You get it. No more convincing needed.
You understand there are multiple ways real estate creates spending money plus long-term wealth. You have a multi-decade outlook on your rental properties. You have even come to terms with the idea that smart leverage is the best way to earn huge returns in the long-run.
Now what? You are going to need to know if you qualify for a loan.
What should you know about rental property loans?
Investment Property Loans
A loan is just someone giving you money for a set future return. There are an infinite number of ways this can be accomplished, but we are going to just talk about conventional loans.
“But I heard I could get a better deal on owner-financing or approved for more loans through something called hard-money lending … why limit ourselves?” It boils down to risk, effort, and repeatability, but we won’t get into that here.
Conventional loans are given by banks and secured by the property itself. So if you stop making payments on your property, the bank has the right to take over ownership. That is fair considering they own more of it than you and you didn’t keep up your end of the bargain.
What are the requirements for these types of loans?
A Moving Target
The requirements change over time. Most banks follow Fannie Mae’s guidelines, although there is some room for interpretation. The guidelines change too throughout the boom and bust cycle: what was allowed in 2007 is not allowed in 2016.
Here is the starting place for what you will need in 2016:
- 630+ credit score
- 20% down payment
- 2 years of tax returns in the same industry
- 6 months of cash reserves
- <36% monthly debt-to-income ratio
And that is just for the first 4 properties. After that the rules change. Let me clarify the last two requirements (to the best of my understanding) because they are kind of confusing.
6 Months of Cash Reserves
You need cash in the bank to be able to pay all your mortgages for 6 months, including the new mortgage you are applying for plus taxes and insurance. This is just smart anyway – as much as I love rental properties, you don’t want to stretch yourself too thin.
If you are interested in your first $100k property, the monthly payment is likely around $600. Add to that your primary residence (if you rent, take your rent amount). For this example let’s use $1000. So you need $1600 times 6. $9600.
The good news is that these cash reserves don’t have to be all cash. If you have a stock account, 65% of its total will count (they adjust for volatility). If it is an IRA or something you would owe tax on, you will probably have to reduce that from the total as well. In addition, only half of the cash reserves can be from these illiquid stock accounts.
So back to the example where you need $9600 for cash reserves. $4800 will need to sitting in a checking or savings account (or even combined across accounts). If I have an IRA with $10k, I believe roughly $5k will count towards the cash reserves after accounting for the volatility hit and tax if you have to access it.
The debt-to-income ratio (DTI) is possibly the most difficult part of qualifying for a rental property loan. Even folks with well paying jobs and lots of cash sitting around still can’t have too many debt payments.
One important thing to point out is that DTI is about the monthly payments, not about the total amount of debt you have.
First add up all your monthly debt obligations. This includes car payments, student loans, and the minimum payment for each credit card. Add all your mortgage payments including tax, insurance, and HOA (if you rent your primary residence, just take your rent). Be sure to include the new loan you are applying for – it shouldn’t push you past the limit.
Now figure out your monthly income before taxes. The day job should be pretty easy, but the rental property income is a little trickier. I believe if it is on the previous year’s tax return, you take the rental income and average it across 12 months. For the new property or new lease agreements, you can use 75% of the total monthly rent.
Let’s run through some example numbers. You have:
- Primary mortgage or rent payments of $1250
- Car payments of $250
- Student loan payments of $400
- 4 different credit cards each with a minimum payment of $25
- A previous investment property with payments of $600
- The new investment property will also have payments of $600
So before the new property you have $2600 per month in debt obligations. After you have $3200.
Add up your income:
- Job that pays $100k, or $8,333 a month
- Rental income on your tax return of $1200 over the last year, $1k a month
- New rental with lease of $1k in place, take 75% of that so $750
Your monthly income before the new rental is $9,333. After is $10,083.
Your ratio before the new loan: 28%
Your ratio after the new loan: 32%
Talk to Someone Who Knows More Than Me
This is intended as an overview of qualifying for a rental property mortgage. I am not an expert and I don’t even play one on the internet. There are thousands of lenders out there who work with investors, you should talk to someone about the specifics of your situation.
I am self-employed which surprisingly complicates things. No matter how much money I had sitting in a bank account, I wouldn’t have been able to get an investment mortgage my first two years after starting my company. They needed to see two years of tax returns to count any of my income. I would not have known that without talking to a lender, so could have put in a lot of unnecessary work to find a property I wouldn’t have been able to purchase!
If you are considering investing in rentals, talk to a lender now.
If you haven’t invested in a rental before, how are you going to take the next step? How about a short phone call with a lender?
If you have invested, what was the most surprising part of the investment mortgage qualification process for you?