The Complete Guide To Investment Property Mortgages in 2019

If the road to real estate riches were an easy one, everyone would be a millionaire landlord or house-flipper.

Making big money from investment property (real estate purchased for the purpose of earning rental income or a profit from reselling it) is rarely as simple as “buy low, sell high.” It requires careful research, planning, hard work and a dollop of good luck.

But as long as you make real estate investing decisions with your eyes wide open, the financial rewards could surprise and delight you.

In 2017, the average gross return (profits before expenses) of house flipping – purchasing, renovating and quickly reselling homes – was 48.6%.

In other words, the average house flipper earned $48,600 for every $100,000 invested.

The average return on rental properties in 2017 was 13%. This means the average buyer of a $500,000 apartment building earned $65,000 in a single year!

By contrast, the average stock market return over the last 10 years was 6.88% (10.09% over the last 50 years) while the average investor’s return on mutual funds was 3.66% over the last 30 years.

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In this article:

• Pros and cons of buying investment property
• Hard money loans
• Conventional mortgage loans
• FHA mortgage loans
• VA mortgage loans
• Home equity lines of credit (HELOCs)
• Should you flip or rent your investment property?
• Our recommended lenders for home loans

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Myths Busted

Before examining the benefits of buying investment property, let’s bust two persistent myths:

Myth 1: Buying a primary residence is the same as purchasing an investment property.

Fact: Although many people think of their homes as investments, a home is not an investment property unless you buy it for the express purpose of generating rental income or a profit upon resale.

Myth 2: Home values have always risen, so a primary residence will end up being an investment property if you own it long enough.

Fact: Adjusted for inflation and local market conditions, home values have not always risen. Nationally and locally, housing prices are subject to boom-and-bust cycles. Regardless of how long you own a property, there’s no guarantee you’ll make a profit when you resell it.

Pros & Cons of Buying Investment Property

For small investors, the most common real estate deals come in two flavors: (1) rental property purchases, and (2) house flipping ventures.

Here are the biggest benefits and drawbacks of each:

House flipping Pros: Handsome profits, delivered fast and in lump sums.

In theory, flipping a house is a short-term investment that provides immediate, outsized rewards.

If you watch HGTV, you know the drill.

First, buy a slightly “distressed” property in an up-and-coming neighborhood for less than market value – or less than its near-future value. Next, strap on your tool belt to refurbish this fixer-upper into a model home. The moment the facelift is done, find a buyer willing to pay more for the property than you invested.

Rinse and repeat.

House flipping Cons: High rewards come with high risk.

Big returns can be deceptive. Sometimes, they don’t include all the costs of acquiring and renovating the property. These costs typically swallow 20% to 30% of profits.

In addition to renovation costs, you’ll pay closing costs, property taxes, insurance and (often) a realtor’s fee, among other things. If you take out a mortgage, and don’t resell the property ASAP, the monthly payments will start gnawing at your profits.

The biggest mistake made by many newbie house flippers is underestimating the cost of purchasing and fixing up the property.

As a house flipper, you’re betting you can sell the renovated house at a significant markup before ever-escalating costs destroy your profit margin.

This isn’t a game for naïve or impatient people.

A successful flipper thoroughly researches the local market before purchasing an investment property. The ideal neighborhood is one where homes are still affordable but appreciating fast. Neighborhoods with sound infrastructures (e.g., good schools and job opportunities) that are just starting to “gentrify” are great places to buy.

Unless you have lots of cash on hand, you’ll need a short-term loan to buy the property. Unfortunately, the requirements for investment property loans are stricter than those for primary residences. To flip a house, you may have to get a “hard-money loan” instead of a conventional mortgage, and these loans are much more expensive.

Finally, your profits will be subject to capital gains taxes.

Long-term capital gains (investments held for a year or longer) are taxed at a rate of 10% to 15%, but short-term capital gains are taxed at the same rate as ordinary income. Because house-flipping profits usually depend on turning over the investment quickly, you may pay rates as high as 20% unless you do a Section 1031 exchange to postpone the tax bill.

