Cash Reserves, Closing Costs, & More
Regardless of whether you borrow from a conventional lender or a portfolio lender, you still need cash reserves.
Lenders require that you have enough cash set aside at settlement to cover a certain number of months’ mortgage payments. The typical range is one-to-six months’ worth of payments.
Where it gets hairy is that lenders often require cash reserves for all of your mortgages — not just the new loan you’re borrowing.
And, of course, you’ll need cash to pay for closing costs. That includes between $1,000-2,000 for title-related expenses, plus taxes, insurance, and lender fees, which will lay on thousands more dollars. No one said borrowing a mortgage was cheap!
The upshot is that you need a lot more cash than just a rental property down payment. Keep these other cash requirements in mind as you run the numbers on financing options.
17 Ways to Come Up with a Down Payment for an Investment Property
Not scared away yet? Good, because despite the high cash requirements for buying investment properties, you have plenty of options to come up with the cash for a down payment on a rental property. You may even be able to buy your next rental property with no money down!
Before we dive in, it’s worth pausing to note that the best source of funds for a down payment was, is, and always will be cash from your savings. When you borrow a down payment from someone else, you leave yourself vulnerable to overleverage, to narrow cash flow margins or even negative returns, and to possible rate hikes or called loans.
This is why we’re so big on boosting your savings rate and cutting your spending, and even going so far as living on half your income. The more of your own savings and cash you can invest with, the better position you’re in to earn high returns from your rental properties.
All right, enough proselytizing, let’s dive into some alternative ideas for coming up with the down payment for an investment property!
1. Home Equity
Have some equity in your primary residence?
One of the most effective ways to borrow money for a down payment on an investment property is to take out a home equity line of credit (HELOC) against your primary residence. It’s relatively affordable, it’s flexible, and if you have a lot of equity, you can borrow a lot of money!
HELOCs can be fixed-interest or variable, based on the prime rate. They typically have a 10-15 year draw period, during which borrowers can transfer funds to the bank account at any time. You typically pay interest only on the credit balance, and don’t have to pay any money toward principal each month.
After that, there’s a 15-20 year repayment period, when the borrower can no longer pull money from the line of credit, and must make regular monthly payments to pay off the balance.
Many real estate investors use a HELOC to cover the initial down payment or the renovation costs when they buy a new property. After renovating, they then refinance to pull some cash back out and pay off their HELOC balance, and then go out and do it all over again.
HELOC for Flipping
Alternatively, you can use a HELOC to fix and flip a house, rather than keeping it as a rental.
You can also tap your equity with a home equity loan. Usually a second mortgage, home equity loans could theoretically be a first mortgage if you own your home free and clear. But home equity loans don’t offer the same flexibility as HELOCs, as standard mortgage loans with a fixed repayment schedule.
As a final note, keep in mind that conventional lenders won’t like you using HELOCs to come up with the down payment for an investment property. First, they don’t want to see any part of the down payment borrowed, and second, it will add more debt to your debt-to-income ratio (DTI).
It may also lower your credit temporarily, like any other new debt.
2. Rental Equity Line of Credit (“RELOC”)
All right, so “RELOC” may not be a term, but it’s still a thing. Landlords can take out HELOCs against rental properties, rather than their homes, if they have enough equity.
As with mortgages, expect the interest rates and fees to be higher on credit lines against an investment property compared to a HELOC. That’s because the risk to lenders is higher, as borrowers are more likely to default on investment property loans than on their home loans.
You can also expect the maximum LTV (loan to value ratio) to be lower, with RELOCs compared to HELOCs. That means that lenders will lend you less of the property’s total value, again because their risk is higher.
Remember that when you borrow money to invest, you need to make sure you’ll earn a higher return on investment than what you’re paying in interest. That includes both your investment property mortgage and any loans for the down payment. Run the cash flow numbers in our free rental property calculator to forecast returns, monthly cash flow, and operating expenses.
3. Cross-Collateralization
3. Cross-CollateralizationAnother option if you have equity in your home or other rental properties is cross-collateralization.
Wait, cross-collata-what?
Also known as a blanket mortgage, you can offer to let your new lender put an extra lien against your home or a different rental property, as additional collateral. Say you apply for a loan to buy a new rental property, and they require a 20% down payment (plus closing costs, plus cash reserves). You don’t have enough cash, but let’s say you do have another property with $100,000 in equity in it.
So, you tell the lender about your equity, and they agree to use that other property as additional collateral, and waive your down payment requirement. They now have two properties secured for one loan, and feel confident that even if you default, they can recover their money by foreclosing on both of your properties.
This, of course, raises your level of risk. If you default on one loan, you lose two properties. Borrower beware.
4. Your 401(k)
Thinking about raiding your nest egg? It gets tricky when you borrow money from your retirement accounts to cover a rental property down payment, beware.
But here are the basics. First, if you know — with 100% certainty — that you will be able to pay the money back in under 60 days, you can withdraw the money from your 401(k). As long as you return it within 60 days, it doesn’t count as a distribution, and you don’t suffer the IRS’s wrath with penalties and back taxes owed and lots of tears.
Since that’s a risky play, you have another option: you can borrow the money from your 401(k) administrator. Sure, it’s technically your own money that you’re borrowing against, but until you reach 59 ½, you don’t have access without the aforementioned penalties. But the good news is that 401(k) loans are cheap, since you’re basically borrowing money from your future self. Money that, incidentally, is already in your account.
You can typically borrow up to $50,000, or up to 50% of your 401(k) balance, whichever is lower.
