primary types of real estate loans you might consider using. These include:
- Conventional Lenders or Loans: though these have the lowest interest rates, they are also the most “personal.” In addition to requiring more documentation, such as pay stubs, tax returns, bank statements, and verifying any large deposits. The mortgage will also appear on your personal credit report and will therefore influence your DTI (along with your ability to invest in additional properties.) Conventional loans which are backed by federally chartered agencies such as Fannie Mae, Freddie Mac, and Ginnie Mae, all have limitations to how many investment property loans any one individual can have, which is 4 properties.
- Non-QM lenders or Loans: these loans don’t conform to traditional mortgage standards, which is why they are not as popular as the alternative. However, they do have more flexibility in their guidelines and DTI ratios than a conventional loan lender so this might be an option worth considering if you are unable to secure a conventional mortgage. However, Non-QM Lenders usually have their own limits (4-5) on how many investment loans they will lend to any given individual borrower and they generally do not lend to LLC’s or other entities.
- Private Money Lenders or Loans: though the rates are slightly higher than Conventional lenders or Non-QM lenders, Private Money lenders focus solely on the commercial aspect of the investment—these lenders use the DSCR underwriting model, meaning the mortgage will not appear or affect your personal credit if you elect to secure the loan under an LLC or other corporate entity. With this combination of DSCR underwriting, applying for the loan under a corporation, and No personal DTI concerns, you can literally purchase or refinance as many properties as you want at any given moment in time which makes this ideal for any real estate investor that wants to grow fast.
- Hard Money Lenders or Loans: structurally, these loans are extremely similar to private loans. However, while the leverage required or LTV will be lower, generally 65% or less, your interest rates and fees will likely be much higher but they will consider the really difficult situations because they know all the other lenders, except perhaps a large Private Lender would even consider.
Clearly, there is a lot you’ll want to think about when applying to finance an investment property. Each lender and loan category will have its fair share of pros and cons that come with it—this is why it is so important to closely examine your finances before making a final commitment.