Financing an Investment Property: A Primer. With interest rates at historic lows, we take a look at some of the various options available for financing investment properties.
Let’s first start with some definitions commonly used when discussing mortgage financing:
Annual Percentage Rate: The interest rate that will be paid to the lender.
Amortization: A schedule for how the loan is intended to be repaid. An amortization schedule shows each monthly payment and the amount scheduled to be applied to the principal balance and interest.
Discount Points: An amount paid to the lender for a certain annual percentage rate. Usually expressed as a percentage of the total loan amount – IE, 1.25 points on a $100,000 loan would be $1,250.
Down Payment: The amount of the purchase price paid up front by the borrower.
Loan to Value % (LTV%): The amount of the mortgage divided by the value of the property.
Origination Fee: The amount paid to the lender to get the mortgage.
Principal: The amount currently owed on the mortgage (not including accrued interest).
Private Mortgage Insurance (PMI): Insurance for the lender against borrower default. Most lenders require PMI if the LTV% exceeds 80%.
Term: The termination date of the mortgage. May be different than amortization period. For example, commercial loans might have a 20-year amortization, but a 5-year term. This means the remaining principal balance must be paid off after 5 years or the mortgage must be refinanced at the then-prevailing interest rate.
Let’s get down to brass tacks. What are some options available for financing investment properties?
Option 1: “Conforming”
If you pick up the phone and call a local mortgage broker, he or she will likely discuss with you a loan that is underwritten to Fannie-Mae guidelines, hence it is “conforming”.
It is beyond the scope of this article to discuss all of the ins and outs of the secondary mortgage market, but it suffices to say that most non-commercial residential investment property loans will be underwritten to Fannie standards.
Here is a graph of 15 and 30-year conventional mortgage annual percentage rates over the last 5 years:
The rates reflected in this graph are for owner-occupied, primary residence loan. You can expect the rate to be approximately .5 – 1.0% higher for a non-owner-occupied (NOO) investment property.
Another useful resource is the Fannie Mae Eligibility Matrix. This document answers many of the questions an investor may have about maximum LTV%, minimum credit scores, etc.
An investor can finance up to 85% of the purchase price for a single-family investment property or 75% for a duplex, triplex, or quadplex (exceptions apply if you have >5 mortgages). However, PMI is typically required if the LTV exceeds 80%. Most investors will put 20% down to avoid paying PMI.
The terms on conforming loans are very favorable and make this option popular for many small investors as the interest rate is fixed for the full amortization period. Who wouldn’t want to lock in historically low interest rates for 30 years?
A question we commonly receive is “How many investment properties can I finance with conforming loans?” The answer, currently, is that you can have up to 10 total mortgages, including your primary residence. So if you have a mortgage on your own home, you could get up to 9 additional properties under Fannie Mae guidelines.
Option 2: Commercial Loan
Want to finance 20 single-family investment properties? Or own an apartment complex? Enter commercial financing.
Commercial lenders can be found at your local and regional banks, as well as the larger national banks, and typically have more flexibility than a mortgage broker who must follow the reams of Fannie Mae regulations for underwriting.
Commercial loans tend to have shorter amortization periods and the interest rates are commonly fixed for only 5, 7, or 10 years.
Common terms for an investor purchasing his 11th single-family investment property might be 20-year amortization with a 5-year term, 80% LTV with an annual interest rate around 5%.
The upside to commercial financing is that it allows an investor to build a larger portfolio, as there are no specific limits on how many commercial mortgages a bank may issue. The underwriting process may be easier as well, with less paperwork and faster closing times.
The downside to this type of mortgage is that because of the shorter term, commercial loans introduce significant interest rate risk (if you believe, like I do, that what goes down, must come up), as well as typically having a higher interest rate than conforming loans.
Option 3: Owner Financing
Perhaps neighbor Bob has a great investment property down the street that he’s willing to part ways with at a fair price. Even better, neighbor Bob doesn’t have a mortgage on the property and says he’s willing to “owner finance”.
With this option, Bob becomes the bank and the mortgage can contain terms that you and Bob find mutually agreeable.
Just remember, if Bob is a smart man he will probably offer you mortgage terms similar to what a bank would offer, so don’t assume you’re going to get extremely favorable terms through option 3. But you might be able to avoid a lengthy underwriting process and have more flexibility in structuring the purchase this way.
There are pros and cons associated with each of the 3 options listed above. From our vantage point, conforming loans are currently a great deal as they lock in historically low interest rates for the duration of the loan, but investors are limited to 10 properties. Commercial financing provides an opportunity for investors to go beyond the 10th property and/or avoid some of the pain of underwriting a conforming loan, but interest rate risk remains a key concern with commercial loans. Owner financing may be a great option, but it may be difficult to find an owner willing/able to provide it.
This article is merely a primer. For the latest information, be sure to contact your favorite mortgage broker or commercial banker. For those of you wanting to dig deeper into the world of investing in and financing real estate, here is a good text on the subject.