We often hear friends and colleagues talk about their investment property and how it brings them rental income every month while owning the property gradually over time as they pay off the mortgage.
It makes us wonder: “Can we buy an investment property too?” After all, it’s a great way to generate passive income with reasonably low risk.
Every time such a thought occurs, we also think of a lot of other questions instantly.
“How much money can I make every month?”
“Will I qualify for a mortgage?”
“Given the maintenance costs involved, does a particular investment property make sense?” “Can I afford to take that risk?”
All those are some very pertinent questions. And a lot of those entail doing a complete financial analysis, just like any other investment.
One should consult a duly licensed investment advisor before making an investment decision. This article is meant to be a primer to help you better prepare for the questions to ask and, whether and how you will qualify for a mortgage.
Benefits and drawbacks
Before you make any decision, the first thing to look at is the benefits and drawbacks of making the decision.
If the benefits outweigh the drawbacks, then it’s likely worth doing it. If not, it might not be a bad idea to talk to people who’ve done it. Cliché, but true.
So let’s talk about the benefits and drawbacks of buying an investment property. Once you have a clear sense of what they are, the decision will probably become a lot easier to make.
The benefits first
There are many advantages of buying an investment property. And that’s exactly why you hear so many people talk about it and buy one (or more). Let’s discuss them one by one.
The extra income that an investment property brings in the form of a monthly cash flow (as a rental) is perhaps the single biggest reason why so many people own investment properties.
If the property is in good condition and needs minimal maintenance, the income is primarily passive. That then makes this so much better because you have to do very little work.
Potentially Lower risk
Real estate is considered to be a relatively lower-risk asset. The prices don’t move around as much as stocks, for example. And for a lower risk asset, the return it can offer can be attractive.
Good Return-on-Investment (ROI)
The return on invested capital, or ROI, in a real estate investment is pretty good. The reason is that one can put in part of their own capital (down-payment) and borrow as much as 75-85% of the capital from a mortgage lender.
Every month, one expects to be left with some cash after paying off the mortgage and the expenses. This cash as a fraction of their own capital is the return on their investment, or ROI. Because they only invest a small amount of their own money (and borrow most of it), this return typically turns out to be effectively larger than if they had invested all of their own money to buy the property (i.e. without a loan).
What is equity accrual? When you make the mortgage payment every month, a fraction of that payment goes towards paying down the outstanding principal balance on the mortgage. That way you own a little more equity in the home every month.
Your equity in the home is probably only 15-25% in the beginning. But as time goes on and you pay down the principal gradually, you own a larger share of the property. At the end of the loan term, you own the property outright. In other words, not only did you get residual cash flow from the rent every month, you also made this additional return quietly behind-the-scenes (i.e. owning the 75-85% of the property that was not yours in the beginning).
Property ownership after the loan is paid off
Once you pay off the loan, you now own the property too. It can continue to generate income for many more years to come. With no mortgage to pay off, the continuing income goes up substantially more.
While you are pretty excited about the prospects already. But now might be a good time to discuss what the downsides of buying an investment property are.
There are a few, no doubt. But the fact that a lot of people do it goes on to indicate that the advantages outweigh the disadvantages for a lot of people.
Whatever decision you make in the end is not what is most important. What is most important is that it has to be an informed-decision. For that reason, we’ll outline the drawbacks and then let you decide based on all the information we provide:
One of the biggest risks when buying an asset is the risk of future devaluation of the asset and real estate is no exception. While we are currently in a sellers market in many regions in the US, there are also neighborhoods where the property value has declined over the last few years. It’s very important to do due diligence regarding future outlook of a property value and consult duly licensed real estate agents to help with that.
The biggest headache most people have with property is maintenance. That entails repair work, tending to tenant calls promptly and taking care of issues such a plumbing, electricity, replacements, etc.
All of this costs time and money. If you have some time and can learn a few handyman skills, it helps a lot. If not, you’ll have to hire someone and it can cost money.
That drags down your ROI. The repairs can sometimes be costly enough for you to have enough cash at hand at all times.
Listing and showing the property
When tenants leave, one big task is to re-list the property as available on rent. Again, that requires time and effort to get it rented out again.
Listing and showing does not require as much skill. Any informed homeowner should be able to do it without much problem. It also doesn’t cost as much, since a lot of websites allow you to list them for free.
Most new renters will expect all issues to be fixed, appliances working and a fresh paint may be. That can cost a little money.
What does take time is to show it. Again, not that bad if you are living in the same area.
