Rental Property Mortgage Financing Tips and Strategies
Financing a rental property is quite a bit different than an owner occupied home. And although rental property mortgage financing can more difficult to get approved for, this certainly isn’t always the case. Approvals can be smooth and straightforward if organised properly. So here we will look at some of the main differences between owner occupied mortgage financing and rental property mortgages. Then we will move into some of the financing tips and strategies that are available, and may be critical in helping to improve your investment returns over the long term.
Rental Property Mortgage Financing Differences
Higher Down Payments. For rentals a minimum of 20% down payment is needed. However, many lenders require 25% – 35% down payment.
Higher affordability standards. Lenders will include rental income produced by the property on the mortgage application to varying degrees. Some lenders will only use 50% of the rental income for qualification purposes. For example if $1000 per month is received from the tenant, then only $500 will be used towards qualifying for the mortgage. This can make it difficult to qualify with some lenders, as all expenses including mortgage, heating and taxes need to be accounted for in the affordability. Thankfully not all lenders are this stringent with the use of rents. Some will use pretty much all of the rent (although they may require a slightly higher down payment).
Affordability will also depend on what sequence or succession that you buy your property in, and how many properties you own. For example, if you own one owner occupied property, and then purchase a rental property for which you need a new mortgage – lenders will usually attribute a lower renal inclusion amount (like 50% of rents) to the newly purchased rental property. This can make it difficult for rents to cover expenses, although there are a few lenders that allow for a better rental inclusion in this case.
On the other hand if you left your existing property to move into a new owner occupied property, and turned your existing property into a rental – lenders will often treat the rents from an existing property in a much more favourable manner, often using 80% – 100% of rents to offset all expenses. Moreover if you own multiple (2+) rental properties, it can often become easier to mortgage the third and fourth property, as long as the existing properties are covering their expenses well.
But with this said, the Debt Service Ratios (TDS and GDS) or expense limits are almost always lower when purchasing a rental property. For example – most lenders will allow a Total Debt Service Ratio of 44% when purchasing an owner occupied property. This means that a maximum of 44% of gross income can be used towards house expense and other debt payments. For a rental property the maximum TDS is usually around 40%.
The solution here is to compare several lenders, noting that there are differences between them and how they approve. I have seen on several occasions instances where a Bank branch flat out declines an application, only to have it approved – at a lower rate – through a different lender.
Higher credit standards. Typically to achieve low rate rental property financing, credit will need to be higher or in the 700 range. Exceptions can be made, and there are alternative lenders who can approve the mortgage at a slightly higher rate. However credit standards are generally higher than owner occupied purchase or refinance applications.
Again it’s important to note that there are differences among lenders too that can make it much easier, or much harder to gain an approval. Using a mortgage broker is likely the easiest way of quickly shopping among dozens of lenders, and there are some mortgage brokers who will be able to provide a wealth of additional knowledge and customized financing strategies to bring even more value to your table.
Rental Property Mortgage: Features and Benefits, Tips and Strategy
It pays to ensure you are getting the lowest rate available. There can be wide variation between lenders when it comes to rates on a rental property mortgage – because some lenders will add a rate premium, and others will not. Although the absolute lowest market rates are usually not available for rental properties, there are still excellent rate specials and opportunities that can be arranged.
To put into perspective – if you could save $3500 on rate over a term from one lender over another, this savings could potentially contribute towards a new roof, a new furnace or a light remodeling of a unit. This represents about a 0.20% difference on a $350,000 mortgage over 5 years. Now imagine this over several mortgage terms, and with several properties. Even though mortgage interest on a rental property is tax deductible, lower rates still offer a very ‘controllable way’ to optimize your returns.
Fixed Rate Vs. Variable Rate? Longer term or shorter term? If you’re looking for more stability and consistency in your costs as an investor, then it is probably a good idea to go with a 5 year fixed rate mortgage – ‘Just Set it and forget it’! Although there are lower rate terms available, this exposes you to more risk. For example – if you took a two year fixed mortgage or a variable rate mortgage, and if in 2 years’ time rates are up by 1.5% then you might not be too happy with this decision. Moreover, your budgets would have to be adjusted to account for the higher financing costs.
