In the past decade, TV shows like Fixer Upper and Love It or List It have permeated American culture and brought a greater awareness to the potential profit in home renovations. However, just because it looks fun to remodel a home with the benefit of editing, there is a lot more that goes into property investment—especially when it comes to financing.
If you’re curious about what it takes to secure enough funds to buy your own fixer-upper, we’ll introduce you to the basics of investment properties and investment property loans, as well as what you need to qualify and apply for investment financing over the next few paragraphs.
What Is an Investment Property?
Real estate purchased with the purpose of being used as a way to generate income for the owner—whether from rental income or from reselling the property for a profit—is considered an investment property. These properties can’t be used for personal purposes by the owner nor can they be used as a primary residence.
The Difference Between Investment Property Loans and Primary Residence Loans
Before outlining the differences between investment property loans and primary residence loans, let’s establish the primary difference between the two. Since we now know what an investment property is, let’s focus on the definition of a primary residence.
A primary residence is the dwelling in which you live for the majority of the year. This residence can be a house, boat, trailer or apartment as long as it provides enough room for a bathroom, kitchen and includes a space for you to sleep.
Simply put, the difference comes down to residency. While you may own both pieces of real estate, you’re only permitted to claim one as your main living space for tax purposes.
The way these differences translate to lending is also related to residency and payment prioritization.
Lenders typically view investment properties as riskier than primary home mortgages. Why? Investment properties have statistically higher loan default rates. Because of this, it’s common for lenders to ask for a down payment of 20 percent or more, along with a credit score either in the “Very Good” or “Exceptional” range.
Additional Investment Property Loan Requirements
To secure a property loan, your financial profile needs to be a bit stronger than it would be for business financing or a personal home mortgage. Beyond the factors above, lenders typically want to see that you have a credit score of at least 620 and that you have a minimum of 6 months of cash reserves for each property you own and any you intend to invest in.
The 6 Steps You Need to Take Before Applying for an Investment Property Loan
Applying for investment property financing typically means you’ve found an investment property that fits your needs. But what does it take to get to that point and find the right property?
Here are the six things you need to do and/or consider before exploring investment property financing:
Making an investment in a property is similar to making an investment in a business. You need to identify how it stacks up to other properties in the area, who it appeals to, its overall potential and the profits you stand to earn if done correctly. Just as a business owner would conduct due diligence before making any financial decisions on a business, you need to take the proper steps to research the property and its viability.
Remember, you’re not looking to invest in the property you like the most—you’re looking to purchase property with the most potential with the highest upside.
Handle Your Debts
Before adding another debt to your financial roster, it’s best to pay off or consolidate any other personal liabilities in your name. These include student loans, medical bills and any other significant debts aside from your mortgage. By limiting the number of debts you have to manage, especially if this is your first investment property, your chances of maintaining regular payments increase dramatically.
Secure a Down Payment
As we noted in the table above, lenders typically want investors to provide at least 20 percent of the total purchase price for investment properties. The reason for this massive difference is due to the fact that investment properties aren’t eligible for mortgage insurance. Insurance companies aren’t interested in covering investment properties since there’s a greater risk of default compared to residential properties. Aside from a lack of insurance, lenders want potential investors to prove that they have the means of handling multiple mortgages/lease payments.
Do the Math Ahead of Time
Considering every aspect of the property before you take the steps to apply for funding makes life much easier for you and your future lending partner.
Beginning with the capital you already have set aside to invest, and then estimating what you’re eligible to borrow, calculate both what you qualify for and what you feel comfortable spending. Using these numbers, project the cost of buying and updating the property you intend to make an offer on, as well as the monthly operating costs. Once you’ve estimated those totals, determine the price you will list the property at for resale or lease.
It’s important to evaluate the larger market at this point to make sure that your price is competitively priced against similar properties and consumer expectations. While market comparison is a good barometer for how attractive your property may be for others, another reason to estimate your expenses and pricing is to project your profits appropriately.
Think Low-Risk, High-Reward
Now that you’ve estimated your ideal and max budget, you’re ready to hone in on properties in your price range. It’s best to invest in properties that are in the lower- to mid-range tier of your budget. This recommendation stems from knowing that you’ll need to make additional investments in the property after closing in order to prepare it for renters or post-renovation buyers. The lower your investment costs, the easier it’ll be for you to reach your profitability goals.
Choose Partners Wisely
Potential investors need to evaluate many factors that go into a partnership, like the language of an agreement or the level of comfort you have, for example, with either a fellow investor or a lending company.
The appeal of working or partnering with friends on an investment opportunity can be very strong. However, it’s not always the shrewdest business decision to mix your personal life with your professional dealings. Aside from protecting your relationship, it’s very much about protecting your investment.
Applying for an Investment Property Loan
Applying for an investment property loan is consistent across the board, regardless of the type of lender you’re working with. Here are the 3 steps you’ll take to secure an investment property loan:
Before your business is approved for an investment property loan, you must first assemble all of your financial and employment records and submit them to your lender. Your lender will then verify and evaluate your documents along with checking your credit score in order to determine how much you qualify for.
Here are the documents you can likely expect your lender to ask you to provide:
- 2 Years of Personal Tax Returns
- Property Appraisal
- Purchase Property Contract
- Copies of Leases (for all rental properties you own)
- Recent Mortgage Statements (on all properties you own)
- Proof of Insurance (for all properties you own)
Whether you’re working with a loan officer or through an online portal, it’s possible to be pre-approved between 5 and 30 minutes.
Underwriting & Approval
Once you’ve gathered and submitted all of the necessary documents, the next step in the process is finding the best offer for your needs. As you’re putting together your documentation for your first lender, be aware of what your second and third lending partner options require so that you can compare and contrast multiple offers at once.
After you’ve found a deal, the lender you choose to work with will begin to underwrite the contract once you make an official offer on a property. Approvals are often valid for 30 days, sometimes 90, depending on your lender.
After you’ve been approved and your offer has been accepted by the seller, you’ll move into the closing process. It’s common for these loans to close in approximately 30 days, during which time the property will be appraised. It’s also possible that your lender will ask for additional documents to either verify or support any questions they or the seller may have.
Applying for an investment property loan takes a good deal of business savvy, as evidenced by strong credit scores, significant cash reserves and the willingness to provide a large down payment.
Making an investment, regardless of its form, is a risk. There is both the possibility of the investment working in your favor and not yielding the return you were hoping for. The best way to protect yourself and your assets from the downsides of investing is to do as much research as possible while also making the safest bet you can. While a simple fixer-upper property off Main Street may not be as attractive or have the same curbside appeal as a brand new rental home in a big city, the return has the chance to be just as good.