Are You Financially Ready for Your First Investment Property?

How do you know when you’re financially ready to tackle your first investment property? That’s the question we’re going to answer together today.

It’s important to understand the differences between a primary residence and an investment property. Your primary residence is your home for most of the year. Your investment property is basically any other property you own.

There are several reasons to distinguish your primary residence from your investment property. But for this discussion, the distinction between the two is important because mortgage lenders view the two differently.

See, lenders view investment properties as riskier loans than primary residences. The thinking is that borrowers will do everything in their power to protect their primary residence when finances get tight, but they might be willing to make some late payments on their investment properties. Or even let their investment properties slip into foreclosure to make ends meet on their primary residence.

So your finances will be held to a higher standard for an investment property than they would be for your first home as a primary residence.

Before we launch into our discussion, I want to quickly mention two things:

1. For first-time investors, I usually recommend buy-and-hold long-term residential rentals. Flips are more unpredictable, and commercial investments are more complex. So we’ll be talking specifically about buying a house to rent out long-term. If you have questions about your specific situation and which investment might be best for you, give me a call! I’d be happy to answer your questions and offer some professional guidance.
2. You don’t have to own your home before you buy an investment property. It’s nice to buy your own home before buying your first investment property because homeownership comes with a bit of a learning curve. But many buyers prefer to rent so they have the flexibility to relocate for jobs. You might even want to consider buying a home as a primary residence for the next few years, then rent it out as an investment property when you decide to relocate for an employment opportunity. It’s a smart way to hop on the property ladder.

Ok, having said that, here are 4 key questions to ask yourself to determine if you’re financially ready for your first investment property.

1. Do I Make Enough Money (And Can I Prove It)?

Perhaps the most important factor in deciding if you’re financially ready for your first investment property is your income.

You may not be terribly concerned about your income because you’re confident you can rent the property for far more than the monthly mortgage expense. Otherwise, you probably wouldn’t be buying an investment property, right? You expect your renters to cover the mortgage and put a little extra money in your pocket every month. So why should your current income matter so much?

The Investor’s View of Expenses

There are several expenses for you to consider as an investor.

First, your monthly expense will be more than just the mortgage. If you haven’t owned property before, you may not be aware of the total expense of property ownership.

In addition to the principal loan repayment plus the interest you pay every month on your mortgage, you’ll also be responsible for homeowner’s insurance and property taxes. These add hundreds of dollars to your monthly mortgage payment.

Then there’s maintenance and repairs. Maintenance and repairs are very difficult to estimate because they partly come down to luck: what crazy thing will go wrong with the house, and will the timing be just wrong?

A very general rule of thumb is to expect annual maintenance costs to equal 1% of the property value. If your property is valued at $200,000, you can expect to spend $2,000/year on maintenance and repairs. So if you set aside $167 every month, you’ll be more or less prepared to handle those expenses as they arise.

Then you need to consider vacancies. What do you do if your tenants move out and you can’t find a replacement right away?

The Lender’s View of Expenses

Lenders are always worrying about the worst-case scenario. They need to do everything they can to be as sure as possible that you will repay your loan with interest as expected.

That vacancy issue we just mentioned, they’re very worried about that. Lenders need to confirm that you make enough money to cover all your existing expense commitments (your mortgage or rent on your primary residence, car payments, student loans, etc.) plus this new investment property mortgage in case you find yourself without renters for an extended period of time.

And it’s not enough to simply make enough money to cover these expenses. You have to be able to prove it to the lender. You need documentation of enough consistent income to appease the lender.

This means inconsistent income (like commission or freelance work) and unverifiable income (like cash tips) might not be considered as part of your income for loan qualification purposes.

2. Do I Have Acceptable Credit?

Credit is exceptionally important in determining whether you’re a good candidate for an investment property loan. It plays a large role in qualifying you for a loan and in getting you a favorable interest rate on that loan.

In the simplest terms, your credit record shows your history of accepting loans and repaying those loans. The loans could be as significant as a mortgage on your primary residence. Or as seemingly-ing insignificant as a credit card or cell phone plan.

