Finance

Thinking About Buying a Rental Property? Here’s What You Need to Know About Loans

For people wanting to venture into the exciting world of real estate investing, the first challenge they have to surmount is money. The median housing price stood at $704,000 in 2022 and this figure is set to rise by 3.5% in 2024. Very few people have enough savings to make that purchase on their own. The vast majority of first-time property investors will need a loan.

But as challenging as getting a loan to buy your own home was, it pales in comparison to the difficulty of getting approval for a rental property mortgage.  Lenders recognize two important facts about investment properties:

  • An investment property loan means you will have two mortgage payments to make every month, in addition to your existing financial obligations. This places a strain on your resources and increases the possibility that the investment will fail.
  • If you are unable to continue paying the mortgage on both properties, you are more likely to stop payments for the rental property. This is why the rate of mortgage defaults for investment properties is higher than for primary homes.

What is the implication for lenders?

This means lenders are exposed to greater risk when they loan money for a rental property. As a way of minimizing that risk, lenders impose more difficult terms on people applying for a rental property loan. This helps to filter out the least-qualified applications and ensure only those investors who are less likely to fail to get the loans.

Mortgage providers exist to provide mortgages; they want you to get the loan. But you have to show you can be trusted with their money. What are the things you need to know before you start sending out loan applications? What do lenders look for? Your chances of success will depend on how much you know and what you do to prepare.

Rental property loans: what do lenders look for?

Rental property loans

The primary thing lenders will be evaluating is your financial standing. This is a combination of factors that reveal how you have handled money in the past and your current financial situation. They also include facts that predict your likelihood of success or default.

1. Creditworthiness

This is your level of competence and trustworthiness in financial matters as revealed by your credit score and history. You should have a minimum credit score of 640 to qualify, although a score of 700+ is preferred. Lenders may also look for a history of late payments in your report.

2. Substantial income

You should have income that is stable and sizable. To show proof of income you will be required to provide a job letter (not more than 30 days old), pay stubs, Notice of Assessment (NOA) for 2 years, and a T1 general. If you are self-employed or earn commissions, expect to provide registration documents for the business, plus financial statements, in addition to other documents.

3. Debt to income ratio

Debt to income ratio

The more debts you are carrying, the greater the likelihood that you will not have sufficient means to make the mortgage payments. As a rule, not more than 35% of your monthly income should go to paying off debts.

4. Emergency reserves

How many months of your housing costs (mortgage + insurance + other costs, both for the rental property and your home) can be covered from your savings? Lenders expect you to have enough money to cover 2-6 months of payments, depending on the lender. Note that emergency funds don’t have to be in cash. They can be held in easily convertible assets.

5. Proof of down payment

Proof of down payment

Lenders expect you to pay part of the purchase price of the property and this money must already exist in your bank account. How much you pay as a down payment will range from 5-20%. The exact rate will depend on the number of units in the building and if you will be living in one of those units. Investors who are owner-occupants (they live in the rental property) pay 5-10%, others pay 20%.

6. Proof of closing costs

You also need 3-6% of the purchase price of the property to cover the loan closing costs. Closing costs are fees you pay for the range of services involved in underwriting a mortgage. You will need to show proof that you have this money.

7. Zoning information for the property

Rental properties are either classified as residential or commercial. The loan terms for residential rentals are easier than the loan terms for commercial rentals. Lenders want to see the zoning information for the property you want to buy. This is to prevent loan applicants which try to pass off commercial properties as residential properties.

Lastly, although it is not a requirement, the viability of the property you are proposing to buy matters. The location must attract renters regularly and those should be quality renters who can pay the rent without default. A rental property with promise will give lenders more confidence and make it easier to get approval for the loan.

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