What Are the Best Ways to Finance Your Investment Property? Learn From the Experts

You can also use a ROI calculator if you prefer.

Understand the Market: Neighborhood Analysis

As a new investor, it’s a good idea to learn as much as you can about the market you’re interested in.

By conducting a neighborhood analysis, you’re crunching numbers to determine if a certain neighborhood is a good investment or not. It can also be used to help you determine how much you may be able to charge for rent. 

Note: A market analysis is comprised of estimates, not actual numbers. While it may not be 100% accurate, it can give you a good idea of what the local market is doing.

What Data Is Used In a Neighborhood Analysis?

The data you’ll want to look at when you’re conducting your analysis should include:

• Historical Data: You’ll want to review performance reports to see what’s been selling and at what price. You can gather this information from National Association of Realtors, US Census Bureau, and the Library of Congress .

• Construction Age: The age of the homes are going to play into property values. Newer homes are usually valued higher than older ones, with the exception of historic districts or homes that are registered in the National Register of Historic Places.

• Neighborhood and Amenities: The neighborhood and amenities will impact the market because most people don’t want to live out in the middle of nowhere or in a bad area. Property values will be impacted based on proximity to things like schools, public transportation, shopping venues, restaurants, and recreational activities.

• Employment Opportunities and Migration: Although some industries are shifting to a remote model, the job market is still an important factor to consider when looking at areas to buy investment properties in.

According to McKinsey and Company, 58% of surveyed Americans report they’re able to work remotely, either part-time (23%) or full-time (35%). As more industries embrace remote work, be it a hybrid model or fully remote, home prices are likely to continue to rise, according to The National Bureau of Economic Research.

Conventional Loans || Jumbo Loans

More than 78% of new homes purchased in the first quarter of 2022 were done with the help of a conventional loan serviced by a private lender, like a bank or a credit union. These loans are not backed by a government agency, but they may follow the guidelines put in place by Fannie Mae and Freddie Mac (which would mean they are a conforming loan). 

The Federal Housing Finance Agency sets a limit on how much borrowers of a conforming loan can borrow every year. 

“Conventional financing requires a down payment of 20% of the property’s purchase price. However, with an investment property, the lender may require 30%. A larger down payment could be a strong incentive and also provides the lender with greater security.” Mr. Capozzolo notes.

Benefits of a Conventional Loan: 

• Low Cost: Well-qualified borrowers often get a lower interest rate with a conventional loan, but that’s not the only savings. Once your property has 20% equity, you can ask to have the PMI removed. 

• Higher Loan Amounts: Conforming loans typically have higher limits than non-conforming loans. However, if necessary, you can take out a jumbo loan if necessary, but we’ll talk more about jumbo loans later. 

• Some Flexibility: Some private lenders may offer qualified borrowers a little more flexibility than they could get with a government-backed loan since they can set their own terms. 

Drawbacks of a Conventional Loan: 

• Higher Credit Score: To qualify for a conventional loan, lenders expect you to have at least a 620 credit score, which is higher than government-backed loans typically require.

• Higher Down Payments: There are some programs where first-time buyers can put 3% down (or none at all), or 5% if you aren’t a first-time buyer. 

• Stricter Qualification Requirements: Since the loan isn’t backed by a federal agency, lenders will put your financial situation under a microscope before making a decision. 

Jumbo Loans

If you need a loan larger than the conforming loan limits, a jumbo loan is an option. Mr. Capozzolo explains:

“A jumbo loan is designed for higher-end expensive properties that are not covered by conventional loans. A jumbo mortgage can give prospective buyers larger funds, provided that they can find a lender that offers one and meets the requirements. The conforming loan limit set by the Federal Housing Finance Agency (FHFA) is limited to $647,000 for the conventional loan.”

Benefits of a Jumbo Loan:

• Higher Loan Limits: Jumbo loans mean you can buy that $1 million multifamily property that otherwise wouldn’t be covered under a conforming loan.

