Investment real estate is property, residential or commercial, which is used for rental purposes. Unless a person has enough cash to pay for the property, he will generally need to obtain a loan, called an investment property mortgage, to complete the purchase. The most common types of mortgages are fixed-rate loans, adjustable rate mortgages (ARMs), and balloon loans.
A fixed rate investment property mortgage is one that charges a set interest rate for the entire length of the loan. This type of loan is often preferred because the consistent payment amount makes budgeting easier. The loan period can be set for any length agreed upon by both parties, but the most frequently used increments are 15, 20, and 30 years. Shorter term loans have larger payments but lower interest rates since lenders consider these loans less risky. An investor who is more concerned about keeping the payment low and improving his immediate cash flow may opt for a longer term.
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The ARM is another investment property mortgage that may be attractive to a borrower because of the lower introductory interest rates. This type of mortgage is linked to the value a financial index, and the rates will be raised or lowered periodically to reflect fluctuations in the market. The advantage to the lender is that the mortgage holder is the party who carries the risk of changes in the cost of money, whereas the lender carries this risk in a conventional loan.
A balloon loan is primarily used if a buyer intends to own the property for a limited amount of time, plans to refinance, or expects to receive a large influx of cash at the end of the term. This loan has lower interest rates and does not amortize the full amount, so the payment is lower until the balloon payment is due, typically in five to seven years. Many balloon loans carry an option to convert to a fixed rate mortgage at the current market rate when the balloon comes due.
Interest rates on an investment property mortgage are generally a little higher than those charged for a personal residence, primarily because a person is less likely to default on a loan for their own home then on an investment property. Also, the amount of reserve cash required is often higher than on a personal residence purchase. Generally, a lender will require that a person seeking an investment property mortgage have the equivalent of six months payments in cash reserves.
Other financial considerations are the buyer’s debt-to-income ratio (DTI), credit scores, and the loan-to-value ratio. DTI is figured by adding all of the monthly obligations and dividing the total by the gross monthly income. If the purchaser has other rental properties which have a negative cash flow, then the negative amount will be considered debt when computing the DTI. If the other properties have a positive cash flow, then the profit can be considered income as long as the buyer can substantiate a history of profitability. When rent from the proposed investment property is being calculated for an investment property mortgage, the lender will only include 75% of the expected rents to accommodate possible vacancies.
Many lenders require a 20% down payment before approving an investment property mortgage. Others, however, may be willing to allow a buyer to obtain part of that down payment through a second mortgage or equity line of credit. Lenders sometimes limit the type of property they will finance; for example, some may not finance condo conversions, and others may only finance commercial units. A person who is considering purchasing an investment property should not only investigate the real estate market, but also the financing options in his area.