How to Finance Rental Property: 6 Strategies to Use

Investing in real estate can set you up for long-term financial success. However, coming up with rental property financing can initially feel like a significant obstacle. Many potential real estate investors don’t know how to jump into the game because they don’t know all the financing options available. If you don’t know how to finance rental property, it’s time to explore your options.

The success of your real estate investment will rely on your ability to finance your property effectively. It’s essential to know how to finance rental property and build wealth without risking too much. This article will cover multiple options for financing real estate investments, as well as when you should choose each funding strategy.

6 Strategies for Financing Rental Property

1. Finance Rental Property Through a Conventional Loan

Conventional bank loans are the most common method for financing a property. According to data from the U.S. Census Bureau, 74% of homes sold in 2021 were financed through conventional loans.

Real estate investor and attorney Clint Coons explains why conventional loans are typically the most difficult type of loan to qualify for. He says, “Typically they’re going to scrutinize your tax returns, they’re going to look at everything you have. And it doesn’t matter the size of the loan—it’s a one-size-fits-all approach because they have these formulas they work through.”

To qualify for a conventional loan on an investment property, most lenders require a credit score of at least 620. Additionally, you’ll need a down payment of 15% with private mortgage insurance (PMI) or 20% without PMI. On top of this, your debt-to-income ratio should be no more than 45%.

To get a conventional loan, reach out to a couple of lenders to discuss your options. Your lender will ask for information about your employment, income, and debts. This helps them determine how large of a loan you can qualify for.

You can save money by discussing your interest rate options with multiple lenders. Research from Freddie Mac shows that borrowers can save an average of $1,500 over the life of the loan by getting just one additional quote and $3,000 by getting five quotes.

What If Your Debt-to-Income Ratio Is Too High?

Although you may be planning to cover the cost of an investment property’s mortgage with rental income before tenants are in place, your debt-to-income ratio may appear too high for a lender to give you a loan. But if you’re motivated to move forward, there are a few strategies for getting around this problem.

1. Buy Rental Property With Tenants Already in Place

Often, landlords sell rental properties while tenants are still living there. This is a perfect opportunity for new investors, as tenant leases prove to lenders that the property produces income.

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2. Turn Your Current Home Into an Investment Property

If you’re already living in your dream home, this strategy is not for you. However, you’ll have more flexibility if you convert your current home into a rental property and purchase a new home. Start showing your home and screening potential tenants while searching for a new property to purchase. Once you’ve found excellent tenants, qualifying for a conventional loan on a new home is easier.

One downside is that there could be a small gap between your closing date and your tenants’ move-in date. This will leave you without a place to live for a short period. To avoid this, you may want to look for tenants willing to set the move-in date further in the future. This will give you time to close on your new property. You can also book a short stay at a hotel or Airbnb to cover the time you are between properties.

2. Draw On Your Current Home’s Equity

Over the last few years, many homeowners’ equity soared. According to Redfin data, the median value for homes in the U.S. increased by 45% between May 2019 and May 2022. Homeowners can draw on this home equity to fund the purchase of investment properties.

The three main methods of withdrawing equity for an investment property’s down payment include cash-out refinancing, home equity loans, and HELOCs. Here’s how to finance rental property with each of these home equity strategies:

Cash-Out Refinance

A cash-out refinance involves replacing your former mortgage with a larger mortgage. The difference in value is then paid to you in cash. Cash-out refinancing was a common way to fund new investments over the past few years while mortgage rates were low. Unfortunately, with rising interest rates, your monthly mortgage payments could increase significantly if you replace your former mortgage with a higher interest rate mortgage.

It’s always a good idea to discuss all your loan options with a lender. In many cases, homeowners in 2022 may be better off choosing a home equity loan or HELOC to draw on their home’s equity.

Home Equity Loan

Instead of replacing your current mortgage with a new higher-interest mortgage, home equity loans allow borrowers to take out a second mortgage. The amount of equity you hold in your home determines the amount you can borrow with a home equity loan. Home equity loan borrowers receive the funds in one lump sum. Yet, the borrower repays the money in fixed payments over a period that can range from 5-30 years.

HELOC

A HELOC (or home equity line of credit) works like a home equity loan. One difference is that you withdraw funds as needed rather than as a lump sum. HELOCs may start out with lower interest rates. However, many HELOCs have adjustable rates, meaning the payments could get expensive over time. HELOCs are often used by house flippers because they anticipate paying off the loan quickly.

3. Apply for a Federal Housing Administration (FHA) Loan

An FHA loan is a property mortgage backed by the federal government, which allows you to qualify for the loan more easily. The required down payment for FHA loans is smaller, and the required credit score is lower. This makes it easier to jump into home ownership.

