Want to learn about down payments on rental property? This is the article for you.
I’ll share everything you need to know about down payments, including how much you need, how to lower the amount, and options for financing.
Ready to learn? Then, read on.
You’ll learn:
- How much down payment to put down on a rental property
- What the minimum down payment is
- What the approval requirements are for an investment property loan
- How to finance your down payment on a rental property
Key takeaways:
- The average down payment on a property in the US is 15% of the property value (but most are 20-25%). The average amount nationwide is $34,248.
- You can lower your down payment by doing things such as living in the rental property, getting a government-backed loan, or borrowing on your home equity.
- If you have low credit, you can try owner financing, group investing, or private lending to finance your down payment.
How much down payment should I put down on a rental property?
For a conventional investment property loan, you’ll need to pay a minimum of 15% of the property value. For reference, the current average down payment in the US is $34,248. However, most down payments are 20-25%. If you want to pay less than 20%, there are a few strategies to try. Read on to learn more.Can you put down less than a 20% down payment on an investment property?
Want to pay less than a 20% down payment? First, let’s talk about house-hacking.House-hacking with government-backed loans
House-hacking is when you live in your investment property and rent out the other rooms. By charging enough rent to cover your mortgage (plus make a profit), you essentially live in your home rent-free and build a successful real estate business at the same time. That’s what I did when I started out in real estate investing.
In this video, I explain how I used house hacking and how to make it work for you:
Other options
Another way to lower your down payment is to borrow the money from loved ones or private investors. That way, you can technically get a home loan with no money down. However, you end up spending more in the long run as you pay off your private lender (I’ll talk more about that in the “Private lenders” section). Finally, a great credit score can make you a much more attractive candidate for a real estate investment loan. That means better conditions on interest rates, mortgage terms, and down payments. But here’s the thing. Putting down a larger down payment is more beneficial in the long run. The benefits include:- Lower interest rates
- Reduced private mortgage insurance premiums
- Smaller monthly mortgage payments
- Shorter mortgage term
- Better chance of securing the property loan
What are the approval requirements for an investment property loan?
Here’s what you need to get approved:- Down payment: As a rule of thumb, you need a minimum of 15% for a down payment, but most investors and lenders prefer 25% (or you could try a VA loan for no down payment if you qualify).
- Credit score: Most lenders require a 680 credit score with a 15% down payment. If you can pay 25%, a 620 credit score should be enough.
- Debt-to-income ratio: Your debt-to-income ratio of non-housing debts should be under 36%. 28% is the sweet spot. You can get approved with a higher DTI ratio for conventional loans, depending on the lender’s requirements, or if you apply for a government-backed loan.
- Cash reserves: Your mortgage lender will want to see that you have enough savings to support you if your rental income drops. Aim to save at least six months’ worth of personal expenses.
- Loan limit: Not all home loans have limits, but FHA loans do. Check that the property you’re looking to buy is within your lender’s loan limits.
- Documentation: Documentation can vary, but most lenders will want to see items such as two years of tax returns, several months of bank statements, your latest credit report, rental receipts (if you’re renting), and so on. At the very least, you’ll want to have these prepared in case they’re required.
How can you finance your down payment on a rental property?
The main ways to finance your down payment include the following:- HELOC (home equity line of credit)
- SDIRA (self-directed individual retirement account)
- Private lenders
- Personal savings
- Owner financing
- Group investing
- Government-backed loans
- Debt service coverage ratio (DSCR) loan
HELOC
A HELOC (home equity line of credit) is when you get a mortgage secured by your home. Basically, your home equity becomes like a credit card. Most lenders allow you to borrow up to 80% of your home’s value minus the remainder on your mortgage (this difference is your equity). And typically, you have up to 20 years to repay. Now, it may seem risky to use your home as collateral for another mortgage, but this is a popular way to get into real estate. You don’t have to use your savings, and the line of credit gives you flexibility. For example, you might be able to afford more than one down payment with a HELOC, if your lender allows it. Keep in mind that HELOCs usually have a lot of fees, including application fees. (Industry secret: These fees are negotiable!) Plus, the variable interest rates tend to be much higher than traditional mortgage rates, so factor this in when you estimate your rental cash flow. The alternative is a home equity loan, which is similar to a HELOC but you can only withdraw a lump sum. Home equity loans also have high interest rates but they tend to be fixed.Self-directed IRAs
You’ve probably heard of an individual retirement account (IRA) before.
But unlike a Roth or traditional IRA, self-directed IRAs (SDIRA) aren’t limited to stocks, bonds, and funds. Instead, you can self-direct your investment into other things like real estate.
Linking your real estate investment with your retirement account makes a lot of sense for long-term tax-advantaged returns.
To get started, you need to:
- Find a custodian
- Roll over the money from your current Roth or traditional IRA
- Pay for your property or an investment property-specific mortgage from your IRA
Sounds good, right? Well, there are a number of things to consider before you apply.