There are 5 main factors that affect your credit score:

1. Your payment history: late payments and missed payments will negatively affect your score.
2. Your debt: lenders want to see that you’re not over-extending yourself even if you technicallycould. They want you to be pre-qualified for a large amount of debt, but not actually use it. Credit cards are a perfect example. If you have a $10,000 credit limit, but only have a $500 balance, it indicates self-control.
3. The age of your credit history: the longer your accounts are open, the more evidence is available to prove that you consistently pay on time year-in and year-out. So it might be tempting to close your credit card accounts as you pay off the cards, but that would actually hurt your credit score.
4. Types of debt: is most of your debt student loans? Or credit cards? These are treated differently. Student loans are considered “good debt”. They represent a financial investment in your future earning power. Large credit card debt is seen as frivolous and irresponsible.
5. Credit inquiries: too many credit inquiries (companies running credit checks at your request) during a one-year period is a red flag, and it slightly reduces your credit score. The logic is that you’re trying to accumulate multiple loans which could over-extend your ability to repay them all. This is one of the reasons you don’t want to apply for credit cards or other loans while you’re trying to secure financing for a mortgage.

While some lenders are willing to work with less-than-stellar credit on a home loan for your primary residence, lenders all have higher standards when it comes to investment properties.

As mentioned in the beginning, lenders are reasonably sure borrowers will do everything they can to save their family home from foreclosure. They are less certain borrowers will go to great lengths to avoid foreclosure on an investment property.

While standards vary by lender, you should have at least a 720 credit score to seriously consider getting a loan on an investment property.

And if you’re credit isn’t great, remember that even if you can find a lender willing to give you a loan, the interest rate will be higher than it would be if you had great credit. That higher interest rate might make the investment less appealing.

3. Do I Have Enough Liquid Savings?

In addition to your income and credit, you’ll need to have enough cash available to purchase an investment property.

There are several low-down-payment loans available to people buying a primary residence. That is not the case with investment properties.

Again, it’s simply riskier for a lender to loan money to an investor than to a normal home buyer. Mortgage insurance (which allows buyers to put less than 20% down on their primary residence) doesn’t apply to investment properties. So you need to have enough money available to put at least 20% down. And 25% down may get you a better interest rate.

For those who are completely new to real estate transactions: “20% down” means you pay 20% of the purchase price upfront and take a loan for the remaining 80%. So on a $200,000 house, you would need to pay $40,000 out of your checking/savings to close the deal.

And the down payment is just the beginning.

You need to pay closing costs for things like appraisals, inspections, taxes, insurance, title searches, and loan origination fees. Expect to pay somewhere between 2-5% of the purchase price in closing costs.

Then there are upfront repairs, renovations, and holding costs until tenants move in.

Most homes need some cosmetic updating to ready them for the rental market. You may need to repaint, update fixtures (lights, faucets, and doorknobs), and install new flooring. Or you may need a full to-the-studs renovation (but maybe save those for the experienced investors!). You’ll most likely have at least a few weeks before your new tenant can move in and start paying rent. So you’ll need to cover the mortgage, taxes, and insurance during that unoccupied time.

Lastly, you need to have liquid funds available for surprises. There is a lot that can go wrong at an investment property without warning: plumbing, electrical, HVAC…The property owner needs to be financially prepared to handle the unexpected.

If you’re looking at this list of upfront costs, thinking there’s no way; why would anyone even buy an investment property? Keep something in mind: this is why real estate investors earn great returns and make solid passive income. They are willing to put in the work and the money upfront to reap benefits for decades to come!

4. Am I Financially Stable?

The final piece of the puzzle is financial stability.

If you’ve been able to answer “yes” to the first 3 questions, you now need to honestly evaluate your situation for any indication that any of those answers could change in the near future.

Is your income stable? How long have you been in your current line of work? What are the chances you could lose that income in the next year or two?

Is your credit stable? Are you protecting yourself against identity theft or credit fraud? Is there anything on the horizon that could dramatically impact your credit score?

Are your liquid savings stable? Do you have any large expenses coming up that will seriously reduce your savings? Do you have a separate emergency savings fund so your investment property savings won’t be depleted because of an unexpected expense?

The bottom line is that investment property is an investment. You need to be financially prepared to be a successful investor. Real estate is a fantastic investment over time, but it’s only available to those willing to put in the upfront work and upfront funding.

We hope you found these financial tips for buying your first investment property helpful!

When you’re ready to start your search, please contact South Florida Pro Realty. We love helping investors acquire their new assets and would be honored to work with you!