She was a three-unit, small apartment in a great location, with stable tenants and an ugly paint job. Years ago, this triplex, which I call “Cherry Street,” was close to becoming the newest addition to my growing rental portfolio. But with Cherry Street, I was about to do something I had never done before: start looking at investment property loans.
You see, before Cherry Street, I had only used conventional home mortgages, seller financing, and hard money lenders to invest in real estate. However, Cherry Street was purely a cash flow beast that I was hoping to buy, re-paint (please!), and hold on to for retirement.
However, as I began shopping around for a mortgage, I quickly realized that the process was not going to be the exact same as it had been in the past. What I soon learned was that investment property loans are slightly different than your typical home mortgage in several ways (but similar in several ways, as well). The information below contains a lot of the things I discovered in my quest for the best investment property loan and enabled me to get a great loan, with a great rate, from a great lender. It is my hope that this article does the same for you.
We’re going to look at exactly what investment property loans are, the difference between an investment loan and a typical mortgage, tips for qualifying for an investment loan, and where to find the best loan for your real estate investment.
What Are Investment Property Loans?
As most readers on BiggerPockets already know, investment properties are vehicles that allow you to enjoy the potential for market appreciation while building equity each month. In addition, the monthly cash flow from a real estate investment can provide extra income to your wallet, help you pay down debt faster, or allow you to quit your job and begin living life on your own terms.
However, unless you have all the cash needed for your investment property, a loan is going to be necessary. Investment property loans can be used for either purchasing an investment property or refinancing an existing investment. Whether you are purchasing or refinancing a single or multifamily home, condo, or shopping mall, getting the best loan is essential to your bottom line. Investment property loans can also be used for real estate development, such as new construction, spec building, or raw land development.
The rate and term that you achieve is going to directly affect your monthly payment, which will affect your monthly cash flow—the lifeblood of any real estate investor. We’ll look deeper at both “rate” and “term” in a little while, but first let’s look at the major differences between investment property loans and regular home mortgages.
There are typically two types of investment property loans:
Because lending institutions will typically have two completely different departments to deal with these different kind of investment property loans, as well as significantly different qualifying standards, it’s important to know the difference before you go searching for a loan. Let’s look at both those types of investment property loans in greater detail.
Residential Investment Property Loans
Residential loans are designed for properties that provide housing for individuals or families and contain four units or less on the property. These loans more closely follow a typical home mortgage, with similar qualifying standards and processes. These standards include:
- Debt to Income: Your debt to income ratio is a number used by lenders to determine your ability to pay a certain debt based on how much income you make, typically in a given month. If you have $2,000 per month in monthly debts on your credit report, but have an income of $6,000 per month, your debt to income would be 33.33 percent. Debt to income can get a little more complicated than that, as well, so for much more thorough information, please see “What Is Debt to Income?“
- Credit Score: Your credit score is a numerical number applied by three different “credit reporting agencies” and is designed to tell inquirers how you handle credit. On a scale from 300 to 850, you will typically need to have a minimum of 700 to obtain an investment property loan.
- Loan to Value: The loan to value is another ratio, used by lenders to discover their risk on the property based on how much equity they have in the property if they had to foreclose. The loan to value, as the name suggests, is determined by comparing the total loan amount to the total fair market value of the property. In the height of the last real estate bubble, many lenders were allowing a borrower to take a loan up to 125 percent of the value, but today, 70 to 80 percent is much more likely on investment properties.
- Landlord Experience: While previous landlord experience is not a requirement to obtain an investment property loan, it can affect your ability to qualify for a loan. You see, as you attempt to obtain multiple loans for investment properties, your debt to income ratio climbs very quickly, even though that debt is being paid by a tenant. To help increase your income, a bank can add your rental income to your regular monthly income but usually will only do so after you have been a property investor for more than two years (though this requirement can differ greatly between lenders). Also, keep in mind that even with landlord experience, a lender will typically only apply 70 to 80 percent of that rental amount toward your income to protect themselves against losses.
Typically, residential investment loans will extend for up to 30 years and the rates are generally some of the lowest you can find—usually between 0.5 percent and 1 percent higher than you’ll obtain for a home mortgage.