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“Mortgage insurance with FHA is typically lower than PMI with conventional financing and that’s why […] if you’re putting 5% down or in some cases 10%, you may be in a better position to use FHA financing even though you can qualify for conventional,” real estate agent Jeb Smith explains. “Mortgage insurance is going to be less per month using FHA than conventional and you could end up with a lower monthly payment,” he continues.

If you’re getting into real estate with a small amount of cash and a low credit score, an FHA loan could help you make your first real estate purchase. When you purchase a property with an FHA loan, you must use the property as your primary residence for at least 12 months. There are a few strategies you can use to get the ball rolling on your next investment while living in that home.

1. Renovate

The budget for your first home purchase may be small, which means you might consider looking at homes needing renovation. While living in your home, you can work on rehab projects that increase the value of your home. After a few renovations and a year of living in the home, you may be able to sell the house for a profit and use the cash to finance future real estate purchases.

2. House Hack

House hacking is a term that refers to homeowners living in a portion of their homes while renting out another portion to earn rental income. It’s possible to use an FHA loan to purchase a home with spare bedrooms or a separate unit attached. While living in the home, start earning rental income and save the extra income to put toward a down payment on a future investment property.

3. Build Equity

As the housing market rises, you’ll build equity in your FHA loan-funded property. Over time, if the market is favorable, you may build enough equity in your home to pull money out through a refinance, HELOC, or home equity loan. You can then use that money toward a down payment on an investment property.

4. Explore the Benefits of a Veterans Affairs (VA) Loan

Current and former members of the armed forces may qualify for a Veterans Affairs loan. A VA loan does not require a down payment, and interest rates are highly competitive, even for individuals with low credit scores.

Similar to FHA loans, VA loans are not supposed to be investment property loans. VA loans are meant to help individuals secure funding for a primary residence. However, once you have your primary residence, you can start working toward the next steps in your long-term investment plan. Through renovation, house hacking, and equity-building, your VA loan-funded primary residence can help you begin your investment career.

5. Get a Private Lender to Finance the Rental

Private money lenders are individuals or groups of individuals who are able to provide you with enough cash to invest. Instead of paying a monthly mortgage to a bank, you’ll repay your private money lender with an interest rate and loan term you both agree to.

Investor and entrepreneur Sam Primm currently owns $25 million in real estate. A $100,000 loan from a private money lender was what allowed him to invest in his first rental property and begin building a portfolio.

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Primm explains, “Our main private money lender that gave us our first loan on our first rental property—he’s probably given us over $10 million worth of loans over the past six years in and out. We have taken that initial $100,000 and used that same money forty different times, and he’s made a ton of money on us, as well. We’ve been able to really accelerate our rental portfolio growth because we don’t have to put 20% down on every single rental property we buy.”

6. Work With a Hard Money Lender

Hard money loans are typically easy to qualify for, even for borrowers without strong credit scores. Lenders use the property as collateral to protect themselves from the risk of the borrower defaulting on the loan. This means there is a higher risk of foreclosure when you use a hard money loan to finance a property.

Some investors use hard money loans to finance distressed properties they plan to renovate. This is because many banks and traditional lenders are unwilling to provide loans for these types of properties.

Hard money loans are generally used as short-term financing. They allow borrowers to quickly access funding. However, the high-interest rates often make the cost of holding onto a hard money loan for the long-term unaffordable.

Fix-and-flip investors who hold onto properties for one year or less are good candidates for hard money loans. Yet, it’s important to remember the risk involved. If the renovation process on the fix-and-flip investment moves too slowly, or you’re unable to sell the property for as much as you hoped, you may be stuck with an extremely high-cost loan and no way to repay it.

It’s common for borrowers to default on hard money loans and their properties become foreclosures. In fact, many hard money lenders make most of their money selling properties after borrowers default and relinquish property ownership to the lender.

If you have a clearly defined, reliable plan for securing funding to pay back the loan and your tolerance for risk is high, hard money loans could be a good option. However, you should always be cautious when considering working with a hard money lender.

Prepare for Short-Term Risk to Achieve Long-Term Success

While nearly all investors start with high hopes, some of those investors are unprepared for the financial risks involved in investing. They struggle to make it through economic downturns and end up losing their investments. Unexpected repairs, drops in the price of rent, and high property manager fees can all cause an investment to go south.

You can avoid loss in the face of these risks with these three strategies:

  • Research extensively before every decision.
  • Prepare for financial downturns through diversification and building a reserve savings account.
  • Have the patience to wait out economic downturns and periods of slow growth.

To learn more about beginning a real estate investment career, check out these articles:

How to Become a Landlord and Build Wealth

What to Know When Buying Your First Investment Property