• Single Loan: Instead of securing multiple loans to finance a large purchase, a jumbo loan is one single payment. This simplifies the accounting and, if needed, you could even use some of the funds from a jumbo loan to finance other life goals like sending the kids to college, consolidating debt, or paying medical bills, on top of buying a first rental property.

• Lower Down Payment: Although it’s a real estate myth that you have to put 20% down when buying real estate, that’s not always true. The same goes for jumbo loans. Some lenders will accept as little as 5% down, providing you meet their other requirements.

Drawbacks of a Jumbo Loan:

• Higher Interest Rates: A jumbo loan is considered high risk  because the amount is so large and it’s impossible for lenders to resell the mortgage as a mortgage-backed security. So, to offset that risk, it’s very likely that you are going to get a higher interest rate. 

• Excellent Credit: If you’re asking for a seven figure loan, you better believe that the lender is going to make sure you have an excellent credit history and that you have the means to repay that loan.

• Stricter Qualification Requirements: Jumbo loan servicers will have stricter requirements for the property you want to buy. They will require an appraisal and if the appraisal reveals that the property isn’t worth as much as you’re asking for, they won’t budge. So if the property is listed at $200,000 more than the appraiser values it at, you’re going to need to secure additional financing. 

Fix and Flip Loans

A fix and flip loan is geared toward investors who aren’t going to buy-and-hold their investments. These loans are perfect for those who are using the BRRR strategy and plan on selling their newly renovated property within 12 to 18 months. 

Typically these loans are used to purchase residential properties from homeowners who want to sell before the foreclosure process begins,  but the loans can also be used to fund house rehab costs, and other expenses you might incur when you manage a rental property. 

Benefits of a Fix and Flip Loan:

• Fast Funding: Instead of waiting weeks for a traditional loan to process and deposit money in your account, these loans can give you cash in your hand within a week. 

• Low Risk: Instead of putting your personal credit and property on the line as you would with a traditional loan, the only thing on the line is the property you want to buy.

• Flexible Loan Terms: Unlike with a traditional loan, fix and flip lenders tend to have more flexible terms and requirements. People who are unable to secure funding via a traditional lender, can still secure funds with a fix and flip lender. 

Drawbacks of a Fix and Flip Loan:

• Higher Credit Score: From a lender’s perspective, there is more risk involved with a fix and flip borrower. Therefore, the interest rates are going to be significantly higher than a traditional loan to offset that risk. 

• Higher Down Payments: “Qualifying for an investment property loan is challenging as lenders view investment properties to exhibit greater risk. Lenders expect a larger down payment for investment properties, generally between 20% to 35%,” Mr. Capozzolo says.

• Investment Property is Collateral: Unfortunately, if you default on your payments, the lender can take your investment property, finish the renovations, and sell it for a profit. 

Home Equity Loan || HELOC || Cash-Out Refinance

When you take out a home equity loan, you’re using your home as collateral and the amount you can borrow is determined by the value of your home.  With this type of loan, you’ll receive a large, lump sum of money that you can use however you see fit. 

 After receiving your loan amount, you’ll need to consider the terms of repayment because it will impact how much total interest will be paid. We recommend working out a monthly budget to see how much you can comfortably repay each month. See the example below:

Seller Financing (AKA Owner Financing)

Under seller financing, the investor will pay the homeowner in installments until the purchase price has been paid off.

With this type of financing, you won’t have to pay in cash right off the bat or take out a mortgage. Since this arrangement is made between the investor and the homeowner, the terms can be negotiated to suit both parties. 

There are four primary ways seller financing agreements can be structured: 

• Promissory Note or Mortgage: This structure is about the same as a regular mortgage. The buyer will sign a document that states the lender will hold a security in the property until the loan is paid in full. With this model, the buyer will get the title and the mortgage will be recorded with the local authorities.

• Deed of Trust: This is similar to the promissory note mentioned above. Under a deed of trust structure, the title of the property will be held by a third-party trustee. Once the loan has been paid in full, the buyer will receive the title free and clear.

