How Mortgage Rates Differ for Investment Properties

Mortgage rates for investment properties typically are higher than those for primary residences. This is because lenders view investment properties as higher risk. Additionally, lenders often require a larger down payment on investment properties, usually around 20% to 25%, compared with 3% to 5% commonly required for primary homes. Investment property loans also have stricter credit score requirements.

If you want to add real estate investments to your portfolio, a financial advisor can help you analyze and manage them.

What Qualifies as an Investment Property?

An investment property is real estate purchased with the intent of earning a return on the investment, either through rental income , future resale or both. Unlike primary residences, which are occupied by the owner, investment properties are used to generate income. Examples include single-family homes rented out to tenants, multi-family units like duplexes or apartment buildings and commercial properties such as office buildings or retail spaces.

Residential properties that the owner does not occupy but instead rents out to others also qualify as investment properties. This includes vacation homes rented out seasonally, as well as long-term rental houses. Even if the owner occasionally uses the property, it is still considered an investment property if its primary purpose is to generate income.

Commercial real estate also falls under the category of investment properties. This can range from office buildings and retail spaces to warehouses and industrial properties. The key factor that defines an investment property is the intention behind the purchase: generating income rather than personal use.

Intended use is the distinguishing factor between an investment property versus a second home . An investment property is purchased specifically to generate income, either through rental income, appreciation or both. In contrast, a second home is typically a residence used by the owner for personal enjoyment, such as a vacation home or a weekend retreat, and is not intended to generate rental income consistently.

Mortgage Rate Considerations for Investment Properties

When financing investment properties, interest rates play a significant role in the overall cost and feasibility of the investment. Mortgage rates for investment properties are generally higher than those for primary residences and second homes.

This difference is due to the increased risk perceived by lenders. For investment properties, interest rates typically range from 0.5% to 1% higher than traditional mortgage rates for primary residences. This premium accounts for the potential volatility in rental income and the higher likelihood of default.

For context, traditional mortgages for primary residences usually offer the lowest interest rates because the risk to lenders is minimal - borrowers are more likely to prioritize payments on their primary home, ensuring the lender receives timely payments.

Higher interest rates for investment properties can significantly impact the return on investment. Potential investors must carefully evaluate the rental income potential and the costs associated with higher mortgage rates. It's essential to factor in these rates when calculating potential cash flow and overall profitability.

Working with a financial advisor can provide valuable insights into managing these costs and making informed decisions that align with investment goals.

Financing an Investment Property vs. Second Home

Financing an investment property differs significantly from financing a second home. Lenders perceive investment properties as higher risk due to the reliance on rental income, which can be unpredictable. As a result, interest rates on loans for investment properties are usually higher.

Lenders also require larger down payments, typically around 15% to 25%, and have stricter credit score requirements. The financial scrutiny is more rigorous because the likelihood of default is perceived to be higher, given that borrowers might prioritize their primary residence’s mortgage during financial hardships.

On the other hand, financing a second home is generally more straightforward. Since a second home is for personal use, lenders view it as less risky compared to an investment property and thus offer lower rates compared to investment properties. Typically, interest rates for second homes fall between those for investment properties and primary residences.

Down payment requirements on second homes are also more lenient when compared to investment properties, usually ranging from 10% to 20%. The borrower must prove that the second home will be used only by them and not rented out, which might include providing documentation such as distance from the primary residence or a statement of intent.

Understanding the difference between an investment property and a second home is important for potential buyers because it impacts financing options, tax implications and insurance requirements. Investment properties can offer lucrative returns but come with higher costs and risks. Second homes, on the other hand, can provide personal enjoyment with potentially lower financing barriers but lack the income generation aspect of investment properties.

Tips for Financing an Investment Property

Financing an investment property can be challenging, but there are strategies to help lower costs and improve your chances of securing favorable terms. Here are seven common tips to consider:

• Improve your credit score. A higher credit score can significantly lower your interest rates. Lenders view borrowers with excellent credit scores as less risky, which can result in better loan terms. Regularly check your credit report , correct any errors and pay down existing debt to boost your credit score before applying for a loan.
• Save for a larger down payment. Lenders often require a down payment of at least 15% to 25% for investment properties. However, putting down more than the minimum required can reduce your loan-to-value ratio , potentially leading to lower interest rates and better loan terms. A larger down payment also means you'll have more equity in the property from the start.
• Shop around for lenders. Not all lenders offer the same terms, so it's essential to shop around and compare different mortgage offers. Consider working with mortgage brokers who can help you find competitive rates and terms from various lenders. Look for lenders experienced in investment property loans, as they may offer more favorable terms.
• Consider a shorter loan term. While 30-year mortgages are common, opting for a shorter loan term, such as 15 or 20 years, can result in lower interest rates. Although your monthly payments will be higher, you'll pay less interest over the life of the loan, ultimately saving money.
• Secure pre-approval. Obtaining a mortgage pre-approval before shopping for properties can give you a clear understanding of your buying budget and strengthen your negotiating position. Sellers often view pre-approved buyers as more serious and financially stable, which can be an advantage in competitive markets.
• Reduce debt-to-income ratio . Lenders assess your debt-to-income ratio (DTI) to determine your ability to manage monthly payments. Lowering your DTI by paying off existing debts or increasing your income can improve your chances of securing favorable loan terms. Aim for a DTI below 43% to meet most lenders’ requirements.
• Consult with a financial advisor. A financial advisor can provide personalized advice tailored to your financial situation and investment goals. They can help you create a financing strategy, explore tax benefits and ensure you're making informed decisions that align with your long-term objectives. Working with a professional can also help you navigate the complexities of financing investment properties effectively.

Bottom Line

Mortgage rates are different for investment properties than primary homes. Higher interest rates and stringent lending criteria reflect the increased risk lenders associate with these properties. Maintaining a strong credit score, saving for a substantial down payment and exploring various loan options can help you get a better mortgage.

Tips for Financial Planning

• A financial advisor can help you build a real estate portfolio. Finding a financial advisor doesn't have to be hard. SmartAsset's free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you're ready to find an advisor who can help you achieve your financial goals, get started now .
• Real estate not only can help you diversify your portfolio, but it can also create a long-term stream of income. Here's a beginner's guide with more information to help you get started .

Photo credit: ©iStock/kate_sept2004, ©iStock/kate_sept2004, ©iStock/Goodboy Picture Company

The post How Mortgage Rates Differ for Investment Properties appeared first on SmartReads by SmartAsset .