Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

3 Troubling Truths You Haven't Been Told About Rental Property Mortgages

Housing mania is once again gripping Wall Street.

With the latest reading on the S&P/Cash Schiller Home Price Index climbing 12% from just last year, homeowners are cashing in on the bullish reversal after prices fell for six straight years from 2006 to 2012.

But even though regular homeowners are seeing big gains, it's rental property owners and investors who are the real winners.

That's what my colleague Nathan Slaughter calls the "Renter Nation," the phenomenon that is taking the U.S. by storm, as more Americans choose to rent rather than buy.

In the next three years, 3.8 million renters (70% of all new households) are going to be fighting with each other for less and less space. That big shift toward rentals is being driven by falling home ownership rates as consumers continue to struggle with little wage growth and too much debt. This is expected to reward apartment owners with higher values on their properties and rising rents. Nathan talks more about this here and tells you how you can cash in.

But just like every other investment, the potential for an outsized gain comes with risk.

And one of the biggest risks in a rental-property investment is the mortgage. A rental-property mortgage is structured differently than a regular mortgage, and that carries hidden risk for investors.

Here are three things you need to know before you try to take out a mortgage for that rental property...

1. You Won't Get Rock-Bottom Interest Rates.

Lending rates are dictated by risk. More risk yields a higher interest rate. With an individual mortgage, the lender is profiling the risk of one individual borrower. That includes credit and employment history. But for a rental mortgage, what the banks understand is that even though it is still making a loan to an individual, the performance of the loan will be heavily influenced by a group of third-party renters who will remain virtually anonymous.

Even though borrowers are using their personal credit to secure the rental-property mortgage, the fact that they have to rely on third-party renters to help generate cash flow is why lenders charge that higher interest rate. It's just more risky for them.

The rental-property market has very thin operating margins and relies on steady cash flows. Even a marginally higher interest rate has the potential to threaten the profitability of a rental-property investment.

2. Get Ready For A Hefty Down Payment.

Individual mortgages can currently be secured for as little as 3.5% down with programs offered through the FHA (Federal Housing Association). This government-subsidized program is designed to support home ownership and increase ownership rates.

But rental-property mortgages enjoy no such luxury. Because mortgage insurance doesn't cover investment properties, 20% down is a minimum. In fact, most rental-property mortgages require closer to 25%.

That is a big cash outlay and it can significantly reduce the operating leverage of a rental-property investment. It could also become a big financial liability in the event of a distressed sale, where property owners with equity have been subjected to total losses while ones with little or no equity have walked away unscathed.

A large down payment on a rental property also has the potential to crowd out other asset classes in a portfolio, including stocks and bonds. Asset allocation is the single most important factor affecting the performance of a portfolio, so a balanced approach is critical for staying properly diversified and reducing risk.

3. Your Credit Is Even More Important.

Credit is always the single most important factor affecting borrowing rates. And that is particularly true for a rental-property mortgage.

In fact, it is more difficult to secure a rental-property mortgage than a residential mortgage. A 720 credit score is considered excellent and might be good enough to secure a residential mortgage. But that number jumps to 740 for most rental-property mortgages.

Beyond credit, lenders will also look closely at how much cash a potential rental-property borrower has on hand, usually requiring six months of operating expenses in order to buffer against weak rental trends and economic volatility. Lenders will also want to know about any other properties owned and the loan-to-value ratios of those assets.

The risk with these higher lending standards is opportunity cost. Even someone prepared to make an investment in a rental property may not be able to do so due to more stringent lending standards.

The Investing Answer: If there's one thing residential and rental-property mortgages have in common it's that rental-property mortgages are widely available at local and regional banks. Large banks are known for carrying higher lending standards and being more selective when choosing potential borrowers. Local and regional banks are known for extending more flexibility and taking on higher-risk borrowers. That will have a big impact not just on your ability to secure a mortgage loan for your rental property, but also the terms of that loan.

P.S. -- Does "owning" rental property without all the hassles appeal to you? Let Nathan show you how to collect "rent checks" with zero work on homes you don't even own. Click here for more information.