Check current mortgage rates.

Rental Property Pros: Whether you buy an apartment complex or duplex, the biggest advantage of rental property is the predictable income stream that it generates.

Whereas a three-month house flip venture might produce a $50,000 gross profit on a $200,000 investment, a $200,000 rental property should generate $4,000 a month (assuming you set the rent using the 2% Rule.) At that rate, you’ll exceed $50,000 in 13 months, and the revenues won’t stop there. They’ll keep pouring in month after month, year after year.

In addition to creating profit, rental income will help you pay down the loan you obtained to finance the property. And in some cases, current and future rental income helps you qualify for more favorable loan terms.

The greatest perk of owning rental property may be the tax advantages. In addition to generating income and potential profits from capital appreciation, rental properties provide deductions that can reduce the tax on your profits.

Common deductions include money spent on mortgage interest, repairs and maintenance, insurance, property taxes, travel, lawn care, losses from casualties (floods, hurricanes, etc.), as well as HOA fees and condo or co-op maintenance fees.

If net cash flow isn’t positive after deducting expenses, your rental income may even be tax free!

Rental Property Cons: If you’ve ever spent time talking with a landlord, you know that owning rental property is not without its headaches and hassles.

Besides generating income, rental properties breed expenses that range from 35% to 80% of gross operating income. (Most properties are in the 37% to 45% range. If your cost estimates fall far below this, double-check your calculations.)

Many new landlords underestimate the cost of owning and maintaining their properties.

(Note: expenses may not be fully tax deductible. It depends on whether the IRS classifies your rental income as “non-passive” or “passive.” If you don’t spend at least 750 hours a year working on your rental properties, any losses are passive and only deductible up to $25,000 against the rentals’ income. (Fortunately, losses over $25,000 can be carried over to the following year.)

And when stuff breaks – from refrigerators and ovens to water pipes and HVAC systems – you’re the one who has to get it fixed. If you’re not handy, or don’t want to field midnight calls from tenants, you’ll need to hire a property management company to handle such tasks.

The good news is that property management firms can handle some (or even all) the unpleasant chores – from keeping units occupied to overseeing repairs and maintenance, collecting rents, finding reliable new tenants and evicting deadbeats.

A good management company will also have all the necessary leases, applications and other documents to ensure that your building runs like a well-oiled income-producing machine. They will also be experts in the landlord tenant laws of your city and state.

The bad news? These services aren’t free.

Expect to pay a management firm a monthly fee of 7% to 10% of the rents collected. And that might be just the start.

Some property management firms tack on additional fees for performing or supervising repairs, for locating new tenants, or even when a tenant renews the lease. Some also charge vacancy fees, meaning you must pay them even when a unit isn’t producing any income.

One of the biggest landlord nightmares is, of course, the deadbeat tenant who damages your property, but takes months to evict. Carefully screening prospective tenants – and buying property in stable, middle-class neighborhoods – can reduce your risk of long-term vacancies and non-paying tenants, but there’s no guarantee that you won’t face these problems.

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Investment Property Loans

Getting an investment property loan is harder than getting one for an owner-occupied home. And they are usually more expensive.

Many lenders want to see higher credit scores, better debt-to-income ratios, and rock-solid documentation (W2s, paystubs and tax returns) to prove you’ve held the same job for two years. (This last requirement can make things difficult for retirees and the self-employed.)

Moreover, most will insist on a down payment of at least 20%, and many want you to have six months’ of cash (or near-cash) reserves available.

And if you already have four mortgages, you’ll need some savvy to get a fifth. Most banks won’t issue new mortgages to investors who already have four, even when the loans will be insured by a government agency.

But just because it’s harder to get investment property loans doesn’t mean you shouldn’t try. Although you might not qualify for a conventional mortgage, you might get one backed by the Federal Housing Administration (FHA) or Veterans Administration (VA). You could also opt for a hard money loan or a home equity line of credit (HELOC).

Some lenders won’t even care about your credit or employment history, as long as they see lots of potential profits in the investment property you’re considering.

