Loan Qualifications for an Investment Property
Considering an investment property purchase?
One of the outcomes 2008-2010 housing crisis is that even though interest rates are at historical lows, obtaining financing has become much more challenging. Investors (borrowers) must now have very high credit scores and have sufficient income relative to their monthly debt obligations. They must also be able to prove the numbers listed on their mortgage application with documentation acceptable to the lender.
Most lenders require a minimum credit score of 680 for investors to obtain a loan; however, minimal credit scores will typically add as much as 1.5 – 2.0 points to the loan origination fees. A credit score above 740 will have the lowest loan fees.
Meeting the lender’s debt-to-income ratio (DTI), sometimes known as the back end ratio, can be a formidable challenge.
DTI = Total Debt ÷ Total Income
Lenders generally look for a DTI of 36% to 45%. They will use the information provided on the borrower’s mortgage application (Fannie Mae form 1003) to ascertain the borrower’s stated income and debts to do preliminary calculations, and then they will demand documentation to verify all of the numbers.
Income will be assessed differently depending on whether the borrower is on a fixed salary, earns commissions, or is self-employed. While lender policies will vary, and Fannie Mae lending guidelines change regularly, the following requirements are currently typical of many banks:
If a borrower is on a fixed salary, current pay stubs and W-2's need to be consistent. Business expenses taken as a deduction on a borrower’s tax return will also be deducted by the lender.
- If a borrower receives commissions, there must be a two year history on the commission income. The lender will average the previous two years and year to date. If year to date commissions are lower, the lender will likely use the lower figure.
- Self-employed borrowers must have at least a two-year history of self-employment. The lender will usually use the borrower’s adjusted gross income averaged across their most recent two tax returns. Year to date income claims must be supported by a P&L statement and a balance sheet.
- A borrower claiming interest and dividend income will have this income averaged on their prior two tax returns, provided that the investor still owns the assets that generated it. Brokerage statements must be provided to document asset ownership.
- Borrowers who already own rental property will have their net income (or loss) considered by the lender from their IRS form 1040 Schedule E’s.
The lender will examine the debt that appears on a borrower’s credit report. Common forms of debt include the investor’s personal residence mortgage PITI (or rent payment), car payments, credit card or installment debt, plus the PITI costs of the investment property to be acquired. The prospective rents from the rental property being acquired will not be considered as income for DTI calculation purposes.
The current stringent loan qualification requirements exist for two primary reasons.
- The lenders and the government want to ensure that only well-qualified, low-risk borrowers get loans so that lenders and taxpayers do not get stuck with bad loans.
- Lenders who do not strictly comply with Fannie Mae underwriting guidelines will not be able to sell the loans in the secondary market, which virtually all of them want to do.
So while obtaining loans for investment properties is more challenging, the rewards are substantial. Because interest rates are still at historical lows, the positive cash flow in investment properties is massive, often resulting in net cash-on-cash returns of 10%-13% in some markets. It is well worth the effort to invest.
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