Why Are Loan Requirements Different for a Rental Property?

Written by Posted On Friday, 10 June 2022 00:00

One might think that a home loan is a home loan. And generally speaking that's correct. Lenders review a loan application and begin the approval process. The lender looks at qualifying income, credit and assets among other things. But overall the process is the same for most all types of home loans. But with a rental property, there are some things that are different when compared to a mortgage for an owner occupied unit.

The first thing one will notice is how much down payment is required for a rental. While a conventional loan asks for a minimum down payment of 5%, and even 3% in some cases, a loan for a rental property can be as high as 20% or more. And, interest rates for rentals are higher compared to a primary residence. Rates can be as much as 1-2% higher for a rental. Further, first time buyers are limited to a primary residence and not eligible to finance a rental as their first buy. A higher credit score will be needed for a rental as well.

So why is that? Why are there differences between loans for a primary residence compared to a rental unit? The answer is due to elevated risk.

The thinking goes like this: if someone gets into some pretty serious financial straits and starts having problems paying the bills, it's the rental unit that will be let go first. The homeowners need a place to live and if push comes to shove, the rental property will go first. If a foreclosure is in the picture, the primary residence stays and the rental is the one that will be foreclosed upon.

As a side note, these requirements are for conventional mortgages, not government-backed home loans. These types of loans, VA, FHA and USDA programs, absolutely require the property to be occupied. No non-occupant purchases are allowed. 

Okay, so how does a lender know whether or not a purchase is going to be a primary residence vs. an investment property? Well, first of all there is a box on the application that asks about the intentions of the purchase. Is the purchase going to be for a home in which to live or is the purchase used for a rental? The question is answered and the appropriate box is checked. Okay, so the next question is, how does a lender verify the loan is used for a primary residence compared to a rental? Good question but the answer is fairly basic. Lenders can find out who lives in the newly purchased unit simply by having someone make a quick stop by the home after the deal is closed, knock on the door and see who answers.

Loan terms for rental properties are a bit more difficult but really not by a whole lot. Lenders need to compensate for the additional risk of financing a rental unit and they can partially offset that additional risk with more down payment and higher rates. Getting rates and terms for a potential rental unit is as easy as picking up the phone and contacting a mortgage loan officer.

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David Reed

David Reed (Austin, TX) is the author of Mortgages 101, Mortgage Confidential, Your Successful Career as a Mortgage Broker , The Real Estate Investor's Guide to Financing, Your Guide to VA Loans and Decoding the New Mortgage Market. As a Senior Loan Officer and Mortgage Executive he closed more than 2,000 mortgage loans over the course of more than 20 years in commercial and residential mortgage lending. 

He has appeared on CNN, CNBC, Fox Business, Fox and Friends and the Today In New York show. His advice has appeared in the New York Times, Parade Magazine, Washington Post and Kiplinger's as well as in newspapers and magazines throughout the country. 

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