Hard Money Loans

These loans are mostly used by house flippers and professional real estate investors. Also known as commercial real estate loans and “fix and flip” loans, they have three main advantages:

1. 1. Faster approval and funding. In some cases, loans will be approved on the same day the application is submitted, and funding can take as little as three days. Thanks to this speed, hard money loans are ideal for investors who want to buy a property fast – before the competition can scoop it up.

1. 1. Easier to qualify. If you make a down payment of 25% to 30%, have sufficient cash reserves and a good track record as a real estate investor, many lenders will overlook a subpar credit score. And they may not care that you already have 4+ mortgages.

1. They are short-term loans. Most hard money loans have terms of 1-2 years or 3-5 years. For someone buying a rental property, this would be a deal killer. Few (sane) rental property buyers want to pay back the loan within a year or two. But for house flippers, these terms are perfect, which is fortunate, because there’s no such thing as a 12-month mortgage. Even if banks wrote short-term mortgages, most would never loan money for a property that needed significant repairs – one that might not qualify as inhabitable.

Other than the 25% to 30% equity requirement, the biggest downside of a hard money loan is the cost. Interest rates typically range from 9% to 14%, and many also carry upfront fees (in the form of “points”) of 2% to 4% of the total loan.

Conventional Mortgages

Compared to hard money loans, conventional mortgages are relatively cheap. In general, you’ll probably pay one to three percentage points more in interest for an investment property mortgage.

According a November 2017 article in The Mortgage Reports, a buyer with a 720 credit score financing a personal residence with 20 percent down would qualify for an APR of 3.875 percent.

Add to this a Fannie Mae risk-based pricing adjustment of .75 percent. (The surcharge adds .75% of the loan amount to the fees, not the rate.)

If the same borrower financed a rental home instead of a primary residence, another surcharge would be added. The size of the surcharge depends on the loan-to-value (LTV) of the mortgage.

If the LTV were 80 percent, the extra surcharge would be 3.375%. So altogether, the rental property buyer would also pay 4.125 percent in additional fees.

For some future real estate moguls, however, the issue with conventional mortgages is not their cost, but getting approved.

Assuming you will not occupy a unit in the building, most banks will want to see the following to approve a mortgage for a rental property:

• • A down payment of at least 20%. If you’d like a lower rate, make a bigger down payment. (On the plus side, there is no mortgage insurance for investment properties.)

• • A minimum LTV ratio of 80%.

• • A credit score of 740 or higher. Scores below 740 won’t (necessarily) doom your application, but they will trigger higher interest rates, higher fees, and lower LTVs.

• Six months of “liquid reserves” (cash, or assets that can be easily converted to cash).

Once you have four mortgages on your credit, many conventional lenders won’t come near you.

Although a program introduced by Fannie Mae in 2009 does allow 5-10 mortgages to be on a borrower’s credit, finding a bank that will give you a mortgage can be difficult, despite the guarantee from Fannie Mae.

The program requires six months’ payments held as a liquid reserve at the time of settlement. It requires at least 25% down for single-family homes and 30% down for 2-4 unit properties. If you have six or more mortgages, you must have a credit score of 720 or more. No exceptions.

Check your conventional mortgage eligibility.

FHA Mortgages

To finance a rental property, an FHA mortgage may be the perfect “starter kit” for first-time investors.

But there’s a catch. To qualify for the generous rates and terms of an FHA mortgage, you must occupy a unit in the building. Then the property qualifies as “owner occupied.”

FHA mortgages are not issued by agency. Instead, the loans are made by private lenders, and the FHA insures those lenders against losses. This gives banks more incentive to lend to borrowers who might otherwise be seen as too risky.

Thanks to government backing, FHA mortgage lenders are lenient with regard to minimum credit scores, down payment sizes, and the borrower’s previous real estate experience.

The down payment requirement for FHA mortgages is just 3.5% for buildings with one to four units. By contrast, a conventional loan might require 20% down on a two-unit purchase and 25% down on the purchase of a 3-unit or 4- unit home.

