I waited for five months to hear back from the bank that they financially accepted my offer on the rental property: $85K!
All of my paperwork was completed, the inspection came out better than expected and the bank was even giving me 2% toward closing costs. In that moment, it appeared as though the entire acquisition process was going to be a smooth ride, until…
A week into escrow, my mortgage broker called to break the news: the underwriter decided I was “too risky” to fund the mortgage. I was back to square one and needed to find a new lender.
The next week was a nightmare.
I shopped my financial profile around to 20-plus institutions and not one of them could guarantee an on-time escrow closing. Luckily, after speaking with dozens of lenders, I found one company (a direct lender) that could make the deal happen. I raced the clock to get all the paperwork submitted with the new lender and had to extend escrow two more times before finally closing on the property.
Having jumped through all of these hoops, I vowed that I would never make the same mistake twice. Before I made my next rental purchase, I did extensive research on mortgage financing and took the time to develop a relationship with a dependable local lender.
Looking back on this transaction, I wish someone had shared with me the lesser-known aspects of obtaining rental property loans. Getting a mortgage is rarely an easy process free of hiccups and headaches, but getting a loan for an investment property can be every trickier.
Considering investing in real estate? Here are some things to know before you apply for a loan for that new income property.
Fannie Mae currently allows each investor to carry 10 loans at once. (Bored? You can read all about Fannie Mae’s investment mortgage underwriting requirements.) If you are working with the right lender, they can help you strategize both a long-term and short-term plan to ensure that you are taking advantage of your 10-loan limit.
It’s worth noting that many lending institutions will only lend up to four loans (typically the bigger banks). You’ll likely have to do a little leg work to find a lender that will go up to the 10-loan limit.
When purchasing rental property, an important aspect of your long-term success is developing a strong, reliable team – and your lender is BIG part of that equation. When I first began real estate investing, I made the mistake of using a broker who didn’t understand the investing landscape. As a result, I spent a lot of time trying to explain my strategy and objective. In the end, I ended up receiving a lot of bad advice and it almost cost me several deals. I could have easily avoided this had I worked with the right lender from the get-go, mainly a direct lender.
There’s nothing wrong with working with a mortgage broker when you are in the market to by a primary residence, but if you’re trying to build a portfolio of rental properties, I recommend you work with a direct lender.
The main difference between a broker and a lender is that a broker shops around your financial profile to their selected list of lenders, where as a direct lender is the institution actually lending you the loan.
When you work with a broker, you give up control. The underwriter can change lending standards (often during escrow) or decide that they want to pull out of the deal at the last minute. When you work with a direct lender, you’re in closer contact with the decision makers from the get go.
Before working with a lender, here are a few good questions to ask:
- Do you currently work with any active investors?
- How many loans can you offer to any one investor?
- Do you personally own any rental property?
As I mentioned earlier, Fannie Mae currently allows up to 10 loans per investor. A little known fact is that there are two different credit-qualification guidelines for obtaining these loans. The first is for properties 1-4 and the second is for properties 5-10, listed below:
- Loans 1-4: requires a credit score of at least 630
- Loans 5-10: requires a credit score of at least 720
In addition to the down payment, lenders will require you to have six months of cash reserves available per property.
This means that if you own a primary residence and you are going to acquire a rental, the lender will require you to have six months of mortgage payments (cash in the bank) for both your primary residence and your future rental.
Once you know the price point of the prospective rental you are considering, it’s a good idea to have a lender provide you with an estimated monthly payment so that you can save accordingly.
Just like there are two sets of guidelines for your credit, there are also multiple sets of guidelines regarding down payments, listed below:
- Loans 1-4 (Single family): 20% down
- Loans 5-10 (single family): 25% down
- Loans 1-10 (multi-family): 25% down (side note: many lenders will require you to pay 30% after loan 4)
Lenders will require a minimum of two solid years of w-2 income. They want to see that you’ve been at your job or working in the same industry for at least two years. The underwriter will calculate your annual income by averaging your past two years of gross income. For example, if this year you earned $100K and last year you earned $50K, your average annual income would be $75K.
If you are self-employed, you’ll need to provide two years of tax returns, a year-to-date profit and loss statement, and most likely a letter from your CPA confirming the validity of your previous tax returns. The calculation for your annual income is the same as the w-2 employee.
Contrary to popular belief, now is a great time to buy rental property. Many markets that were over-priced during the housing bubble have over-corrected and property can now be purchased far below the cost to rebuild – which can mean substantial cash flow (even with the costs of property management).
I initially began purchasing rental property as a way to diversify my wealth-building strategy. After I acquired three houses, I noticed that over the course of six months, my rentals were far out-performing my IRA and 401(k). I decided to pull my money out of the financial markets and reinvest it into building a strong rental portfolio. I’m not saying that this is a strategy everyone should employ, but I will say that anyone looking to build wealth should at least review the real estate investment vehicle.