When you buy a rental property, it might be best to just forget everything you learned about mortgages when you bought your home. Rental property mortgage lenders and those that make home mortgage loans frequently have different requirements. The loans' structures might also differ, and the Internal Revenue Service does not treat them the same way.
Finding a Mortgage
Rental property mortgages are specialized loans. In most cases, they don't have the same government backing as residential mortgages, and this makes many lenders shy away from them. Many rental property mortgages come from small community banks that lend to small business people and investors in their local areas. In some areas, banks may not want to lend on investment properties at all and you might need to go to a private mortgage lender, also known as a hard money lender, to get a loan.
Qualifying For a Mortgage
Rental property lenders typically have more stringent standards that the borrower must meet. If your credit score is below 740 or so, you can expect to either not be qualified for a loan or to have to pay a significantly higher rate. Lenders will also look at your property differently. Instead of making a loan that is tied to a percentage of the property's value, they may also look at the property's debt service coverage ratio. Lenders calculate this ratio by dividing a year's worth of mortgage payments into your property's projected yearly profit. If your profit isn't 20 percent to 25 percent higher than your payments, many lenders won't lend you the money because they don't see you making enough money on the property to keep paying the loan if something goes wrong.
Rates and Terms
Most rental property mortgages are more expensive than residential mortgages. Rates and fees can vary, but a good rule of thumb is to expect to pay at least half a percentage point more. In addition, it's almost impossible to get a rental property mortgage with less than 20 percent down since there is no private mortgage insurance to support low-down-payment investment mortgages. When you get done with all of your closing costs, though, you could end up putting 25 percent to 35 percent down. Finally, your lender may also require you to place extra money in a reserve account just in case something goes wrong.
The IRS softens the blow of the extra difficulty obtaining a rental property mortgage. First, you can amortize all of your closing costs over the life of the loan. If you spent $5,000 to take out a loan with a 10-year term, you can write off $500 a year. You also won't be subject to any limitations on how much mortgage debt you can claim as an expense. If it's a mortgage tied to an investment property, you can claim all of the interest on either line 12 or 13 of Schedule E. It also won't count against your cap on personal mortgage interest deductions. From the perspective of the IRS, a rental mortgage is completely different from a mortgage on your residence.
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