Determining A Down Payments For A Rental Property

Investing in real estate can be a lucrative business, as it offers passive income as well as potential appreciation in the long term. However, one of the biggest barriers to entry for most real estate investors is the down payment required to buy an investment property.

Understanding the dynamics of your investment property down payment is the first step every new landlord needs to take before venturing into the world of real estate investing. This article discusses at length the determinants of a down payment for investment property, including the traditional investment property loan requirements, financing options, and ways to manage and potentially reduce the initial financial outlay.

Understanding Down Payment Requirements

A down payment for investment property is an upfront payment you make when financing a property, often represented as a percentage of the investment property's purchase price. Lenders usually require larger down payments for investment properties than for owner-occupied properties since there is greater risk associated with rentals or non-primary residences. The size of your down payment varies based on several factors, including loan type, property type, and investor's financial condition.

Below are a few common mortgage types and how they work for investment properties:

• Conventional Loans: Conventional mortgages are standard loans for investment property. Lenders normally require a down payment of 15% to 25% or more for conventional mortgage loans. For example, some banks require investment property loan borrowers to put down at least 15% and have a minimum credit score of 620. Keep in mind, though, that although 15% may be the minimum down payment, putting down 20% or 25% can lead to better loan terms (like not needing private mortgage insurance) and interest rates.
• Government-Backed Loans: Government-backed loans, such as VA or FHA loans, are specifically for owner-occupied residences and are not typically available for investment properties. These loans do allow for lower down payments, even as low as 0% to 3%, but they have special occupancy restrictions that usually make investors ineligible for them.
• Hard Money Loans: For investors who are not able to qualify under traditional lending criteria, hard money loans provide an alternative. They are short-term, high-interest loans provided by private lenders and are usually given based on the after-repair value of the property rather than the creditworthiness of the borrower. While they can be used to facilitate quicker acquisition, they usually come with large down payments, higher closing costs, and increased interest rates and thus are most suitable for short-term investment strategies like property flipping.

Factors Influencing Down Payment Needs

There are several factors that can influence the down payment needed for an investment property.

• Property Type and Units: Property type and number of units can significantly influence down payment needs. For example, purchasing a multi-unit property often requires a higher down payment compared to a single-family residence. Lenders consider multi-unit properties riskier, especially for first-time investors, so they require higher down payments.
• Investor's Creditworthiness: An investor's credit score plays an important role in determining rental property loan terms. The better the credit score, the better the terms and the lower your potential down payment requirement will be. Conversely, a weaker credit score will find lenders calling for a higher down payment to mitigate perceived risk.
• Debt-to-Income Ratio (DTI): Lenders compute the ratio between an investor’s debt compared to their income to assess their ability to carry additional debt. The DTI should be as low as possible, as lower debt burdens can have a favorable impact on down payment requirements.

Down Payment Requirement Management Strategies

Down payment requirements may be steep, but the criteria needed to meet these requirements for your investment property depends on several factors and investors have numerous strategies available to manage or even reduce the upfront monetary requirement:

• House Hacking: House hacking involves the purchase of a multi-unit property, living in one of the units, and renting out the others. By doing so, investors are able to qualify for owner-occupied financing with lower down payment requirements. Some lenders can provide down payments as low as 3% for owner-occupied properties.
• Seller Financing: Sometimes, sellers will carry investment property financing, and buyers will make monthly payments directly to the seller instead of getting a traditional mortgage. This can lead to more liberal down payment terms, depending on what the buyer-seller agreement allows.
• Partnerships: Forming partnerships can help split the financial burden of the down payment. With partnerships with other investors, individuals are able to pool resources together in order to meet down payment requirements, thus making investment properties more affordable.
• Using Home Equity: Investors who already have property can leverage their current home equity to finance the down payment on a new investment property. This is accomplished by taking a home equity loan or line of credit on the current property to buy the down payment on the new investment.

Tax Implications and Considerations

Understanding the tax implications that accompany investment properties is critical in ensuring maximum returns and compliance with tax laws.

Once your property is in service, you must declare all rental income on your tax return. However, expenses related to your rental income, such as property management fees, maintenance, and mortgage payment interest, can generally reduce your taxable income by being deducted.

The IRS allows property owners to depreciate residential rental property over 27.5 years, providing a yearly deduction that can protect rental income. It is wise to calculate depreciation accurately to receive the complete advantage of this allowance.

If you choose to sell an investment property, consider the installment sale method. This method allows you to receive payments for the property over time through a seller-financed agreement, which can stretch the tax burden over several years. This method can be tax-friendly, especially if postponing the income results in lower tax brackets in future years. Under IRS regulations, you report and pay tax on the gain portion of each installment payment as you receive it, rather than paying taxes on the entire capital gain in the year of sale.

Understanding Rental Property Down Payments

Determining “How much down for investment property?” is a multifaceted question that depends on various factors, including loan products, types of properties, and the investor's finances. While traditional lenders may require large down payments, innovative strategies like house hacking, seller financing, and partnerships can help you begin to invest in rentals and grow your real estate portfolio.