Financing a vacation rental property is similar to getting a loan for your primary residence. You’ll be required to pay a down payment, closing costs, and monthly mortgage payments. This blog explores all of the financing options for rental properties, their pros and cons, and what to expect when applying. Buying vacation rentals is easy when you stick to these financing tips!
Types of Investment Property Loans
Several types of financing are available for vacation rentals, each with advantages and disadvantages. Understanding the nuances of each loan allows investors to know exactly what they are financing and help them make short-term rentals a good investment. Here are just a few of the most common options:
- Traditional bank loans
- Private lenders and hard money loans
- Home equity lines of credit (HELOCs)
- Seller financing
- Crowdfunding platforms
- Cash-out refinance loan
Bank loans offer low-interest rates but require good credit scores and higher down payments (usually a minimum of 15%). On the other hand, private lenders may provide higher loan amounts but usually have higher interest rates than banks.
You can use HELOCs to finance up to 100% of the purchase price, but you must already be a homeowner. Similarly, cash-out refinancing allows investors to borrow against the equity of their primary residence or other investment homes.
Seller financing allows buyers to avoid traditional lenders altogether, yet you must have stellar negotiation skills. Crowdfunding platforms allow investors worldwide to invest in your project without having any direct contact with you, but often crowdfunding campaigns do not meet their goals.
Conventional Loans for Vacation Rental Properties
Traditional bank loans are a popular financing option for residential homes and vacation rental properties. Before applying for a loan, you must understand the requirements and potential benefits and drawbacks of this type of financing.
Requirements for Conventional Loans
When you apply for a bank loan, the lender will likely have the following requirements.
- Strong credit score: Borrowers must have good credit scores, usually 600 or above, to qualify for most bank loans.
- Proof of income: The borrower must be able to provide proof of income through bank statements, tax returns, or signed letters from an employer.
- Decent debt-to-income ratio: Most banks look for a less than 36% debt-to-income ratio.
- Down payment: Generally, a down payment of at least 20% is recommended to avoid private mortgage insurance, but lower upfront payments are accepted in some scenarios
Advantages of Bank Loans For Vacation Property
- Lower interest rates: One advantage of obtaining a traditional bank loan is that interest rates tend to be lower than those offered by private lenders or hard money loans.
- Flexibility: Banks typically offer more flexible repayment terms than other financing options.
- Commonality: Because bank loans are so common, many sellers prefer them to other financing options.
Disadvantages of Bank Loans For Vacation Property
- Long application process: The application process for a bank loan can take longer than other lending forms due to stricter qualification criteria set by banks.
- Many requirements: Applying for a traditional bank loan involves completing an application form that requires a lot of detailed information. Before being approved for the loan amount requested, you must provide information about your financial situation and documentation, such as tax returns, pay stubs, and bank statements.
Private Lenders & Hard Money Loans for Vacation Rentals
Private lenders are an alternative to traditional banks for financing vacation rental properties. They typically offer short-term loans with higher interest rates, called hard money loans. Private lenders may provide other types of loans, but hard money loans work best for commercial and investment properties.
Hard money loans are easier and faster to obtain than traditional bank loans. However, you must put up the property as collateral for the loan. If you default on the loan, the private lender can take ownership of your property.
Before discussing more pros and cons of hard money loans, we will explain private lenders and how to find them.
What Is a Private Lender?
A private lender is an individual or group that provides capital for real estate investments in exchange for repayment plus interest. They may also require additional security, such as personal guarantees or liens on the property. Unlike banks, private lenders do not have strict lending criteria and can often provide funding quickly without extensive paperwork or credit checks. However, the borrower loses more if they default on the loan.
How To Find Private Lenders
To find potential private lenders, you must research local investors who specialize in providing capital for real estate investments. You can also network within your circle of acquaintances – friends, family, and colleagues. Finally, consider attending local real estate investment events. They could become your next source of financing.
Pros of Private Investors
- Faster funds: The main advantage of using a private lender is that you can access funds faster than through a bank loan.
- No credit checks: No credit checks are involved in obtaining a loan from a private lender. Therefore, hard money loans may be an option even if your credit score is not high enough to qualify for a traditional loan.
