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What qualifies as an investment property?

Before you sign a Purchase Agreement, you may need to make sure you have good financing for buying an investment property. As you look at your loan options, the first step is often defining what qualifies as an investment property. At its most basic, an investment property is real estate you buy to earn money by making a profit on your investment. These profits may come from rental income, a higher future resale value, or both.

An investment property is typically not a second home. Unlike a second home, investment properties often let you earn income from one or more tenants. Commercial property can also be investment property. Corporations, investment groups, or individuals can buy investment property.

What options are available to finance investment property?

Many investors are not sure how to decide what type of loan is best once they decide to invest in real estate. Investors usually have options when it comes to borrowing money, and the right type of financing depends on your unique situation.

Will you be working with a partner or group of investors, or will you do it alone? If you are working with other investors, you may be able to get a private money loan. Other common financing options include conventional bank loans and hard money loans.

What is a private money loan?

Private money loans come from people or companies that are willing to invest their money if you give them some of the profits later. They might be someone you already do business with, which can make it easier to get a loan with a low interest rate and good terms.

A Promissory Note usually backs private money loans. The note is a legal document that binds you to pay the loan back in full and on time. If you do not, the lender may be able to claim the property, force a sale, or take other legal action.

If you are new to real estate investing, you may not know anyone who can connect you with private money lenders. The key to attracting these lenders is writing a convincing plan that answers most of their key questions. These include:

  • When will they get their money back?
  • What are the risks that could prevent you from paying them back?
  • Why should they invest in your project?
  • How well did you research the plan for the property?
  • What will they get if you do not pay back their investment?

Once you can answer these questions confidently, it is time to work with people you know in the real estate industry. Real estate agents, lawyers, private investors, and title companies may all know private lenders who are looking for projects to invest in. If there are no private lenders in your business circle, you might try looking outside the real estate industry. Friends, coworkers, and even family members may know a new investor who is waiting for the right chance.

What is a conventional bank loan?

Maybe a private money loan is not an option for you. Most investors use conventional bank loans, which are simply normal home loans. However, these loans are harder to qualify for when you plan to use them for investment property than when you are just buying a home.

Loans for investments are usually more risky for lenders. Often lenders want you to prove you are financially strong enough to pay the mortgage for both your own home and an investment property. Conventional lenders often try to lower this risk by requiring a larger down payment or raising the interest rate.

What is a hard money loan?

If you need another option besides private and conventional loans, some companies provide loans designed for real estate investment. These are called hard money loans, and they are often easier and faster than a conventional bank loan. Hard money loans typically base approval on the value of the investment property instead of on the investor's credit score and income. These loans are usually better for investors who are planning to flip a property quickly rather than collect rental income.

Hard money loans are designed to be short-term, usually around three years. Investors sometimes use a hard money loan when they have to move quickly to buy and resell a property. Often, hard money borrowers try to find other financing before the loan term ends.

Is it hard to get financing for investment properties?

As the real estate market continues to boom, investors have lots of options for financing investment properties. But lenders are still taking on a big risk with these loans. There are steps you can take to make sure you get the best possible financing options:

  1. Be the kind of borrower  that banks want. These borrowers have a great debt-to-income ratio, a high credit score, and a strong business plan to make sure the investment property earns a profit.

  2. Be ready to make a bigger down payment. Bank loans often require at least 20% down before giving you a loan for investment property. If you have 25%, or even 30% as a down payment, it can give you more skin in the game and often leads to better loan terms.

  3. Set up a network of lenders. Networking in the real estate industry is one of the best ways to find private investors who may offer the best loan terms.

In short, it can be harder to get a loan for an investment property than for a traditional mortgage. It often requires more than meeting the usual credit score, debt-to-income ratio, and down payment requirements. You may need to show lenders a good employment history as well as any experience you have had as a landlord or real estate investor.

What is the difference between financing a rental property and financing your home?

Lenders see rental properties as having a higher risk of default, or failure to repay, than primary homes. These risks mean lenders often charge higher interest rates for investment property loans. The final interest rate typically depends on how good your credit is, but it is often higher than the interest rate on your mortgage.

Most lenders require a down payment of at least 20% of the purchase price for investment properties, and some may require 25% or more. A larger down payment can often help you qualify for a better interest rate.

A credit score above 740 is usually high enough to help you get most loans on an investment property. If you have a lower credit score, you might have to jump through more hoops to qualify for a loan. A lower credit score also means you may have to pay a higher interest rate.

Some lenders may require you to put money into a reserve fund. These funds hold six months or more of mortgage payments, plus enough to cover taxes, maintenance, and other expenses for your rental property. A required reserve fund is meant to keep you from relying only on your rental income to make mortgage payments. It can also help lower the risk of default on a loan. Some lenders may even offer a better interest rate if you set up a reserve fund.

Before you agree to the purchase terms or sign any loan documents, it is a good idea to ask a Legal Pro any legal questions you may have. A Legal Pro can help you get the best terms possible and help you spot any tax benefits you might get from an investment property.

This article contains general legal information and does not contain legal advice. Rocket Lawyer is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.

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