Are you thinking about buying an investment property? Do you already own an investment property and you’re considering refinancing, either to reduce your rate or to take out some cash?
Perhaps you already own your own home where you live, and you’ve gone through the underwriting process a few times so you’re familiar with what banks look for when they analyze your income, assets, and credit. Get ready for a little bit of a shock. Underwriting is significantly different for investment properties. You may have sailed through the process for your own home, but when it comes to an income producing property, banks are much more cautious.
Why Are Banks Stricter about Underwriting Investment Properties?
It comes down to risk. Banks assume that if you run into tough times, financially, you will pay the mortgage on the home you live in first. You may not be able to keep up the payments on an investment property, and to you, it may not matter, because you still have a home to live in.
The other reason banks are stricter when underwriting investment properties is that they know you rely on the rental income to qualify and to make your mortgage payments. If your tenant leaves or stops paying rent, you may have trouble making your payments.
Both of these reasons mean that investment properties represent a greater risk of default for the lender.
1) Qualifying to Purchase an Investment Property
How do banks underwrite loans for investment properties?
If you are buying a two family home, and one unit can rent for $1,350 and the other unit can rent for $1,650, you have just added $3,000 a month to your income used to qualify, right?
Wrong. Banks normally “haircut” your gross rental income by 25%. So the rental income you can use is only $2,250. Why do banks reduce your rental income by 25%? They do this to account for vacancy, the cost of repairs and maintenance.
Do you need to have a tenant lined up when you buy investment property?
No. You don’t own the house yet, so there’s no way you could have a lease between you and the tenant. Then how do banks know how much you can rent the house for?
They order an appraisal with Form 1007 (rental schedule). This appraisal not only appraises the market value of the house you are buying; it also does a market analysis of similar units for rent in the neighborhood. You will get a rental schedule that estimates the market rent for each unit. The appraiser uses the same “haircut” as banks do and they will reduce your gross rental income by 25%.
Let’s take an example. You are buying a two family house for $400,000. You are putting down $100,000. Your mortgage is for $300,000. Taxes and insurance add up to $500/month. Using a rate of 3%, your monthly payment including tax and insurance is $1,765.
You have other debt payments (a payment on a car lease and some credit card debt) that add up to $450 per month. Your mortgage on your own home where you live is $2,000/month. Your salary is $90,000/year.
Right now, without using the rental income to qualify, your ratios are 27/56. You would not be approved. Your total debt-to-income ratio needs to be at 43% or below. Exceptions can be made up to 50% but it depends on your whole credit file.
But you’re buying a house with two units, which rent for a total gross income of $3,000 per month. After the “haircut”, you can use 75% or $2,250 to qualify. Add that to your income and now your ratios are 21/43. You qualify!
I have a relative who will sign a lease that’s more than the normal rent. Can I use that higher number to qualify?
No. If the appraisal comes back with the market rent being significantly lower than the rent shown on an executed lease, banks will use the lower of market rents or a signed lease to qualify.
How do banks know if a lease is “real”?
If you present a lease to show you have someone willing to rent a unit, and that lease was signed by both parties a month ago (so the lease is now in effect), banks will expect you to provide proof that the renter paid you one month’s rent and one month’s security deposit. Otherwise, they will view it as a fake lease and they won’t use it to qualify.
2) Qualifying to Refinance a Investment Property
What if you already own an investment property? Is qualifying different? Yes. By and large, if you have owned an investment property for six months or longer, lenders will expect to see that rental income on your tax return (Schedule E — Income or loss from rental real estate).
I put the rental income on my Schedule E, but my accountant writes off all the rental income with expenses. Which number do they use?
Banks look at the net rental income (or loss) on your Schedule E, and then they add back certain expenses such as depreciation and interest expense. So even if you show a loss on Schedule E, after adding back depreciation and interest, you might have a positive number to use to qualify.
What if I did renovations to the house after I bought it and I just started renting it?
If that is the case and you can prove that you did these renovations with bills from contractors and paid receipts, then you might be able to use the appraisal form 1007 to estimate the value of the market rents for the units.
Is it worth it to buy investment property? Yes, if you understand all the hurdles to qualifying that are unique to investment properties.