Because the FHA allows cash gifts for down payments and the use of down payment grants from a municipality, it’s even possible to get an FHA-financed home with no money of your own.

Just as important, the agency states that it will insure loans to borrowers with credit scores as low as 500. This is more than 100 points below the minimums for conventional and VA mortgages.

The FHA also makes allowances for home buyers who have experienced a recent foreclosure, short sale, or bankruptcy because of “extenuating circumstances,” such as illness or loss of employment.

Through its Back to Work program, the FHA requires home buyers to wait just 12 months after a major credit event before re-applying for a mortgage. The industry standard is closer to four years.

FHA mortgage lenders would like applicants to have a minimum credit score of 620.

Check your FHA eligibility.

VA Mortgages

According to a 2016 study by the National Association of Realtors, 16% of active duty military personnel own investment properties compared with 9% of the general public.

There are two reasons for this:

1. 1. Because active duty personnel are frequently forced to move, they are often unable to sell their current homes at a price that would let them recoup their investment. So instead of selling the houses, they become absentee landlords.

1. VA mortgages allow veterans, active duty service members and their surviving spouses to obtain investment property loans with no money down and low mortgages rates. As with FHA loans, the only requirement is that the borrower live in one of the building’s units (in this case, for at least one year). After that, they can rent out the entire building and live somewhere else.

Rental properties can have as many as four units, or can be a duplex or triplex. The property can even be a home in which a room is rented or a home with a separate apartment on the property.

Borrowers can even buy one property, live there for a year, and then repeat the process with multiple buildings until they reach a financing maximum known as the entitlement limit.

Another advantage of VA mortgages: borrowers can use the rents from other units in the building to qualify for the loan by including that rent as income. Typically, they can add 75% of the market rents toward their qualifying incomes.

On the minus side, the rental property must be in move-in condition and receive approval from a VA home appraiser before the loan can be approved.

Check your VA eligibility.

Home Equity Lines of Credit (HELOCs)

HELOCs are revolving credit lines that usually come with variable rates. Your monthly payment depends on the current rate and loan balance.

HELOCS are similar to credit cards. You can withdraw any amount, any time, up to your limit. You’re allowed to pay the loan down or off at will.

HELOCs have two phases. During the draw period, you use the line of credit all you want, and your minimum payment may cover just the interest due. But eventually (usually after 10 years), the HELOC draw period ends, and your loan enters the repayment phase. At this point, you can no longer draw funds and the loan becomes fully amortized for its remaining years.

Compared with conventional mortgages, HELOCs offer more flexibility and lower monthly payments during the draw period. You can borrow as much or as little as you need – when you need it.

The potential drawbacks are the variable interest rates (which rise in tandem with the Federal Reserve’s prime rate) and the possibility that the monthly payments could skyrocket once the repayment phase begins.

In some house flipping situations, a HELOC could be a lower-cost alternative to a hard money loan.

But unlike a hard money loan, a HELOC could have more risk attached: if you don’t already own an investment property, you’ll secure the HELOC with your primary residence. If you default on the loan, the lender will foreclose on your home, not the investment property.

If you already own an investment property, you can overcome this problem by applying for a HELOC on one or more of those properties. The only trick is finding a lender.

Because many real estate investors defaulted during the 2008 housing bust, a lot of banks won’t approve home equity lines of credit that are secured by investment properties. The few banks that do offer these HELOCs make it much harder to qualify for them than they once did.

In many cases, lenders will set the LTV ratio at 75% or lower. They will also require a minimum credit score of 680 (versus 620 for a borrower who lives in the building).

Lenders will want to see lower debt-to-income ratios (30% to 35% for investment property borrowers versus 40% for someone borrowing against a primary residence). And, to nobody’s surprise, they will also charge higher interest rates or require you to pay 2-3 “points” upfront.

Expect to make a down payment of at least 25%.

