If you plan to hold residential investment property for the long term, whether as a rental, lease option, or seller financed resale, you’re probably going to need investment or rental property mortgage financing from a traditional bank or mortgage lender.
There are a variety of money sources you can use to finance your deals, but traditional bank financing is best suited for long-term investment because it typically offers the lowest rates and longest terms. Other money sources such as hard or private money typically want their money back in less than a year. Though the rates and terms are usually the most favorable, traditional bank loans also tend to be the most complex to get – if you don’t know how to “groom” your financial profile to fit what the banks are looking for. My job as a loan consultant is to help you do that.
The key to getting traditional bank financing is preparing yourself ahead of time to fit the profile of what the bank is looking for. In other words, as you’re getting into your deal with hard money, private money, etc., you need to be thinking about the financing needed to exit the deal.
The following is a general overview of the basics of traditional bank financing. Taking the time to understand the basics will not only help you maximize the ROI of your investments, it will help push you ahead of your competition.
For purposes of this article, traditional bank financing (TBF) is your typical mortgage financing offered through a mortgage lender or bank for 1-4 unit residential properties (5+ units is considered commercial). Because most investment mortgage financing these days ultimately comes from Fannie Mae or Freddie Mac, TBF guidelines will be pretty close to the standard Fannie and Freddie guidelines. When banks fund mortgages, they’re often sold on the secondary market to Fannie and Freddie so the banks can quickly replace their capital and continue funding loans.
Mortgage underwriting criteria falls into three general categories called the “three Cs”: credit, capacity and collateral. Let’s take a closer look at each of these categories.
Credit: Your credit scores are an important part of qualifying for a mortgage loan, so it’s important to keep your credit in good shape by not over-utilizing open credit card accounts, making payments on time, and clearing up errors quickly.
Scores below 620 are generally considered to be “bad” credit and scores above 720 are considered “good” credit. Everything in between is middle of the road or “fair” credit.
Ideally, you want to have all three scores in the mid 700s or better to get the best traditional bank financing terms. Mortgage lenders will typically use the middle of the scores on a “tri-merge” credit report pulled from the three major credit bureaus.
Capacity: Capacity refers to the borrower’s ability to make the payments on the loan. The underwriter will determine a borrower’s capacity to repay the loan by analyzing employment, income, assets, and debt levels.
Whether you're self-employed or a W2 wage earner, the underwriter is typically going to want to see steady and gainful employment in the same line of work for at least the last two years. If you've changed jobs during the last two years, that's not necessarily an issue as long as you're in the same line of work as before.
The underwriter will calculate a debt-to-income ratio (DTI) based on your income and outstanding debts. Fannie Mae guidelines generally allow a maximum DTI of 45%, but will occasionally go to 50% under limited circumstances.
Assets in reserve are a big part of qualifying for TBF, particularly if you are financing rental property. The following are the most important guidelines regarding reserves:
Collateral: Your collateral, meaning the property being financed , is obviously a big consideration in the underwriting process. The type of property, whether it’s a single-family home, condo, duplex, triplex, or fourplex, has a bearing on the rate and fees associated with a traditional bank loan. Muti-family buildings are considered riskier than single-family homes, so be prepared to pay higher costs and rates if you're planning to buy these. Condos are more of a minefield these days as well, so be sure to work closely with your mortgage consultant if you're shopping for condos to make sure he can lend on them.
For investment property loans, the maximum loan-to-value allowed under traditional bank financing is typically around 75%. In other words, you won’t be able to borrow more than 75% of the value of the property (potentially less, depending on the property type). If you’re purchasing investment property with TBF, this means you need to plan on putting down 25% of the purchase price.
It's possible to go to 80% loan-to-value (meaning come in with 20% down), but I don't recommend it. The pricing tends to be much worse than if you come in with 25% down.
It’s important to note that investment property rates are significantly higher on average than rates for owner occupied properties because Fannie recognizes the increased risk of investment property loans. Expect to pay at least 1% more than the prevailing owner-occupied rates.
Back in the heyday of the housing boom, it used to be possible to purchase a beat-up property with hard money, rehab it, and immediately refinance at the new value and get cash out. Not anymore! Today, Fannie requires that you own a property at least 6 months before you do a cash out loan and the LTV is limited to 70% to 75% LTV. There are some ways to get around this issue, but it takes a little planning ahead. Feel free to contact me and I can discuss with you further.
Again, this is just a general overview. There’s a lot more that goes into an investment property loan and guidelines can change at any time, so it’s important to consult with a qualified mortgage professional. Have questions? Want to get qualified for an investment property loan? Give me a call or request a call back! I’m happy to answer any questions you may have.
If you haven't already, grab a copy of my FREE report about how to finance investment property with a traditional bank mortgage. There is a lot more detail in it than what I've presented here.