How to Secure Financing
For a Rental Investment

Few people have enough cash available to buy properties outright, so they have to apply for a mortgage. The selection of a competitive mortgage will determine the long-term cost because a fractional change in interest adds up over the years.

Rules for conventional financing are restrictive because lenders have to meet specific criteria. Most loans aren't kept by the original lender, but are resold to the secondary market. Even if lenders continue to service a loan, such as collect payments and impounds, the debt usually ends up being sold to an organization such as the Government National Mortgage Association (GNMA), also known as Ginnie Mae, or the Federal National Mortgage Association (FNMA), known as Fannie Mae. Mortgages are pooled together and shares are then sold to investors.

With this secondary market dictating terms for mortgage loans, it's not always up to the lender whether to grant your loan. If the lender intends to sell your mortgage debt on the secondary market, the specific terms have to be met. These terms relate to credit rating, interest rate, down payment and property type.

The lowest risk -- from a lender's point of view -- is a loan granted on an owner-occupied house, with a large down payment and a borrower whose credit is excellent. Not everyone meets all of these conditions, so varying degrees of approval are possible. The higher the risk, the higher the interest rate will be, and the more down payment you'll be required to deposit.

Homeowners borrowing for their primary residence can make little or no down payment and often get financing with little trouble. Investors will have more difficulty financing properties at a level of 80% to 90%. Whenever your equity in the property is less than 20%, you're going to be required to carry a form of mortgage insurance designed to pay the lender in case you default. Even though you're required to make a larger down payment, you also avoid paying expensive insurance in addition to the fire and casualty insurance you must own for the property.

Some landlords prefer to seek loans on their primary residence rather than trying to meet the higher standards of a loan for an investment property. For example, if you live in a house, one solution is to locate a new primary residence and apply for financing based on your plans to move into the new property. As soon as the transaction is complete, you move into the new home and convert your current residence into a rental. You'll continue making the same mortgage payments on your current home (which was financed originally based on your occupying the property as your primary residence) and rent the property out.

If you time it right, you may be able to accumulate several rental properties by moving into a series of new owner-occupied homes. The only requirement on the part of a conventional lender is that the property being financed must be your primary residence at the time the loan is approved. You could change your mind the day after the loan was approved and convert the new property to a rental. However, you also could be accused of making a false claim on your loan application. Therefore, it's safer and wiser to move into the new home and convert your former primary residence to a rental as a bonafide change of status, even if only for a few months.

The decision to treat a specific property as a rental or as your primary residence should be based on practical considerations. If you ask your family to move to a property that is poorly located, too small for your needs or too uncomfortable, you're risking personal dissatisfaction and conflict at home. One advantage of moving to a series of newly acquired homes is that you apply the same standards to rentals that you apply to your own home. If you've maintained your current primary residence well, it will be a pleasant place to live. A tenant will be willing to pay a reasonable level of rent based on how well you've cared for the property.

The strategy of financing properties as primary residences and moving from one property to another should be viewed cautiously. You should plan to actually move into the new property to avoid being accused of misleading your lender. Once the transaction is complete, the lender will be satisfied, especially if you continue making timely mortgage payments. When you're established in the new property and you convert your previous residence to a rental, the lender on that home will not care whether you live there -- as long as you keep the property insured and the payments continue arriving on time.

As a general rule, expect to do more work and meet a higher standard to finance your real-estate investment. At the same time, you also want to shop for the best possible deal. Look for a loan with the lowest possible upfront costs. Loan-origination fees (points) are charged as an alternative to higher interest rates. A point is equal to 1% of the loan.

For example, if you borrow $100,000, each point will cost you $1,000, which can add up. It makes a comparison between two different loans more difficult. If one lender charges 6% and no points, and another charges 5% and three points, which is cheaper? The only way to make a valid comparison is to calculate the overall interest payments over the term of the loan, plus points. This is an easy calculation involving three steps:

1. Multiply the monthly payment by the number of months in the loan term.
2. Subtract the amount being borrowed. The remaining amount is total interest.
3. Add the points the lender wants to charge you. The result is overall interest. Once calculated, you can determine whether one loan is going to be a better deal than another.

When you study the overall interest expense of mortgaging a property, you soon realize that the cost of the investment is not limited to the sales price. You'll pay far more in interest over 30 years compared to the original price of the property. Investigating beforehand and finding the best deal is more important than finding a house that costs a few thousand dollars less. Basing the comparison on overall costs, you can save more by finding the best interest-rate deal than you would in trying to save a few dollars on the purchase price. If you get a good deal in your price, but pay too much for interest, you'll be spending more in the long run.

-- Mr. Thomsett is author of "The Landlord's Financial Toolkit" (Amacom, 2004), from which this article has been excerpted.

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