• Contract for Deed: Unlike the previous two structures, a contract for deed means the seller will hold the deed and title of the property until the property has been paid in full. Once the terms of the arrangement have been satisfied, that’s when the investor will receive the title and deed.

• Lease-Purchase Agreement: A lease-purchase agreement (also referred to as rent-to-own agreement) is when the buyer will lease the property for a certain amount of time before settling on the final terms to purchase the property. If at the end of the lease period the buyer decides to go ahead and purchase the property, any rent that has been paid during the time will be used toward the sale of the property. 

Benefits of Seller Financing:

• Easier Path to Securing Financing: Instead of dealing with banks or other lending institutions, you’re dealing directly with the seller, which means borrowers may find it easier to secure financing that they may not have had access to with traditional lending options.

• Everything Is Negotiable: The appeal of seller financing is that the whole deal (down payment, repayment terms, interest rate, etc.) can be negotiated to suit both parties. 

• Reduced Costs: You can save hundreds of dollars by foregoing the home appraisals, closing costs, bank fees, and the like.

Drawbacks of Seller Financing:

• Existing Mortgage Problems: If the seller currently holds a mortgage on the property, there could be issues (liens or judgements)  that could cause a few bumps in the buyer’s road to loan repayment.

• Higher Interest: Unfortunately, the flexibility that comes with seller financing typically has a higher interest rate and shorter repayment terms. 

• Balloon Payments: Some sellers will include a balloon payment clause in the seller financing agreement. If this is in the agreement, the buyer may have to pay a large lump sum at some point.

Portfolio Loan

Unlike conventional mortgage lenders, a portfolio loan will stay with the servicer instead of being sold off to an entity like Fannie Mae or Freddie Mac. By keeping the loan, the lender can customize the underwriting requirements. Consequently, this means each lender may have their own guidelines. 

Portfolio loans are ideal for people who have experienced divorce, bankruptcy, or a previous foreclosure — all of which can be damaging to your credit history.

The trade-off for the flexibility of these loans, lenders may tack on higher interest rates, higher origination fees, and include prepayment penalties in the contract. 

Benefits of a Portfolio Loan:

• Relaxed Qualification Requirements: Since each lender will have their own rules, you may be able to secure financing that you otherwise may not qualify for. 

• Work Closely with Your Lender: You’ll be able to work closer with your lender for the entire life of the mortgage. They’ll know your situation, your goals, and offer advice when you have a problem or question about the loan.

• More Flexibility: Lenders can work out terms that typically aren’t seen with conventional loans. They may allow borrowers to apply for more money, have a lower down payment, and may be able to avoid needing PMI despite the lower down payment. 

Drawbacks of a Portfolio Loan:

• Higher Interest Rates: Lenders typically do not resell a portfolio loan, therefore they’re losing the opportunity to recoup their loss in the event that you default. To compensate for that lost opportunity, they may impose a higher interest rate.

• Higher Fees: Since lenders are generally more flexible with some of the underwriting terms, they might charge higher fees.

• Flexibility May Not Be an Option: Although portfolio loans can offer some level of flexibility, there may be some instances where the lender will craft underwriting rules that conforms to Fannie Mae or Freddie Mac standards. This would allow them the possibility of selling off the loan, therefore the borrower might lose that flexibility.

Land Contract

A land contract is a form of seller financing in that the deal is conducted between the investor and the seller.

The seller will agree to finance the property if the investor agrees to certain terms. Since the deal is between the seller and investor, the terms can vary widely from seller to seller. 

That said, with these types of contracts, the seller will keep the legal title until the land contract is paid in full.

As the investor is paying off the contract, they are building equity by way of an equitable title. This can be beneficial if the investor wanted to pay off the contract by getting a traditional mortgage.

Benefits of a Land Contract:

• More Relaxed Qualifications: It might be easier for those with low credit scores to purchase property when they deal with the seller directly to form a land contract. Also, borrowers can have time to improve their creditworthiness so that they can get a traditional loan in the future.

• Tough Market Be Damned: In markets where interest rates are on the rise and credit isn’t given so easily, a land contract may be your chance to purchase property that you may not otherwise be able to otherwise.