Cons of Private Investors
- Higher mortgage rates: These loans have higher interest rates and fees than bank loans, quickly increasing your vacation rental’s operating costs.
- Shared cash flow: Private investors may be interested in becoming long-term stakeholders, which could require sharing potential income.
Home Equity Lines of Credit (HELOCs) for Vacation Rentals
A Home Equity Line of Credit (HELOC) loan allows homeowners to borrow against the equity in their current homes. You borrow up to a certain amount and pay it back over time with interest, just like any other loan. The main difference between this type of loan and others is that you only pay interest on the amount you use rather than paying off an entire lump sum at once.
You can use a HELOC loan for various purposes, including financing vacation rental properties.
Pros of HELOCs
- Lower interest rates: HELOC loans for vacation rental property financing typically offer lower interest rates than traditional bank loans or private lenders.
- Fewer requirements: Since these are secured loans, lenders may be more willing to work with borrowers with poor credit scores or financial histories.
Cons of HELOCs
- More risk: If real estate values decline significantly during your repayment period, you could owe more money than your property is worth, known as being “underwater.”
- Limited borrowing: This type of loan limits your borrowing amount to the cost of your current home, which can potentially be more limiting.
Seller Financing Options for Vacation Rentals
Seller financing involves the seller providing the buyer with a loan to finance the property purchase. There are no middlemen in this type of financing, which can benefit both parties. It allows buyers to avoid high-interest rates and fees, and sellers can receive payment over time instead of in one lump sum at closing.
Both parties typically negotiate the terms of a seller-financed loan, including the following.
- Interest rate
- Repayment period
- Down payment amount
In some cases, sellers may even offer incentives, such as no-interest or low-interest loans, in exchange for the buyer agreeing to certain terms – for example, not renting out certain parts of the property.
Pros of Seller Financing
- Flexible terms: Buyers can often get better terms using seller financing than they would from traditional lenders, especially during periods of higher Federal interest rates.
- Fewer closing costs: Since fewer third parties are involved, buyers often save money on closing costs.
Cons of Seller Financing
- Challenging negotiations: Seller financing requires a great deal of trust and collaboration, which can cause expensive delays.
- High risk: The seller takes on added financial risk in seller-financed loans. For example, the buyer could default, or the market could experience a downturn.
Both parties should always consult legal professionals before finalizing the contract in a seller-financed loan. Doing so will ensure that everyone understands their rights and responsibilities and they comply with all legal requirements.
Financing Vacation Rental Property FAQs
How Much Do You Have To Put Down on a Vacation Rental Property?
The amount you need to put down on a vacation rental property depends on several factors, such as the type of loan and the lender’s requirements. Generally speaking, most lenders require a 20%-25% down payment for investment properties. However, some lenders may offer lower down payments depending on your credit score and other qualifications.
Can You Use Vacation Rental Income To Qualify for a Mortgage?
Yes, you can use vacation rental income to qualify for a mortgage. However, the lender must be able to verify that the income is consistent and reliable. Lenders will not approve a loan based on future rent payments. Instead, you must clearly document the vacation rental income must through tax returns and bank statements. Ultimately, it is up to the lender to decide whether to give you a mortgage based on your vacation rental income.
Can I Use FHA Loan for a Vacation Rental Property?
Strictly speaking, you cannot use an FHA loan to buy a vacation rental property because FHA loans are only designed for owner-occupied primary residences. FHA loans require that the borrower intends to live in the property as their primary residence for at least one year after the purchase.
However, you can still purchase a home with an FHA loan and use it to earn monthly income as a vacation rental. For example, you can purchase a multi-family home (up to four units), live in one, and rent out the other. You can also live in your home and list part of it as a short-term rental.
Vacation Rental Fiancing Made Easy
Ultimately, buying a home to use on Airbnb offers similar loan options as a traditional purchase. With traditional bank loans, private lenders and hard money loans, home equity lines of credit (HELOCs), and seller financing options available for prospective investors, there are plenty of ways to purchase a vacation rental. Use the information presented in this article to find the perfect financing options for your situation.