If you are pursuing investing in rental property and you have no clue about financing, hopefully this article will shed some light on the subject for you. Your ability to obtain financing will be critical if you plan to use the bank’s money instead of your own.
There are two ways rental properties can be financed- through a commercial loan or through a conforming loan. A conforming loan means that it will meet fannie mae and freddie mac guidelines. These are typically obtained through a mortgage broker and they will typically be sold to the secondary market.
If you obtain a commercial loan, you will likely get it through a commercial loan officer of a bank. It will be the bank’s money used so typically your loan payment is made to them. Commercial loans are easier to obtain in many ways. The big difference between a commercial loan and a conforming loan is that a commercial loan is based more on the property and less on the individual’s personal finances, whereas a conforming loan is based more on the individual’s debt to income ratio and less on that particular property.
Think of it like this: with a commercial loan the bank is accessing whether or not the property is a good investment and can easily support the debt repayment. With a conforming loan the lender is asking if the individual has the total personal income to make the debt payments (part of the rent of the property is factored into that).
With a commercial loan they will typically ask for a minimum of 20% down and they will lock the rate in for anywhere from 5-10 years depending upon the lender. They will amortize the loan for up to 20 years typically. That means that the loan will balloon at the end of the rate lock (again 5-10 years) and will then be refinanced based upon the current interest rates.
With a conforming loan, they will likely ask for 25% down, but the rate can be fixed for 30 years and the payment amortized over 30 years. With these loans you have no worries about interest rates going up.
Here is what it takes to qualify for a conforming loan: decent credit score, debt to income ratio of less than 50% and some lenders want it even lower, a certain amount of reserves in your checking or savings account, and the property will need to appraise for at least the purchase price.
What is a debt to income ratio? What are reserves? The debt to income ratio, or DTI, is the total of all your monthly installment payments compared to your gross monthly income. Monthly installments include credit cards, car payments, mortgage payments, etc. Basically anything that shows up on a credit report. If your total monthly installments equal $2500 per month and you gross $6,000 in monthly income, your DTI ratio is 41.67% (2500/6000).
Reserves are a certain month’s worth of insurance interest, and taxes for the property you are buying. The lender will want to see you have a certain amount in your bank account. Keep in mind this is in addition to the down-payment required.
With a commercial loan the lender will want to see that the current rent will cover 1.25 times the debt. Some lenders like to look at capitalization rates as well. On the DCR (debt coverage ratio), if a house rents for $1000 per month and the monthly loan payment is $900 you would have a DCR of 1.11 (1000/900). A commercial lender will look less at your personal finances, but they will want to know you are in decent financial shape. They will likely ask for a current financial statement.
So which way is better? Here are the pros and cons of each:
Commercial loan Pro’s:
- much less documentation to submit to obtain loan
- can be done in your LLC and not your personal name
- no limit on number of units of property
Commercial loan Con’s:
- interest rate can only be fixed for a short period
Conforming loan Pro’s:
- interest rate can be fixed for up to 30 years
Conforming loan Con’s:
- cannot be in LLC, has to be in your personal name
- much more documentation to obtain loan
- harder to get loan as your personal finances matter way more
- can only do up to 4 units
- there is a limit on how many properties you can own
So which is better? Well it depends upon what your concerns are. I cannot get conforming loans anymore due to the number of properties I own. But if I still had the choice it would depend upon how concerned I am about interest rates. I like the idea of not having to refinance every 5-10 years. However, I do not like that a conforming mortgage has to be in my personal name. If liability is a concern (which it should be for everyone), a commercial loan might be a better option. I have done both over the years and you can be successful with either. The main thing is to find a good investment!