• No Traditional Lender: Since the deal isn’t being financed via a traditional lender but through the seller directly, there’s more flexibility and room for negotiations.

Drawbacks of Land Contract:

• Fewer Protections for the Buyer: Unlike traditional financing, land contracts lack the provisions that protect the buyer. For example, if the buyer misses one payment, they could be evicted quicker and lose all the payments they have made toward paying off the contract.

• Buyer Could Lose the Property: If the seller is still paying on an existing mortgage on the property, you are at risk of losing the property if they default. 

• Higher Fees and Interest: Unfortunately since you’re agreeing to a land contract, the seller can assume that you were denied traditional financing. To them, you’re a high risk borrower, therefore they may charge you higher origination fees and interest rates.

1. Research, Research, Research

Mr. Capozzolo advises: “Aspiring investors must be aware of the pros, cons, and due diligence associated from beginning to end. 21% of aspiring investors show their cards by not being aware of the market conditions.”

“My professional advice would be to conduct research and due diligence in depth regarding the investment property, physical features, market growth, and future trends. They must also be aware of who they are getting into business with. Around 10% of new investors don’t take verifying the other party into heed and end up on the wrong side of the business.”

2. Check Your Credit Report

Your credit score and credit report is an important, perhaps the most important, factor lenders look at when determining your creditworthiness.

It impacts the interest rate you’ll get, what type of loans you qualify for (if any), and repayment terms. The minimum credit score most lenders will work with is 620, but you can find some lenders who’ll work with borrowers with poor credit.

You can get a free credit report from all three credit unions by going to AnnualCreditReport.com. You’ll be able to review your full credit report, check for inaccuracies and dispute anything that you don’t recognize as your debt. 

Between now and when you actually receive the funds, keep paying your bills on time, don’t take out any more debt or incur a lot of credit card debt, and don’t quit your job!

3. Pay Down Existing Debt to Lower Your DTI Ratio

If your DTI ratio is higher than 40% (yes, 43% is the industry standard, but it’s always better to be safe with a lower DTI than to be sorry), you’ll want to work on paying down that debt. 

Some ways you can pay off your debt quickly include: 

• Paying more than the minimum payment
• Pay more than once per month
• Pay the debt with the highest interest rate first
• Consider using the snowball method
• Consolidate debt

4. Have an Emergency Fund for Surprise Expenses

Sometimes lenders will require that you have a sizable amount of cash in savings in case of an emergency. The amount of cash reserves you’ll want to have will depend on your investment goals, your budget, and the type of loan you’re trying to get approved for.

Some lenders only require three months of mortgage payments worth of savings, while others will require a full year’s worth of mortgage payments. Experts, on the other hand, recommend having three to six month’s worth of total living expenses on reserve. 

5. Determine Your Budget

In order to apply for a loan, you first need to know how much you can afford to borrow. Housing is the largest monthly bill that Americans have — it’s recommended that no more than 30% of your gross monthly income goes to housing, but on average, that figure is more around 35% (or more!) on average. 

When you’re trying to figure out how much you can afford to borrow, you’ll need to consider upfront costs and recurring costs. 

Upfront Costs:

• Down Payment (if necessary)
• Closing Costs
• Cash Reserves 

Recurring Costs:

• Landlord insurance
• Property Taxes
• Property Management Fees (if applicable)
• Vacancies
• Homeowners Association Fees
• Maintenance and Repairs

6. Gather Necessary Documents

Most lenders will require that you provide them with a bunch of documents for them to review with your application. The most common documents you’ll need to supply include: 

• Two years worth of tax returns
• Pay stubs, W-2’s, 1099 forms, direct deposit statements, and other forms of proof of income
• Bank statements, investment statements, and retirement statements
• Letter explaining negative marks on your credit report
• Letters from someone who has gifted you money to help fund your purchase
• Photo ID
• Renting history and references

7. Apply with Different Lenders within a 14-Day Window

Did you know that there’s a 14-day window where you can apply for loans with different lenders without hurting your credit score? When you submit mortgage applications with different lenders in that period, it will only show as a single hard credit inquiry. 