Seller Financing

Once every third “blue moon,” you might be able to obtain seller financing for an investment property. Also known as owner financing, a land contract or a contract for deed, this is an arrangement in which the seller acts as the bank, providing you with a private mortgage.

Instead of the getting a traditional loan through a mortgage company or bank, you finance the purchase with the existing owner of the home.

Seller financing isn’t easy to come by. The vast majority of sellers want to be paid in full at the closing in order to pay off their own mortgages.

Also, a home can’t legally be seller financed unless it’s owned free and clear. Relatively few homes are owned free and clear. Most owners have some sort of mortgage.

Owner-financed land contracts are often structured on a 5-year balloon mortgage. This means they are due in full after just five years, no matter how much or how little the buyer has paid off.

Some come with 10-year amortization, meaning a schedule of payments that completely pay off the loan in 10 years. This option results in very high mortgage payments.

In some instances, seller financing might make sense for a house flipper. But in most cases, this type of loan is neither possible nor desirable.

Check current mortgage rates.

Getting the Best Property Investment Loan

We don’t know anything about your personal finances or the properties you may be considering, so we can’t offer specific advice on how to finance your purchases or structure the deals. That said, these simple tips should help you finance more property for less money:

• • Always shop around for the best rates! Contact multiple lenders, starting with the bank that issued your first mortgage, to compare interest rates and terms, as well as the closing costs and other fees.

• • Read the “fine print” to uncover any large fees and extra costs, including extra costs triggered by the number of existing loans/mortgages you already have.

• • Whenever possible, reduce the interest rate in exchange for a larger down payment. In some cases, it might also make sense to pay upfront fees (“points”) to lower the rate. If you apply for a big loan, and plan to hold the property for a long time, paying upfront fees and/or a higher down payment could trim thousands of dollars from your repayment total.

• • In the months before you launch your property search, check your credit report to learn which types of loans you qualify for. If your score is a bit anemic, takes steps to improve the score – e.g., by paying down (or paying off) as much debt as possible.

• • Be sure you have ample reserves of cash or other liquid assets. Six months’ cash reserves are usually required to qualify for investment property mortgages.

• • Consider your long-term goals to determine which type of loan would work best in your current, and a possible future, situation. For example, what would you do if your company made you relocate while you were in the middle of a fix-and-flip venture? Did you borrow enough to hire contractors to finish the job? (If so, by how much would that reduce your profits – and ability to repay the loan?)

• Determine how much property you can afford, and stick to your budget. First-time real estate investors frequently underestimate their costs. If you purchase only those properties you can afford, cost overruns may result in annoyance and a minor reduction of your profit margins. If you fall in love with a property and exceed your price caps, any additional expense may spell catastrophe.

Flip or Rent?

Should you flip houses or purchase rental properties?

Is one investment better than the other?

It all depends on your goals, and to what degree you can leverage your skills, expertise (construction skills are very helpful) and your current financial situation.

In general, house flipping is usually the bigger gamble because these deals hinge on whether property values will rise in the near future. Although price depreciation is never a good thing for property owners, stable and/or falling prices have less impact on someone whose main source of income comes from rents versus a fast resale of a property.

In mid-2017, the highest flipping returns were in Pittsburgh, at 146.6%; Baton Rouge, LA, at 120.3%; Philadelphia, at 114%; Harrisburg, PA, at 103.3%; and Cleveland, at 101.8%, according to ATTOM Data Solutions. These cities topped the list because they had lots of affordable, older homes that could be quickly renovated. At the same time, housing prices there were also rising.

For rental properties, the best markets in early 2017 were Cleveland, with an 11.5% annual return; Cincinnati, at 9.8%; Columbia, SC, at 8.6%; Memphis, TN, at 8.5%; and Richmond, VA, at 8.2%. The worst markets were generally located in the biggest cities on either coast, where real estate prices have long been sky high.

But local markets are always changing, so these statistics may soon be out of date – if they aren’t outdated already.

Like any other type of investment, real estate carries both risks and rewards. You can reduce the risks by thoroughly researching markets and your financing options, but you can never entirely eliminate them.

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