The Complete Guide to Financing an Investment Property

Real estate is perhaps the world’s oldest asset class. Investment properties provide diversification beyond traditional assets like stocks and bonds, have historically kept pace with inflation, and offer the potential for steady, predictable cash flow.

They can be financed with leverage (borrowing), enabling you to benefit while spending less money upfront. However, investors can quickly feel overwhelmed by the countless loan options available. In addition, you’ll need to assess down payments, your creditworthiness, interest rates, and how much debt you already have.

Below is our guide to help investors navigate the many choices available and choose the one that best aligns with their investment goals.

Why Buy an Investment Property?

There are several key reasons why you might find investment properties appealing:

• Steady cash flow and passive income potential: Properties in an attractive market
  can provide a consistent revenue stream, helping to offset mortgage payments and expenses. In addition, investment properties can offer passive income with minimal day-to-day involvement.
• Property appreciation: Real estate historically appreciates over time. For example, since 1963 inflation in the U.S. has risen by an annualized rate of 3.9% while home prices have increased by over 5.5% annualized over the same period. Rent has also increased in line with inflation, acting as a hedge against rising prices.
• Tax benefits: Investors can deduct mortgage interest, depreciation, maintenance costs, and property taxes, reducing taxable income. Certain investment strategies, such as 1031 exchanges, could allow you to defer capital gains taxes when selling a property and reinvesting in another.
• Portfolio diversification: Researchers have generally found that real estate values tend to follow bonds but not stock performance, which could mean your property investments gain value even during stock market downturns.
• Leverage: Investors can finance properties with loans, allowing them to control a high-value asset with a relatively small down payment. In addition, as tenants pay down the mortgage, investors build home equity over time and can realize a healthy return on their investment, even if their property value stays the same.

Understanding Investment Property Financing

Financing an investment property differs significantly from financing your primary home. Lenders consider investment properties at a higher risk, resulting in more stringent lending criteria and qualification requirements.

As an investor, you should expect the following:

• Higher qualifying credit scores than those required for primary residences
• Larger down payment requirements
• Increased interest rates to offset the perceived extra risk

One advantage of investment property loans is that lenders typically let you count 75% of anticipated rental income toward your qualifying income. However, this requires documentation of a current lease agreement or a rental schedule based on an appraiser‘s assessment of the property’s likely rental income potential.

Financing Options

Conventional Mortgages

Conventional mortgages are the most common option for investment properties. Issued by private lenders and following guidelines set by Fannie Mae and Freddie Mac, these loans typically require higher credit scores, down payments, and underwriting criteria than mortgages for
primary residences.

These are the key features:

• Higher down payment requirements: Investment property loans generally require larger down payments. While primary residences might qualify for down payments as low as 3% to 5%, investment properties often require at least 15% to 25% down.​
• Stricter credit score criteria: Lenders typically expect higher credit scores for investment property loans, often a minimum of 620 with 25% down and 680 with a 15% down payment.
• Higher interest rates: Because of the increased risk associated with investment properties, interest rates are usually 0.5% to 0.75% higher than those for primary residences.​
• Reserve requirements: Your lender might expect you to keep at least six months of cash set aside to cover your loan without income from the property.

Here are the three types of more conventional bank loans:

•  Fixed-rate mortgages: ​Most (92%) have preset interest rates that last the entire mortgage, with the remaining 8% having adjustable rates.
• Adjustable-rate mortgages (ARMs): ARMs offer a lower initial interest rate that remains fixed for a set period (e.g., five, seven, or 10 years), after which the rate adjusts periodically based on
  market conditions. However, payment amounts could increase drastically if interest rates shift significantly after this initial period.
• Jumbo Loans: Jumbo loans are used for properties that exceed the limits set by Fannie Mae and Freddie Mac. These loans typically require higher credit scores, larger down payments, and lower debt-to-income ratios. They are suitable for investors purchasing luxury rental properties or high-value vacation rentals, especially in high-cost areas where conventional loans may be insufficient.

Alternative Financing Options

• Hard money loans: These are short-term, asset-based loans provided by private lenders or companies, primarily secured by real estate. These loans focus more on the property’s
  value than the borrower’s creditworthiness. As such, they’re helpful as a bridge loan rather than a more permanent source of financing and are particularly attractive for house flippers.
• Private money loans: As the name implies, private money loans are funds lent by individual investors or private entities, often based on personal relationships. As such, the repayment schedules, interest rates, durations, qualifications, and structures are all highly flexible.
• Home equity loans and HELOCs: Home equity loans and home equity lines of credit (HELOCs) allow homeowners to leverage the equity in their primary residences to finance additional investments, including purchasing investment properties. Home equity loans provide a lump sum amount with fixed interest rates and set repayment terms, while HELOCs act as revolving credit lines with variable interest rates, allowing borrowers to draw funds as needed up to a predetermined limit during the draw period.

Commercial Loans for Investment Properties

Commercial loans are used to finance multiunit residential and commercial properties. They have more stringent credit requirements and potential prepayment penalties, featuring higher down
payments and have shorter repayment terms of five to 20 years. Commercial loans come in three common varieties:

1. Traditional commercial mortgage loans

Traditional commercial mortgages are not government-backed and are issued directly by banks or lenders, typically requiring higher credit scores (700+) and down payments (15% to 35%).

2. SBA 7(a) loan for commercial real estate

SBA 7(a) loans are government-backed loans for businesses that don’t qualify for traditional financing, covering up to 85% to 90% of the property purchase price with a maximum loan of $5 million.

3. CDC/SBA 504 loan for commercial real estate

The community development corporation (CDC)/SBA 504 loan combines funding from a private lender (50%) with a CDC (40%) alongside a 10% borrower down payment. These loans feature no maximum loan amount and have interest rates ranging from 3.5% to 5%. A key criterion is
that the businesses must meet local job creation goals.

Creative Financing Strategies

Seller Financing

In seller financing, the property seller acts as the lender, allowing the buyer to make installment payments directly to them. This can expedite transactions and provide flexibility for buyers who may not qualify for traditional loans. However, risks include potential default by the buyer and the absence of standard consumer protections associated with conventional mortgages. These loans may also require stringent legal counsel and thus may be quite costly.

Crowdfunding and Syndicates

These methods involve pooling resources from multiple investors to fund real estate projects, enabling participation in larger investments with reduced individual capital outlay. While this strategy offers diversification and access to substantial properties, it presents challenges like complex management structures and potential regulatory hurdles.​ In particular, syndicates must become registered legal entities regulated by the U.S. Securities and Exchange Commission. They also require a sponsor to identify properties and bring together passive investors, as well as a syndication company to draft agreements, determine how the syndicate should be managed, and conduct due diligence. As such, syndicates should only be considered by experienced investors with a deep pool of resources.

The Bottom Line

Investing in real estate offers diversification, steady cash flow, tax benefits, and leverage opportunities, but financing an investment property can be complex. Unlike primary residence loans, investment property financing requires higher down payments, stricter credit requirements, and risk-adjusted interest rates. Strategic planning is crucial in selecting the right financing option to fit your investment goals and to maximize returns while minimizing your risks.