If you are buying an investment property, you probably already know that you’ll have to put down a larger down payment, use a smaller seller’s concession, and have more available in reserves, but are you aware of these three important differences when it comes to your loan’s interest rate, points, and available programs?
Difference #1: Interest Rates for Investment Properties Are Higher
Why are rates higher?
Because lenders see additional risk with investment properties. They think that if you lose your job or have a financial down turn, you’ll pay the mortgage on your primary residence first (so you don’t lose your home) then you’ll pay the mortgage on your investment property (if you have any money left). Plus banks know that if you’re buying an investment property, you’re relying on the rental income to qualify and pay your mortgage. If you lose a tenant, or they stop paying, your ability to pay your mortgage is jeopardized. Therefore, banks charge higher rates to compensate them for the additional risk.
How much higher are the rates for investment property compared to owner occupied?
Let’s take an example with the same loan amount, loan program, loan to value, property type and credit score: purchase of a single family home for $500,000 with 25% down, 740 score, 30 year fixed. The owner occupied loan would have a rate of 2.625%, and with a loan amount of $375,000, that means monthly principal and interest of $1,506.19.
The non-owner occupied loan would have a rate of 3.125% and payments of $1,606.41. That’s right – a difference of .50% in rate which amounts to a difference of $1,200 per year in higher monthly payments for the investment property loan.
What happens to rates when the loan to value is 80%? The owner occupied loan would be at 2.75% and the non-owner occupied loan would be at 3.625%, resulting in a difference of $191 per month or $2,295 per year. The difference is greater not only because the loan amount is larger ($400,000 vs. $375,000) but also because the rate differential is greater (.875% vs. .50%).
You might be okay with the higher payments because, after all, you’ll have a renter who will help you cover the mortgage, but that brings us to Difference #2.
Difference #2: Points for Investment Properties Are Higher
Why are points higher?
Two reasons, the first one being that same explanation given above: lenders view investment property loans as being riskier than loans for primary residences or second homes. The second reason has to do with prepayment risk. Investment properties are often bought then sold in a shorter cycle than primary residences (in a practice called “flipping”). Banks want to make a loan and be able to count on getting that income stream (in the form of your monthly payments) for a long period of time. They know that investment properties usually get bought and sold more rapidly than most primary residences, so they know they won’t be able to count on a long income stream. Therefore, they want to get their money up front in the form of points.
However, if you don’t have a high credit score, and you want maximum financing, and you’re buying an investment property, you might find that, unlike with an owner occupied loan, you have to pay points (the examples above were all with zero points). Let’s see what happens to pricing with this scenario: purchase of a single family home, 80% financing ($400,000 loan amount), 660 score, 30 year fixed.
The owner occupied loan would be at 3.25% with zero points. The non-owner occupied loan would be at 4.75% with 1.50 points. That’s right – a much higher rate and you have to pay points at closing (1.50% of your loan amount or $6,000.00). You can’t get a zero point loan based on all the parameters of your scenario (80%, investment property, 660 score). The risk associated with your loan makes the lender price the loan so they get not only a higher rate but also points up front.
As you can see, if you want to narrow the gap in rates between an owner occupied loan and an investment property loan, you need to do two things:
- Try to put at least 25% down
- Have a credit score of 740 or higher
Difference #3: Fewer Programs Available for Investment Property Loans
If you are buying a primary residence, you can choose between fixed rate loans of varying terms, adjustable rate loans, jumbo loans, and increasingly, you have the option to take an interest only loan. Many banks restrict the product availability for investment property loans to fixed rate only or only conforming loans (within the FNMA loan limits). And interest only loans are typically not offered to financing investment properties.
In sum, to make financing an investment property as affordable as possible, stick with a fixed rate loan at 75% financing and do whatever you can to make your credit score as high as possible.