First, real estate IRAs can be hard to find. Then, once you find a custodian, they will probably charge you high fees.
There are also many rules. For example, you cannot live on the property, so house-hacking is not an option. All expenses and income must flow from your IRA, and like other IRAs, you lose tax benefits if you withdraw from your IRA before retirement.
So, keep all of this in mind when considering this option.
Private lenders
If you have low credit or savings, private lending is a great option.
This is when a friend, family member, or private investor lends you the money for the down payment.
Unfortunately, the interest rates are far riskier than traditional fixed-rate loans because it’s a private agreement. A private investor will typically ask for a higher interest rate and faster loan repayment.
However, borrowing from someone you trust could help you avoid interest rates altogether. You’ll still want to work out the details and contract with them, though. This keeps everyone on the same page, and there’ll be no question about the terms.
Personal savings
Do you have a 9-5 that pays well? With a little discipline and time, you can save the money you need. Paying for your down payment this way also saves you money in the long-term.
To save for the down payment, you’ll need to:
- Track your expenses
- Cut down on leisure spending
- Open a savings account with a good interest rate
- Downsize or move in with family members
- Increase your income with a part-time job
This is basically what I did early on. I’d take on whatever extra shifts I could at my 9-5 pharmacy job and invest that money into real estate.
Now, a few years later, I’ve been able to retire from that job and run my business full time.
I also cover this in more detail in this video:
Owner financing
If you don’t qualify for a traditional mortgage, owner financing is a good alternative.
This is when you and the seller make a private agreement to buy the property.
Normally, you still pay a down payment, but the amount is negotiable. Then, you pay the rest of your mortgage in monthly installments.
Because you have no bank loan approval process, closing is faster and cheaper. But sellers often request higher interest rates to offset their personal risk.
Plus, you risk having to pay off the seller’s previous mortgage because many mortgages have “due-on-sale” clauses, which means when your sale is complete, the previous mortgage lender requires full payment, or they can foreclose the property. If the seller doesn’t pay off the mortgage immediately, your purchase is at risk.
Group investing
Who said you need to invest in property on your own?
Instead, you could sign a traditional mortgage with a friend, family member, or fellow investor as a partnership. That way, you can pool resources for the down payment and split the profits from the rental income.
I created a group investment partnership with my uncle to purchase my first rental property, which, among other things, I talk about in this video:
This is a popular way of investing in property for the first time because you can build a larger portfolio with more resources. The only drawback is your profit share is smaller when split among multiple investors. It’s also complicated to separate if someone wants to leave.
Tip: Create an LLC with all partners as stakeholders. This will make splitting your profits much easier.
Lower down payments under government-backed loans
Let’s say you want a traditional bank loan and have some money in savings but not enough for 20%. That’s where government-backed loans can help.
Federal Housing Administration (FHA) loans are specifically for lower-income, first-time buyers.
Even if you have student loans or a credit score below 600, you could still qualify. And, as mentioned before, the best part is down payments can be as low as 3.5%, depending on the lender.
Before you apply, keep in mind that the government sets a limit on how much you can borrow. Right now, it’s almost $500,000, but they revise the limit every year.
FHA loans also have a tough appraisal process, meaning you can’t fix and flip your property.
If you’re a veteran, you can apply for a Veteran Affairs (VA) loan. These loans have no down payment at all with no limits on how much you can borrow. This is one of the best options for buying rental property.
Note: To qualify for either an FHA or VA loan, you need to live on the property for at least the first year. But this is a good thing because if you purchase a larger house, you can rent out the other rooms and live rent-free.
DSCR loan
A debt service coverage ratio (DSCR) loan is ideal if you:
- Have significant cash saved up (at least 20-25%)
- Have a credit score of 680 or above
It’s a non-income-based loan, so no W2 or proof of income is required. Instead, the lender bases the loan on the estimated return from the investment property you’re buying.
Essentially, the rental income from an investment property needs to cover the mortgage payment plus profit.
Therefore, lenders require a DSCR ratio of at least 1.25.
For example, if your mortgage is $1,000 per month, your rental income should be $1,250 per month, as a minimum.
A DSCR loan works well for real estate investors because you’re not limited to 10 mortgages like traditional loans. But keep in mind the interest rate, while it can equal conventional mortgage rates, will often be 0.5-1% higher.
Next steps
And that’s everything you need to know about how to put a down payment on a rental property.
But that’s just the beginning of your real estate investment journey. There are so many things to learn when it comes to running a successful business in this industry, including:
- Finding a rental property
- Negotiating your mortgage
- Screening potential tenants
- Managing your cash flow
- And more
Don’t worry, though – I can help.
Now that I’ve built a successful million-dollar portfolio, I’m on a mission to assist newer investors like you to achieve financial freedom too.
So, if you’re ready to start building your real estate investment business from scratch, get in touch.