That said, you’ll want to shop around for a mortgage to find the lender with the best terms. Some lenders will have more relaxed qualification requirements, while others may offer lower interest rates. This is your chance to cast your net wide!

8. Review Offers and Choose the Best 

As you hear back from lenders, don’t go with the first one who says that you’ve been approved. You’ll want to go through the offers to see which lender has offered the best terms. Pay close attention to interest rates, closing costs, and prepayment penalties. 

Debt-to-Income (DTI) Ratio

The percentage lenders use to determine how much of your monthly income goes toward making debt payments. You can use a DTI calculator to figure this out or use the equation:

(Total Monthly Debt) / (Gross Income) x 100 = DTI

Private Mortgage Insurance (PMI)

To protect themselves, some conventional loan servicers may require that you take out a private mortgage insurance (PMI) if you don’t have an adequate down payment. Sometimes PMI is paid in one lump sum at closing, but usually the premium is rolled into your monthly mortgage payment.

You can use a PMI calculator to determine how much you’ll pay over the life of the loan. However, once you have accrued 20% equity in the property, you can remove the PMI, thus saving you a little bit of money.

Fannie Mae and Freddie Mac

Fannie Mae and Freddie Mac are organizations that were created by Congress to “provide liquidity, stability, and affordability to the mortgage market.” These organizations buy mortgages from lenders and will either hold them or resell them as mortgage-backed securities.

Conforming Loan

A conforming loan meets guidelines set by Fannie Mae and Freddie Mac, but they aren’t backed by the federal government. Conforming loans are readily available and they often have lower interest rates and fees. That said, to qualify for these loans, a borrower must have good credit and a low DTI ratio.

Non-Conforming Loan

A non-conforming loan does not follow the guidelines set by Fannie Mae and Freddie Mac. These loans typically exceed the maximum loan limit for an area; but, there are other reasons a loan could be considered non-conforming, like being backed by the government like FHA, VA, and USDA loans. 

After-Repair Value (ARV):

This is a term often used by investors who buy flip houses or use the BRRRR method of real estate investing to figure out the property’s value after renovations have been completed. The ARV is also used to secure certain types of loans.

You can use an ARV calculator to figure out the property’s ARV value or you can use this equation:

Property’s Current Value + Value of Renovations = ARV

ARV can also be used by investors when they’re submitting an offer on a property that needs work. They use something called the 70% rule where they will use the ARV and cost to make the necessary repairs to come up with their offering price.

You can use a 70% calculator to figure out your maximum offer price or use this equation:

(ARV x 70%) – Estimated Cost for Repairs = Maximum Offer Price

Loan to Value Ratio (LTV):

When applying for a home equity loan, HELOC, or cash-out refinance, lenders will use this ratio to determine the amount of risk they’ll take on should you default. Higher LTV ratios won’t disqualify you from being approved for funding, but you will have a higher interest rate and may need PMI. 

You can use an LTV Ratio calculator to figure out the LTV ratio on your property, or you can use this equation: 

Mortgage Amount / Appraised Property Value = LTV Ratio

After taking the time to really think about your goals and how you’d like to achieve them, you’ll want to look into the area that you’d like to begin investing in.

By researching the local market, you’ll be able to see what properties are being sold for, how active the market is, and there’s a demand for rental properties. Fortunately, that’s not an issue considering 36% of households in the United States are renters. Even if you prefer to fix and flip, the demand for housing is there. 

Once you find the area you’d like to begin investing in and you’ve found an investment opportunity, you need to figure out which financing option is right for your situation.

There are many options out there and it’s in your best interest to research all of your options before making any concrete plans because you don’t want to fall victim to predatory lenders who will foist high interest rates and strict repayment conditions on you. 

Our goal with this guide was to provide you with easy to digest information regarding the different financing options available to new investors.

If you need some more in-depth advice about how to finance an investment property or have questions about investments in general, you can always count on New Western’s experts for great advice.