Commercial Investment Property Loans
Commercial investment property loans are designed for properties with five units or more, as well as other non-residential investment properties.
These loans can be used to buy or refinance anything from a shopping mall, apartment building (with five or more units), an office complex, and any other kind of commercial investment. You will likely find higher rates than you’d get with a residential loan, as well as shorter lengths of time before the loan is due, with balloon payments required after five or seven years.
Commercial loans differ from residential loans in several key ways. Although borrowers are scrutinized by the same standards as residential loans, it’s from a slightly different angle. Let me explain:
- Debt to Income: Obviously, debt and income are still important for a lender to look at, as they show the lender what kind of person you are. However, when dealing with multi-million dollar loan amounts, a person’s personal income becomes much less important. Why? Because frankly, if things went south, a borrower’s job income is not going to be able to cover the payment, regardless. This is why commercial lenders look at commercial property with a different lens. Their decision is based heavily on two things:
1. The ability for the property to provide cash flow
2. The investors experience and ability to manage the business
These two characteristics of the deal are much more important in decision-making for the lender than the official “debt to income.” This is why it is so important to obtain the best deal possible when looking for investment property. It is why I advocate “buying smart” when shopping for a real estate investment. When you are searching for a commercial loan, it’s also important that you portray yourself as the business owner that you are—not some hobbyist. Have a business plan prepared, know the answers to the questions they will ask, and know the deal inside and out. Consider a property investment loan request the same as a job interview—and come prepared.
- Credit Score: Credit score is still highly important for commercial lenders, because it conveys your ability to handle money and credit well. Although the rates differ, a commercial lender is typically going to want to see at least 720 for a credit score.
- Loan to Value: Loan to value (LTV) is much more significant in commercial real estate lending than residential. As mentioned earlier, a commercial lender wants to be sure they are not over-leveraged and they have significant equity in the deal. Typically, a commercial lender will want a minimum of 70 percent LTV on a deal so they have 30 percent equity in case they need to foreclose and re-sell the property.
- Debt Service Coverage Ratio: Exclusive to commercial investing, the debt service coverage ratio, or DSCR, is a ratio used by a lender to look at the property’s ability to generate cash flow. Essentially, the DSCR compares the total income that comes in (not including the mortgage payment) with the payment on all debts.
DSCR = (Net Operating Income) / (Debt Service)
For example, if a property’s net operating income (the total income left to pay the mortgage) is $10,000 per year and the total debt payment is $10,000 per year, the DSCR would be “1.” Typically, a commercial lender wants to see a DSCR of at least 1.2, meaning that after all the expenses are paid, there is at least 20 percent cash flow profit on top. Keep in mind, this is a very basic explanation of the debt service coverage ratio, so be sure to read this article on Wikipedia for a much more thorough explanation.
- Landlord Experience: As mentioned earlier, a commercial lender is lending more on the strength of your ability to manage than your personal ability to pay the loan. As such, experience is a highly important factor when a lender is considering your loan application. Experience as a landlord is not always a requirement, but it definitely helps your case for being a good bet in the eyes of the lender.
Hard Money Loans/Private Lenders
An ultimate guide to investment property loans just wouldn’t be complete without a conversation about hard money lenders or their cousin, private money loans. So, let me briefly talk about the difference between the two:
Hard money loans are short-term loans obtained from professional private lenders, who lend based on the equity in the deal more than the strength of the borrower. Typically, hard money loans are used by house flippers to purchase ugly homes, remodel them, and re-sell them on the retail market or to refinance them into buy and hold investments.
Hard money rates usually include both an interest rate and a certain number of “points” (where a “point” is equal to 1 percent of the loan amount) added to the loan or paid as a fee at closing. Interest rates are typically between 10 to 18 percent, with points ranging between 1 to 10 depending on the lender and the strength of the deal.
Hard money lenders can be found in all 50 states. Be sure to check out the most comprehensive list of hard money lenders online here on BiggerPockets at BiggerPockets.com/hardmoneylenders and watch the video below for some tips on getting a hard money loan:
Private money loans are very similar to hard money loans (and the terms are often used interchangeably) but with less formality and typically not extended by “professional lenders.” Private money lenders can be anyone with extra money, such as:
- Your cousin
- Your mom
- Your next door neighbor
- A co-worker
- Someone you met on the BiggerPockets Forums
- Any other individual looking for higher returns on their money
In other words, private lenders are usually someone who you know. Because the investment property loans are much less formal, there are no rules as to the rates or points you will pay, though they are typically slightly less than what a hard money lender may charge, with fewer (or no) points.
