Consumers are taught early on about the importance of saving. Saving for emergencies, saving for a financial cushion and saving to build wealth over time. Different financial advisors will say that how much of a consumer’s funds should be in stocks, bonds or cash depends upon the individual’s personal situation, years to retirement and so on.
But while the conversation centers around stocks or bonds or keeping the money in a bank account, what’s not mentioned as often is another investment- real estate. Real estate is typically a long-term hold strategy although there are those who look for undervalued properties, buy and repair them and flip for a profit. But over time, real estate can provide stability and long-term wealth accumulation that other investments cannot while at the same time providing a monthly cash flow. Stocks and bonds can increase over time but won’t be able to send a monthly check each month as profit.
Buying a rental property is much like buying a primary residence. Most of the rental investment financing options centers around residential conforming loans of the Fannie Mae and Freddie Mac variety. These options provide perhaps the most competitive in terms of interest rates and fees. Note here however that government-backed mortgage programs such as VA, FHA and USDA loans are only for primary properties, not investments. Rates and fees will be a bit higher compared to financing a primary a residence, but not by very much.
In general, a 30 year fixed rate program to finance a rental might be 0.50 to 1.00 percent higher than an owner-occupied property. That can translate to a higher interest rate in the 0.25 percent range. When doing that math, that’s really not all that much difference. Higher rates apply because lenders consider an investment property a greater level of risk compared to someone’s own home. The thinking is that should someone find themselves in some degree of financial straits, a rental property will be let go before someone’s owner-occupied property.
In addition to changes in an interest rate, borrowers can expect to bring a little bit more money to the closing table. Most conventional loan programs for rentals ask for a down payment of at least 20 percent of the sales price. You may recall that private mortgage insurance, or PMI, is required for most conventional loans if the amount financed is greater than 80 percent of the value of the property. However, PMI is not available for rentals, just owner-occupied units. That’s the reason for the 20 percent down payment. Borrowers can also get a slightly better rate with a down payment of 25 percent or more.
How do investors evaluate a particular property? The bottom line is cash flow while the secondary reason would be wealth accumulation. Few investors will buy a rental property and hold for the long term if the property doesn’t cash flow. The market rent for a specific property must exceed the financing costs including principal and interest, taxes, insurance and maintenance. If the cash flow is negative, the investor is likely to pass.
One final note, and an important one for would-be real estate investors. When buying and financing the first property, the rental income from the unit cannot be used to help qualify for a new mortgage. Instead, the buyers must be able to qualify without the benefit of rent and do so for at least two years. with any subsequent rental property purchase, income can be used to offset financing costs.