If you are buying or refinancing an investment property, the first thing you need to know is “how much can I borrow”? To answer this question, we need to look at the maximum loan-to-value guidelines (“LTV”) for conventional loans that are sold to Fannie Mae or Freddie Mac. This article lays out the five differences between investment properties and owner occupied properties (i.e., primary residence or second home).
Difference #1: LTV Is Lower
Given the same loan with the same credit score and underwriting ratios, the LTV for an investment property will always be lower than the LTV for an equivalent owner occupied property.
How much lower?
If you were buying a primary residence, you could put down as little as 3% (as long as it was a single family home, condo, or PUD). But if that same single family home was something you planned on renting out, the loan-to-value drops to 85% from 97%. There is no situation where maximum financing is the same for investment property and owner occupied loans.
Why is the LTV lower?
Because of risk. The lender who is considering making this loan to you evaluates your application based on several different risk parameters. A major factor in this evaluation is the occupancy of the property you are buying or refinancing. There are three categories of occupancy: primary residence; second home; and investment property. Investment property is viewed by the lender as being riskier than a loan against your primary residence or second home.
Why are investment properties viewed as riskier?
Lenders assume you will always pay the mortgage on the house you live in first, then if you still have any cash left over, you will pay the mortgage on a rental property. And if a tenant leaves, the chances that you can make that payment are very slim.
How does LTV reflect this increased risk?
Banks protect themselves against this perceived risk by cutting back their maximum loan-to-value for investment properties. Banks want you to have more skin in the game if you’re buying an income producing property. They know this usually means you are more likely to pay the mortgage on time in order to avoid putting your hard earned savings at risk.
Difference #2: Gifts Are Not Allowed
The second difference concerns gifts. You might think you’re okay with the tougher LTV guidelines for investment property because you can always get a gift to come up with the additional down payment.
Wrong. With an owner occupied purchase, you can get a gift from a family member. That gift can be up to 20% of the purchase price. If you wanted to buy an owner occupied single family home with 3% down, that entire 3% could be a gift.
But with investment property (think “higher risk loan”), Fannie Mae does not allow you to use a gift. Therefore, not only are the LTV guidelines tougher but you also have to come up with the money from your own savings.
Difference #3: No Exceptions for First Time Home Buyers
If you wanted to buy a house with your partner, and you had not owned a property in the last three years, but your partner did, you would still be allowed the First Time Home Buyer status since one of the borrowers had not owned a property in the past three years. This status would allow you to buy an owner occupied single family home with 3% down!
But what if you wanted to make your first home purchase an investment property? Perhaps you are happy where you’re renting but you know of an area where people pay top dollar to rent and you found a property you want to purchase as an investment property. Does being a first time home buyer help you?
No (at least not in terms of loan-to-value). There is no FTHB exception to LTV if you’re buying an investment property.
Difference #4: Drastically Reduced Options for Secondary Financing
With an owner occupied loan, you can break the loan into two parts to avoid PMI. Instead of borrowing one loan at 90% financing, you could take two loans (a first and a second) that add up to 90%. With an investment property, you can’t do that. There are virtually no investment property second mortgages out there. So if you are putting down less than 20% on an investment property, be prepared to pay PMI.
Difference #5: There Is No FHA Option
With an owner occupied loan, if you don’t qualify for conventional financing, you can always switch your loan application to an FHA loan. FHA underwriting is more lenient in terms of credit score, down payment, and ratios.
But FHA only finances primary residences. If you are buying an investment property and you don’t qualify for a Fannie Mae loan, there is no FHA option. You would have to investigate private lenders or non-QM (non-qualified mortgage) options.