Understanding Investment Property Financing

Paul Merchant
Commercial Investment Property

Investment property financing is slightly different than the average mortgage and can provide you with the cash you need to purchase property specifically for investment purposes.

Financing Properties for Investment

Investment property financing is a credit arrangement that allows you to purchase real estate property for income-generating purposes. This type of credit financing is suitable for individuals, partnerships, or organizations seeking to purchase profit-generating properties. Ideally, investment properties generate profits through rental income or capital gains, such as by purchasing a property for the sole purpose of rehabbing and reselling it for profits. Some of the properties that commonly feature in the investments properties market include:

Investment Property Financing versus Residential Mortgage Loans

The most basic difference between investment property loans and residential mortgage lies in the nature of the property under consideration. Investment property financing opportunities are accessible to borrowers seeking to purchase income-generating properties while residential mortgage loans are given to borrowers seeking to purchase primary residential properties.

The loan application process for these two forms of mortgage loans also differ in terms of document verification, collateral, down payment requirements, and the terms of lending. In comparison to residential mortgage loans, investment mortgage loans tend to attract better lending terms such as lower interest rates. This is because the income-generating potential associated with investment properties makes them viable business opportunities to lenders.

Types of Investment Property Mortgages

There exists different types of investment property financing options that you can choose from depending on your financial abilities and chosen lender. Lenders mostly offer fixed rate mortgages, adjustable rate mortgages (ARMs), balloon payments, and interest-only mortgages.

Fixed Rate

A fixed rate mortgage is a loan that is repaid at a constant interest rate and monthly payment throughout the duration of the loan. Your lender cannot subject your mortgage loan to any form of interest rates alterations throughout the term of your loan. Once you take a fixed rate mortgage loan, you will be assigned as definite repayment period generally ranging between 15 and 30 years. The shorter your term, the higher your monthly repayments and the lower the interest rates and vice versa.

Adjustable Rate

ARMs, on the other hand, are loans that are subjected to fluctuating interest rates in relation to the prevailing market conditions at a given time. As such, your initial interest rates and subsequent monthly installments will increase or decrease for a number of times during the term of your loan. Luckily, the applicable increments on your interest rates are usually capped and cannot exceed certain limits. When your ARM is not capped, then it effectively becomes a subcategory of ARMs that in known as cost of funds index.

Balloon Payment

Balloon payment mortgage is a type of loan that allows a borrower to repay reduced monthly installments before clearing the loan with one final lump sum payment at the end of the mortgage period. The advantage of this type of mortgage loan is that it has the flexibility for clearing the final lump sum installment through refinancing options. You can also pay off the loan before the maturity date. A balloon payment mortgage loan could be suitable in circumstances where you expect some big earnings at a future date which you plan to direct towards the settlement of the final lump sum payment.

As for an interest-only loan, you will be required to repay only the interest accrued on your principal amount over a specified duration; this type of loan typically ends in a balloon payment.

There are numerous other customizable lending options for investment property financing, but they vary from one lender to another.

Location Considerations

The nature and location of your investment property are very important factors that lenders consider when determining the applicable interest rates on your loan. You can negotiate for lower interest rates on an investment property for rental income compared to a property that you intend to rehab and resale. Property location weighs in when it comes to issues that concern the income potential and value of the property. For example, you may find yourself in a favorable position to negotiate for lower interest rates if your investment property is located in a posh residential area because of its reassuring potential to maintain high occupancy rates or high resale valuation.

Choosing a Suitable Lender

The applicable interest rates on your investment property loan will often vary according to your chosen lender and down payment terms. For instance, specialized investment mortgage lenders generally charge higher interest rates than conventional lenders.

This is why it is very important to choose the right lender. Use an investment property mortgage calculator to compare rates offered by different lenders. There are many financial institutions that offer financing investment properties. Some of the reputable lenders and brokers of investing property financing include:

Approved Federal Housing Administration (FHA) lenders provide investment property financing on strictly duplex (or greater), of which one or more units must be your primary residence. Search for FHA-sponsored lenders because they can be your best bet especially when you are seeking lower interest rates, low down payment requirements, and friendlier qualification criteria such as leniency in credit history requirements.