This can be a little bit of a drag. It can sometimes take a month, or even more, to rent out the property.
Every day that the property is lying vacant is a cost because you still have to pay the mortgage, taxes, insurance and other expenses.
When doing the ROI calculation, assume 1-month of vacancy (or more if you want to be conservative) to see if the ROI makes sense.
Real estate is illiquid
One of the big issues with real estate is that it is an illiquid asset. While you can find buyers all the time, the costs associated with buying and then selling can be pretty substantial.
You’ll likely pay significant closing costs when purchasing, and then again when selling (in the form of commissions to buyers’ and sellers’ real estate agents). Unless you are sure about keeping the property for a long enough time, this might be a big factor to consider when buying an investment property.
Getting a mortgage for an investment property
Getting a mortgage for an investment property works a bit differently from an owner-occupied property.
That is because lenders have a lot more restrictions associated with an investment property loan. We discuss many of the restrictions below along with the reasons why they are there.
The interest rates for an investment property tend to be higher than those for mortgages on primary homes.
The main reason is that the default rates (or foreclosure rates) on investment property mortgages are historically higher. And to account for the additional risk that lenders take by making investment property loans, they demand additional return in the form of a higher rate of interest.
Higher down payment
While one can get a conventional loan with only a 5% down payment when they buy a primary home (or as little as 3% down with Freddie Mac Home Possible and Fannie Mae Home Ready programs), for an investment property, the down payment required is at least 15%.
With investment properties, multi-family homes with 2-4 units are quite popular and sought after. There the down payment requirement is even more, at 25%.
Some borrowers have explored owner-occupied duplex, triplex and quadruplex as a potential investment property route, renting out the non-owner-occupied 1-3 units.
FHA mortgages allow owner-occupied duplex, triplex and quadruplex properties with 3.5% down payment options. However, FHA mortgages carry significant upfront mortgage insurance premiums and monthly mortgage insurance costs, so it might not be ideal for your scenario. Reach out to discuss your scenario in detail.
Minimum credit score requirements
Fannie Mae and Freddie Mae do not have specific restrictions on the minimum credit score required for investment property mortgages.
But lenders often impose overlays on that and may have higher credit score requirements for investment property mortgages.
More reserves required
On a mortgage for a primary home, there are no minimum reserves requirements.
On the other hand, when you get a mortgage for an investment property, you’ll need 6 months of reserves.
If you have more than properties that you have financed, then depending on how many such properties you have, you could be required to have 2%, 4% or 6% of loan balance. Review Fannie Mae guidelines for more details on that.
Higher rates for PMI (Private Mortgage Insurance)
Because investment properties entail more risk for the lender, they can come with higher rates for PMI.
For the same down payment on two different properties (one being primary and the other being investment), the rates for PMI can be different, mainly because of the extra risk that investment property mortgages have
As far as taking cash out against a property you own, Fannie Mae guidelines allow you to take more cash against a primary home vs an investment property.
You can get a loan of up to 80% of the value of the property for a primary home. That same number is 75% for an investment property.
A word of caution on occupancy fraud
In the previous section, we outlined the differences between the mortgage for a primary home vs a mortgage for an investment property.
It is pretty clear that mortgages for primary homes are better in every possible way.
- Lower rates
- Lower down payments
- Less restrictive credit and reserves requirements
For that reason, there is incentive to not disclose the occupancy of the property correctly. If you are buying a property as an investment and the sole motive is to rent it out (rather than live there yourself), you should disclose it correctly.
Failing to disclose the true occupancy of a property can be construed as Occupancy Fraud and is a federal offense. It can trigger severe financial penalties, prosecution, and even prison time if convicted.
Is buying an investment property a good decision for you?
In the previous sections of this article, we outlined the pros and cons of buying an investment property. These are meant to help you make a preliminary assessment of whether an investment property is right for you.
Later, we highlighted the salient features of an investment property mortgage and what you should take into account.
For some of you, the advantages outweigh the disadvantages heavily, or vice-versa. In either of those cases, a decision to buy an investment property, or not, will be fairly obvious.
In many other cases, it may not be that clear. On top of that, you might also have additional questions about mortgage qualification or specific questions depending on your own situation
At Stem Lending, our goal is to help guide you in the right direction when making such decisions and provide you with as much information as we can to help make a sound decision.
We are here to answer any questions you may have. Or if you are ready to explore a mortgage quote, you can start one right away at: stemlending.com/quote