Making an Investment Property Mortgage Pay Off

On the surface, a small residential rental property may not look much different from a home in which you'll live. However, investing in one of these properties is somewhat more complicated than buying a home. The potential upside is that it can be a rewarding long-term investment.

The following material highlights some of the keys to getting an investment property mortgage and making the investment pay off in the long run.

Qualifying for an Investment Property Mortgage

As opposed to large apartment complexes, a residential rental property is one with one-to-four rental units. These can be financed with a mortgage, but the qualification standards for an investment property mortgage are somewhat higher than for a loan on a primary residence. Here are three key hurdles to clear in getting an investment property mortgage:

  1. Expect to make a larger downpayment. Fannie Mae underwriting standards allow you to qualify for a purchase mortgage on a primary residence with just five percent down, but that number goes up for investment properties. The loan-to-value (LTV) ratio for a fixed-rate mortgage cannot exceed 85 percent for rental properties with one or two units, and cannot exceed 75 percent for those with three or four units. That means you will have to put at least 15 percent down on smaller residential rental properties, and at least 25 percent down on the larger ones. That LTV ceiling drops another 10 percent if you choose an adjustable-rate mortgage. These LTV restrictions also affect how much of the property's value you can refinance, and what kind of refinancing loan you can get.
  2. Your mortgage rate will be higher than primary residential rates. Like primary residential mortgage rates, investment property mortgage rates go up and down according to market conditions, but there is an additional premium added. According to Fannie Mae pricing guidelines, this premium ranges between 1.75 and 3.75 percent, with the size of the premium depending on the LTV ratio. Note that you can reduce this premium -- and thus your mortgage rate -- by making a larger downpayment than the qualification standards require.
  3. Not all of your rental income may count towards qualification. Naturally, your income is factor in qualifying for a loan, and you can include rental income you expect to earn on your mortgage application -- but you cannot count the full amount of that rental income.Qualification standards assume that some portion of rent will go to property maintenance, and some will be lost due to tenant turnover. So, only 75 percent of rental income can be counted for qualification purposes. If this 75 percent of rental income is not enough to cover your mortgage payments, it could negatively impact your debt-to-income status.

Fannie Mae mortgage qualification standards specify that the hurdles for qualification get even higher if you own between five and ten investment properties. What all this boils down to is that mortgage lenders consider investment property to be a higher loan risk than your primary residence, and the more such property you have, the riskier the loans are considered to be.

Note that these are Fannie Mae guidelines, which govern the majority of conventional loans for residential property in the US. However, Fannie Mae and Freddie Mac (Freddie's guidelines are similar but not identical) are not the only games in town. You may be able to find portfolio lendersor local banks with requirements that are a little more forgiving. It's important to shop around for your mortgage for that reason.

Assessing the Investment

One benefit of the tougher underwriting standards for investment property is that they force would-be buyers to address some of the issues that will determine whether or not the investment will be a successful one. To evaluate this kind of investment opportunity, you have to look at it two ways:

  1. Cash-flow basis. Owning investment property is a cash-intensive business. Your rental income will be offset to some degree by ongoing expenses such as the mortgage, insurance, property taxes, and maintenance. Before you make the investment, calculate both your projected rental income and those expenses. If there are existing leases, these might be a good indication of what rental income to expect, but even so you should look at comparable rentals in the neighborhood to make sure the current rents are competitive, and examine local occupancy rates, population growth, and employment trends to get a sense of how sustainable current rental rates are. On the cost side, use a mortgage calculator to factor all elements of your loan into a schedule of monthly payments. You should also look at past records from the current property owner (he or she should report them on a Schedule C, E or F) to see what ongoing expenses may amount to. The idea is to subtract the expenses from the rental income to see what net cash flow to expect. Even if you have high hopes for eventual appreciation of the property, you won't last long enough to realize that appreciation if negative cash flow drains your resources dry in the interim.
  2. Return-on-investment basis. The cash flow analysis will tell you whether you can sustain an investment in the property, but to calculate the full return-on-investment (ROI) you need to also factor in the change in market value of the property from when you buy it to when you sell it. It is all too easy for property buyers to assume that real estate will appreciate in value over time, but this depends on how much you pay for it, what the future prospects of the neighborhood are, and how quickly the structure and mechanics of the house are deteriorating. Take all this into account and try to project the property's value over a ten-year holding period (you may well own the property longer, but longer projections become extremely speculative). Use the change in value and your net cash flow to calculate a rate of return over the holding period. The final step is to assess whether you could earn a better return on another investment, such as bonds, stocks, or different property.

The first time most people go through getting a mortgage for a primary residence, they find the process somewhat complicated. Applying for an investment property mortgage further raises the complexity level, but that's not all bad. The qualification standards and investment considerations make it clear that this is serious business, and approaching it as such is your best chance of earning a serious return.

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