What Type of Loan Is Best for Investment Property

To purchase an investment property, you'll likely need to obtain financing. From traditional banks to private money lenders, numerous sources of real estate financing should be available to you. There are also many types of loans and choosing the right one is crucial for maximizing returns and minimizing risks. 

Why Choosing the Right Loan Matters

Choosing the right loan is necessary to ensure you make a successful investment. The loan you choose can impact cash flow, long-term investment success, and profitability. It also affects interest costs, the ability to scale a portfolio, and your monthly payments. 

For example, let's say you receive an interest rate that's higher than the national average. In this scenario, your monthly mortgage payments will also be high, which can negatively impact the property's cash flow. 

Keep in mind that certain loans come with stricter requirements or different tax implications. The terms of VA and FHA loans are typically less restrictive than conventional mortgages. 

Risk tolerance and investment strategy can also influence your loan choice. If you have a higher risk tolerance and want to utilize a short-term investment strategy, you may benefit from a DSCR or hard money loan. 

Common Types of Loans for Investment Properties

There are many types of loans available for investment properties. To determine what type of loan is best for an investment property, weigh the pros and cons of each.

Conventional Mortgage

Conventional mortgages are effectively governed by Freddie Mac and Fannie Mae, which means that they aren't backed by the government. These mortgage loans are available from local and national banks. Even though they need to conform to specific guidelines, they aren't required to have the same terms or interest rates. Each bank or financial institution can set its own terms as long as they fall under the guidelines.

Conventional loans are available as adjustable-rate and fixed-rate mortgages. If you use an adjustable-rate mortgage, you'll likely pay a fixed rate for an initial period of three to five years, after which the loan will move to a variable rate. It can be more challenging to be approved for a conventional loan if you're investing instead of using the home as your primary residence. You'll also need to provide at least 15-20% as a down payment to gain approval.

FHA Loans

FHA loans are backed by the Federal Housing Administration (FHA). They are available to lower-income buyers, which is why they often have reduced interest rates. Borrowers who qualify may also benefit from a lower minimum credit score, flexible DTI requirements, and reasonable down payment guidelines. 

Keep in mind, however, that an FHA loan doesn't support single-family rental investments. If you purchase a multifamily property, you can live in a unit to meet the loan's residency requirements. You only need to live there for a year to meet these stipulations. Mortgage insurance is necessary to gain approval for an FHA loan.

VA Loans

A Veterans Affairs (VA) loan is available to veterans and active military members. If you qualify, you may be able to invest in a property without paying for insurance or making a down payment. If you've been wondering how to buy your first investment property with no money, a VA loan may be your best option.

Closing costs and interest rates are also low. However, you can't use this loan to buy a property solely for investment reasons. The residency requirements are similar to those of an FHA loan. If you purchase a multi-unit property, you can rent out any excess units as long as you also live there.

DSCR (Debt-Service Coverage Ratio) Loans

A debt service coverage ratio (DSCR) loan is designed specifically for real estate investors. It measures the property's potential net operating income (NOI) when determining if an application should be approved or denied. 

A larger DSCR ratio indicates that the property has a high net operating income and will be able to service the debt. This ratio also dictates the maximum loan amount that you'll be approved for. The main advantage of a DSCR loan is that lenders care more about a property's cash flow than the borrower's income. 

Hard Money Loans

Hard money loans are available for many types of real estate strategies but are commonly used for fix-and-flip investments. The approval times for hard money loans are much quicker than conventional ones. Lenders don't thoroughly review your financial history and credit score. Instead, they look at the details of the property as well as any collateral you provide. The drawbacks of applying for a hard money loan are shorter terms of six to 12 months and higher interest rates.

Portfolio Loans

A portfolio loan has many of the same characteristics as a hard money loan. If you're approved for this loan, it will be retained by your lender, which means that it won't be sold to the secondary market. The advantage of this approach is that you may receive more flexible loan terms. Lenders that underwrite and keep portfolio loans are able to set their own standards and terms. You may receive simpler qualification requirements or more customized loan terms. However, interest rates are usually higher than standard financing options.

Commercial Loans

Commercial loans can be used to invest in storefronts and many other types of commercial properties. If you own a business or have created an LLC, you may qualify for this type of loan. The term for a commercial mortgage can range from five to 20 years, which is less than what you get with a conventional loan. Along with a minimum credit score of 660, you might need to provide a down payment that ranges from 20% to 30%.

Key Factors to Consider When Choosing a Loan

When you start searching for the right loan, there are many factors to consider, which include everything from your current credit score to your investment goals. For example, a minimum credit score of 620 is necessary if you wish to qualify for a conventional loan. However, a lender may only approve a mortgage loan to a borrower with a 620 credit score if they make a down payment of 25% or more. The minimum credit score for FHA loans ranges from 500-580, depending on the down payment amount.

Your down payment plays a critical role in determining your loan terms. For many types of loans, a 20% down payment allows you to avoid paying for private mortgage insurance (PMI). It can also help you obtain a lower interest rate. Each type of loan has different down payment requirements. 

For example, a minimum down payment of 3.5% is required for an FHA loan if you have a 580 credit score or higher. If your credit score is between 500-579, you must make a 10% down payment. For conventional loans, a 20% down payment may be required when buying an investment property.

It's also a good idea to consider the type of property when looking for the right loan. The top investment property options include single-family, multifamily, and commercial. If you wish to invest in a commercial property, you may need a commercial loan. A wide selection of loans is available to investors who wish to add single-family or multifamily properties to their portfolios.

Identify your investment goals before selecting a specific type of loan. Let's say that you're looking to buy and flip a distressed single-family home. For a short-term investment strategy like flipping, consider hard money loans or bridge loans, the latter of which serves as temporary financing until you obtain a permanent mortgage. If you're investing in long-term rentals, DSCR and conventional loans are ideal. 

Your preferred lender may also consider your income and debt levels. Lenders for most types of loans want borrowers to strike a good balance between their debt and income levels. You may not be approved for a conventional loan if your debt-to-income (DTI) ratio is higher than 45%. On the other hand, DSCR loans focus more on the income the property generates than your personal income.

Keep in mind that your experience level as an investor might dictate which types of loans are available to you. Conventional lenders may not approve loans unless borrowers show proof that they have already bought investment properties in the past. You may also receive less favorable terms if you're new to investing.

Tips for Getting Approved

If you'd like to increase your chances of being approved for your preferred type of loan, there are numerous steps you can take. To improve your current credit score, start by making every payment on time. Your credit score can be impacted significantly by a late payment. 

If you have existing debt that's weighing down your credit score, begin paying it off slowly. It's also a good idea to avoid applying for new loans or credit cards in the months before you seek investment property financing. If you find errors in your credit report, dispute them. You can also improve or maintain your score by keeping your credit utilization at 33% or below.

Consider saving for a higher down payment as well. If you can increase your down payment to 20% or 25% of the property's total sale price, you'll benefit from more favorable terms and access to better financing. 

Before you apply, prepare full documentation, which includes your income and assets. You'll also need to provide the lender with extensive details of the property. You may have an easier time finding the right financing solution by working with a mortgage broker who's familiar with investment loans. 

Now that you know how to get a loan for an investment property, you can begin taking steps to increase your approval odds. Before buying a property, do your due diligence to ensure you're making an investment that has a high potential for success.