"The Investment Property Mortgage: Guidance for New Investors"
As I'm sure you are aware, there are many types of investment property mortgages available in this day and age. Here's a quick primer.
FIXED-RATE VS. ADJUSTIBLE-RATE MORTGAGES
You will generally have a choice between a fixed rate mortgage and an adjustable rate mortgage (ARM). The former keeps your payments fixed for the life of the loan until it is paid off (typically 15 or 30 years). Conversely, ARM payments fluctuate, as they are tied to an unstable index such as the Prime Rate.
Although less and less common, some ARM products entice buyers by featuring lower upfront payments – such as interest only payments or a "teaser rate" that resets to the "standard" rate after a certain period of time elapses.
Generally, investment property mortgages that are adjustable are problematic because:
- They make budgeting and financial planning activities less accurate because the payment associated with one of your largest
could fluctuate unpredictably.
- The unpredictability of your rental property mortgage payment adds risk. No matter what the investment type, the more variables you have, the more difficult it is to predict the long-term outcome.
- Investment property loans featuring interest-only payments tend to increase the total amount of interest you will have to pay over the life of the loan. Why? Because your monthly payments only cover the interest and do not reduce the loan's principle balance. Therefore you are paying interest on the entire loan balance, month after month, year after year, with no reduction in this base amount over time.
So assuming you are with me at this point and you have a
long-term investment horizon,
I would avoid ARMs like the plague. Fixed rate investment property mortgages are much safer, period.
FIXED RATE PROPERTY MORTGAGE COMPONENTS
Fixed rate investment property mortgages typically have the following variables / options, most of which directly impact the cost of the loan to you:
- Term. The mortgage duration can run 15-, 30-, or even 40-years. Typically, mortgages with shorter terms carry higher monthly payments. Experts agree that the 30-year fixed rate mortgage is still the sweet spot in terms of getting the best deal.
- Interest rate. Determines your monthly payment and how much you'll pay over the life of the loan. This will vary depending on your down payment, term, the state of the market, your credit & income level, and other factors. When comparing your mortgage options, take a close look at the annual percentage rate (APR). This figure combines the yearly interest costs and other fees charged by a lender over the life of the loan to enable apples-to-apples comparisons.
- Loan-to-value (LTV) ratio. This figure represents the mortgage amount as a percentage of the purchase price. For example, an 80% LTV mortgage on a $100K rental property means that the loan amount is $80K and your down payment amount is $20K. Lenders like to maintain a 20% equity cushion, so any loan with more than an 80% LTV will typically be priced higher and will be subject to the dreaded
- Escrow account for
Some investment property loans require an escrow account, some don't. If possible, pay these expenses directly to ensure flexibility down the road.
- Points and other
These usually add thousands of dollars to your borrowing costs and can vary dramatically between lenders, so shop around.
- Prepayment penalty. You could be charged a penalty by some lenders if you pay the loan off early. While this is much less common than it used to be, loans with this "gotcha" are still out there. Avoid them!
MORTGAGE TIPS & RECOMMENDATIONS
- Always use a traditional bank lender unless you are buying a
or you intend to
refinance investment properties
over a short period of time.
- Focus on 80% LTV, 30-year fixed-rate investment property mortgages.
- Find a zero down financing option to minimize your out of pocket cash requirement.
- If forced to go with a high-LTV mortgage, plan to refinance into a 30-year fixed rate loan in a couple of years.
- Deal directly with a lending bank if possible, as opposed to a mortgage broker. While a broker can save time by shopping your loan around to a bunch of lending banks, their rates and fees are almost always higher because...well, they need to get paid too.
- Request a GFE from all the competing lenders to facilitate an apples-to-apples comparison of rates and closing costs.
- Finance the closing costs by requesting a 3% seller's concession.
- Avoid investment property mortgages that require paying for insurance
and property taxes from a bank-managed escrow account, because this could limit your ability to transfer title to your
real estate LLC
down the road.
- Pay extra toward the principal each month – the equivilant of one extra payment per year will knock about 8 years off the loan, thereby saving you tens of thousands of dollars in interest and increasing your profit when you
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