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Oct 10, 2022 PropStream

How to Finance a Rental Property

Purchasing an investment property is a great strategy to diversify your portfolio. However, investing in real estate often comes with high startup costs before you begin generating rental income. With the recent spike in mortgage rates and the ongoing rise in home prices, smart financing decisions are more critical than ever for investors.

There are several ways to finance an investment property, and the type of financing you choose will depend heavily on your current financial situation. Options include home equity loans, HELOCs, FHA mortgage loans, and more. Each method comes with its own unique set of terms and eligibility criteria. Before you approach a lender, it’s essential to understand how the different options work. 

Read on to learn which investment property financing option is right for you. Keep in mind, though, that before seeking financing, you should always consult a qualified financial professional.

1. Home Equity Loan

If you already own your home and paid off a significant amount on your primary mortgage, you may be able to use a portion of its equity to finance your rental property. The loan amount is based on the property's value, which an appraiser evaluates.

Because it's secured by the equity in your home, a home equity loan offers fairly low interest rates and repayment terms of up to 30 years. Keep in mind that the longer the term of your loan, the more interest you may end up paying on your primary residence. It's important to evaluate your total cost against the expected returns from the investment property.

Home equity loans typically have fixed rates and provide the funds in one lump sum.

2. Home Equity Line of Credit (HELOC)

what is a heloc

A home equity line of credit is another way to tap into the equity on your primary residence. A HELOC offers investors a revolving line of credit with a variable rate. Some lenders provide fixed rates for a set number of years.

Typically, a HELOC allows you to access up to 80% of your home equity. You can then use these funds to purchase a rental property and fund any necessary repairs.

Unlike a home equity loan, a HELOC lets you draw the money as needed, instead of receiving it as a lump sum. You can repeatedly draw and repay funds from the HELOC until the draw term expires, with only a minimum interest payment due each month. Once the draw period ends, you'll repay the loan over a set period (usually 10 to 20 years). The total cost of your loan will depend on how much you end up borrowing and how long it takes you to repay it.

Important: With both a Home Equity Loan and a HELOC, you must use your home as collateral in case you're unable to pay back the amount you've borrowed. We recommend careful planning and talking with a financial advisor before signing any contracts.

3. Federal Housing Administration (FHA) Mortgage Loans

If you’re considering purchasing your first property to live in for a short period before renting it out, an FHA mortgage loan is worth considering. An FHA loan is a government-insured home loan granted by a bank or other lender approved by the Federal Housing Administration. It's intended to assist those of low to moderate income in achieving home ownership. 

To meet the requirements of an FHA loan, you need to meet two conditions: You must live in the home within 60 days of the mortgage closing and stay in the home for at least one year before renting it out.

This type of financing offers down payments as low as 3.5% and a minimum credit score of 500. Depending on your credit, rates can be 0.5-0.75% lower than conventional loans.

4. 401(k) Loan

A 401(k) retirement account is one of the most popular ways to save for retirement. It's more than just a savings vehicle, though. You may be able to also use your 401(k) to purchase investment property by taking out a loan from your account. If you go this route, you can borrow up to half of your balance or $50,000 from your 401(k) — whichever is less.

You also have the option to withdraw all or a portion of your 401(k) to invest in a rental property. This can be expensive, though, as you'll be subject to taxes. Plus, a 10% penalty applies for early withdrawals.

Because of these withdrawal costs, borrowing may be the better option, However, when you borrow from your 401(k), you’re required to pay the money back within five years. And since you'll be pulling money out of the assets in your 401(k), your returns may suffer.

5. 1031 Exchange

If you're an investor with an existing portfolio, then you might consider a 1031 exchange. This method lets you defer capital gains tax on a property sold for business or investment reasons. However, you must exchange the proceeds for a new property purchased for the same intention.

The sale's proceeds are kept in trust by a third party before they're used to purchase the new property. You cannot receive the funds, even temporarily.

This strategy is popular among investors who wish to maintain higher levels of working capital. A 1031 exchange helps them expand their investment portfolio at a faster rate.

6. Seller Financing

what is seller financing

A seller financing agreement is a real estate contract that involves the buyer paying the seller in installments. Because of this, you don't have to obtain a conventional mortgage from a bank or other lender. Seller financing works similarly to a mortgage loan, but it allows the seller to own and manage the debt.
Seller financing offers several benefits to real estate investors. These include flexible terms, reduced closing costs, and greater accessibility for those with low credit ratings. Keep in mind that there are potential drawbacks, though. These include larger down payments, higher interest rates, and fewer rules to protect property buyers.

Do Your Research First

Investing in a rental property can be an exciting venture. However, most newer investors need a plan for financing as they often don't have the means to buy property in cash. It’s vital to do your research before you seek real estate financing to ensure the financing you choose supports your goals and resources.

If your financial foundation isn't firm enough to try financing a rental property, consider wholesaling instead. Wholesaling is the simplest form of property investment — especially for those interested in a low-risk, low-reward strategy. Consult a financial expert to see which method best fits your circumstances.

Published by PropStream October 10, 2022