Many seasoned real estate investors turn to private money after the banks start saying no, finding win-win ways to close deals quickly without the hassle of dealing with banks or other lenders.
The most important aspect when dealing with hard money or private money are similar to those of a commercial loan, which means your ability to obtain a loan is weighted more heavily on the strength of the deal and your ability to manage the project than your personal income or credit score.
Be sure to check out these great articles on finding private money:
- Where Do You Find Your Investors? Here’s Exactly Where I Find Mine…
- A New Real Estate Investing Lesson I Just Learned About Raising Private Money
- How to Raise Private Money Anytime, Anywhere. Even Over Chicken Wings!
With both hard money and private money, the lender will place a lien on the property to protect their interest. Additionally, the loan typically does not show up on your personal credit report and is considered “non recourse”—meaning the lender can do nothing but foreclose on the property if you don’t pay (so they won’t be coming after your kneecaps with a baseball bat!).
Let’s wrap up our discussion on hard money and private money—and head back over to the institutional lenders. Next, I’ll explain how to find those investment property loans.
Discover hard money lenders on BiggerPockets
Access 150+ lenders who specialize in asset-based loans in BiggerPockets’ directory of hard money lenders. No matter whether you’re fix and flipping or investing in long-term rentals—or even need a bridge loan—you can find a hard money lender who meets your needs.
How to Find Investment Property Loans
Investment property loans are not difficult to locate (though finding the best loan can often be difficult). In my opinion, there are two great ways to find lenders:
- Ask other investors for referrals
- Make a lot of phone calls.
Although this solution may seem too simple, it truly is a great way to find a lender. Most investors, such as those on BiggerPockets or at your local real estate investment club, can share the good and the bad with you in a completely honest way, with nothing to lose or gain by recommending you to a great lender.
As for what kind of lender you want to use, there are multiple options. So, the rest of this section is going to explain several places you can look for investment property loans.
The first and most obvious choice for an investment loan is a bank, and this is the most popular choice for many real estate investors, especially for the first few deals. With thousands of different banks in the world, there are thousands of different loan products. So, be sure to check multiple banks to find the best loan for your needs.
Most banks sell their loans in packages to Fannie Mae or Freddie Mac, so they are very strict on their standards. As such, banks don’t exactly tend to be flexible.
Credit unions can often be slightly more flexible but still usually sell their loans. That means they must abide by the same rules as banks when it comes to qualifying. For example, most banks and/or credit unions cap an investor between four and 10 loans, due to a requirement by Fannie Mae and Freddie Mac.
Portfolio lenders can be a great tool for getting more “creative” in your real estate financing. A portfolio lender can be either a bank or credit union. Each has a distinct advantage for investors: They do not always sell their loans to Fannie Mae or Freddie Mac.
Portfolio lenders can be a little more creative in their lending abilities. Because the money is their own, they can invest how they want and thus can cater to real estate investors. For two great stories of investors who are using portfolio lenders to fund their real estate investments, check out:
- BP Podcast 006: Investing While Holding a Full-Time Job with Arthur Garcia
- BP Podcast 023: Flipping While Working a Job, Partnerships, and Military Investing with James Vermillion
Finally, a mortgage broker is an individual or company that can search multiple (sometimes hundreds of) different loan products to find the best loan for you and your investment property. A mortgage broker generally works on commission and is often paid by you at the loan closing, so consider the cost part of the cost of doing business. However, not all mortgage brokers are created equal, so do your research and find a broker that is efficient, responsive, and effective.
Obtaining investment property loans is not impossible; it’s simply a matter of understanding the process and fitting the deal within the requirements of the lender. Hopefully this post has provided you some help on that front. You can now begin shopping for your perfect investment loan to continue on your real estate investing journey!
If you have any questions or comments about investment property loans, please leave them below in the comments. Or did I miss any large section to this ultimate guide?
Let me know, and I’ll update this post!