Before the housing meltdown in the early part of the century, rental houses were a solid source of income for both house-flippers and middle-class Americans who could afford a second mortgage payment. Following new consumer protection rules established by the Dodd-Frank Act in 2010, lenders are precluded for letting people into larger mortgages than they can handle. Qualifying is tougher, and because mortgages on rental homes are not covered by insurance, lenders charge higher finance charges and steeper down payments than they do on mortgages of primary residences.
Expect 25 percent Down Payment Requirements on Rental Property
There you go: that's the sticker shock even if you have good credit. In considering an application for a rental property mortgage, underwriters will focus on credit scores, Fannie Mae and Freddie Mac debt-to-income regulations, and liquidity. Most expect applicants to have a reserve sufficient to cover property expenses, repairs, principal, interest, taxes and insurance on the rental property for at least six months.
Some homeowners may leverage their principal residence through a home equity line of credit (HELOC) to make the hefty 25 percent down payment. One benefit of the HELOC is that fees are low and so are current interest rates. Some investors may use equity on several properties as they speculate on homes to flip. Those planning on buying Boardwalk and Park Place, however, are playing in a different league. For most folks, lenders set ceilings on the total number of structures they can purchase as rental properties.
Liquidity/reserve is especially vital when combined with income expectations on the new rentals and operating costs. Mortgage guidelines call for financial reserve protection of a 25 percent vacancy factor, meaning that the owner loses one fourth of total rental income on vacancies. Income is further reduced by the costs of maintaining the building. Lenders generally balk if the applicant's total monthly debt exceeds 36 percent of their monthly gross income.
There are tax implications on second homes too, ranging from state or local property taxes to income taxes on rental income. And don't forget title insurance, property/hazard insurance (theft, fire, flood), and "optional" liability insurance.
Negotiating on Closing Costs
One of the best ways to know where you stand is to grab a copy of your current credit score at LendingTree. Ratings are commonly considered as:
- Poor: 300-599
- Fair: 600-659
- Good: 660-719
- Very Good: 720-779
- Excellent: 780-850
Borrowers with a score below 720 may pay points to get the prime rate on their rental home mortgage, or they can finance the home at a higher interest rate. In buying points (1 percent of the mortgage amount), consumers can lower monthly payments on the new mortgage. Points are also tax deductible (talk to your financial advisor).
It's a good idea to get loan offers to reign in the total price of the new rental property. For example, a new owner may be looking at costly upgrades or repairs, appraisals, recording/origination fees, and carrying costs. Smart shoppers will ask the seller to pick up some of the closing costs or they'll move on to house candidate #2.