Alternative Sources of Investment Property Financing

You may also opt for alternative creative sources of investment property financing such as seller carry back and subject-to existing loan. Seller carry back involves paying installments directly to the seller within a stated deadline. Subject-to existing financing, on the other hand, simply involves acquiring a property with a pending loan but retaining the repayment program under the seller's name. It is mostly used circumstances where individuals (sellers) seek to avoid imminent foreclosure.

Getting Investment Property Financing

Begin the process by shopping around for lenders while comparing the interest rates that they charge. Be prepared to go through a thorough vetting process by your chosen lender. The other important aspects of your preparation should entail confirming your credit score, raising the down payment amount, gathering the requisite documents, and undertaking property income verification.

Confirm your Credit Score

Begin the loan application process with the confirmation of your credit worthiness. Many lenders will require you to have a credit rating of not less than 740 FICO score. A good credit rating will position you favorably in your negotiation for lower interest rates. Evaluate your credit history and sort out any issues that might reflect negatively on your income.

Raise the Down Payment Amount

A down payment is a prerequisite requirement for investment property financing. Prepare a down payment of at least 10 percent of your target loan amount. Indeed, it is prudent to commit sufficient funds toward your down payment in order to achieve a favorable loan-to-value (LTV) ratio.

You can raise your down payment through various ways such as using your savings, seeking for a personal loan, or securing private financing. You can also employ alternative lines of credit such as home equity or put a lien in the funds in your brokerage account.

100% investment property financing is hard to come by. This is because down payment has become a norm among lenders. You may have to secure some really creative financing using collateral such as property equity, other properties, lease options, or lease purchase agreements. You will pay higher interest rates and your investment property mortgage will subject you to more stringent terms of financing.

Undertaking Property Income Verification

Verify the income potential of your target property. Be sure to examine key parameters such as tenancy occupancy rates, rehabbing costs, and resale valuation of the property. If you already possess a real estate investment property such as a rental home, your lender may require you to verify your income-to-loan value by providing your rental receipts and statements of net income as per your annual tax return filings.

Gather the Requisite Documents

Organize all the requisite documents before approaching your chosen lender. These documents always vary with regards to employed and self-employed individuals as well as group applications. You should also bear in mind that the required set of documents are not uniform among all lenders. Some lenders may require just a number of the documents listed below while other lenders may require all of the listed documents and may even request for additional documents according to their internal operations policies.

Documentation for Employed Individual Applicants

For an individual application, you may be required to present the following documents:

  • Completed commercial mortgage application
  • Bank statements (two months or more)
  • Recent pay statements (at least two)
  • Income tax (W-2) statements
  • Statements of accounts for your investments, if any
  • Copy of property lease
  • Property appraisal
  • Social Security Card
  • Drivers' license
  • Documentation of bankruptcy, divorce or separation, if any

Documentation for Self-Employed Individual Applicants

If you are self-employed or you already own a rental real estate property, be prepared to present your personal tax returns (usually all schedules) in place of the pay statements. If your self-employment is through a corporation, then you will require at least two years of tax return filings and year-to-date financial statements (balance sheet and profit and loss account) for your corporate.

Documentation for Partnerships and Groups

If you are organized into partnerships or groups, lenders will generally consider you like any other organizational or business entities. You will be required to present the following documents:

  • Completed commercial mortgage application
  • Registration certificate
  • Certificate of incorporation (for a partnership business)
  • Bank statements (two months or more)
  • Income tax returns filings
  • Statements of accounts for your investments, if any
  • Copy of property lease
  • Documentation of bankruptcy, if any

The Tax Factor

An investment property can have a dramatic effect on the amount of income tax that you pay. There are also state and local property taxes that must be considered. In some cases, the taxes paid are deductible and in some cases they are not. To learn more about these tax considerations and deductions, visit the official IRS website.

Understanding Investment Property Financing