Contrary to the thoughts of many at the time of writing this – if rates reverted to anywhere near the average historical interest rates, than rates have quite a bit more room than 1.5% to increase. But any increase would likely happen gradually, and as has been mentioned earlier, increased rates correlate positively with higher rents and property values, due to inflation.
Moreover, as interest rates are tax deductible, the higher your rate, the more you will be able to write off in taxes. The lower your rate the more you will pay in taxes. So if looked at from a tax perspective – what is your risk adjusted after tax difference in rate of return? After taxes are taken into consideration, is the difference between a variable or a 2-3 year fixed rate really worth it?
Rates should remain relatively low for the foreseeable future but truth be told – no one really knows exactly how interest rates will move over the long term, so it may be prudent to opt for a longer term fixed, such as the 5 year, if you are looking for a simple way to reduce your risk going forward.
Given the small differences or ‘narrow spreads’ between fixed and variable rates, I tend to advise on 5 year fixed rate terms for rental properties. But with this said, there are some good cases for shorter fixed rate, such as a 2 or 3 year fixed, or a variable rate when purchasing a rental property that should be given some credence:
- If you are planning on selling within a specific time frame and you do not have 5 years to wait. For example, if you plan on selling in 2 years, it probably makes sense to have a 2 year mortgage which will become ‘open’ at that time, avoiding any potential penalty on the property sale.
- A variable rate mortgage can make sense if selling within a 5 year time period – but you do not know when exactly the sale will occur. The reason for this is that variable rate mortgages typically carry a 3 month interest penalty. Compared to an Interest Rate Differential Penalty that is often found with fixed rate mortgages, the 3 month interest penalty is much less. So variable can give you a lower rate, with more flexibility to leave the mortgage during the term when you are ready.
- Using a lower rate to maximize your principle payment. When a lower rate is used simply to lower the payments slightly over a short period of time, this adds some additional risk to your rental portfolio which could easily prove more costly over time. However if the lower rate is taken advantage of, and penalty free pre-payment privileges are used to ‘top up’ the payment to levels comparable to a 5 year fixed or even a 10 year fixed mortgage payment, than this can yield some excellent results. This kind of strategy can offset or mitigate the risk of taking a lower rate, and can often work in your favour.
For example, a 5 year fixed payment is $1000 per month and a 3 year fixed payment is $950 per month. If you took the 3 year mortgage, by allocating an additional $50 per month towards the mortgage principle, your 3 year mortgage payment would be equivalent to the 5 year payment, and would allow for faster principle payment over the 3 year time period. Your mortgage broker should be able to provide various calculations and scenarios to show savings unique to your situation. They could also show you what future rates would have to become, in order to break even. The same way of thinking applies to variable rates. For those looking for a variable rate, increased pre-payments can be an excellent way for potentially achieving savings and lowering risk.
- Strong Applicants. Stronger applicants with substantial liquid assets and free cash flow are more likely to withstand the additional risk of a lower rate mortgage – pre-payment or no pre-payment added.
Rental Property Mortgage Quality
Although rate and term selection are big factors when selecting your best mortgage, a good understanding the quality of the fine print, and what it can mean to your bottom line, cannot be overstated.
If the mortgage contains costly fine print provisions, this can prove financially damaging when you are least expecting it. Indeed, as you may have heard, the devil is often found in the details. For example, if you wanted to or needed to sell a property during the mortgage term – is your penalty 3 months interest (lower) or 3% of the balance (much higher)? Higher penalty cost and Collateral Charge terms are two of the big things to watch out for, however there are several other provisions that a lender may include in the fine print that could easily cost you more.
Do you know what the penalty calculation is?
Even with the best investment property Financial Plans, there is still room for variation of the Plan that cannot be foreseen. In fact, over 50% Canadians make some sort of changes during their mortgage term – not on the renewal date. Given this, how is your penalty calculated?
Penalty calculations can differ by $10,000 or more between lenders – even on identical looking mortgages! And no one wants a $10,000 penalty surprise if they wanted to sell during their term. So this feature can be very limiting and costly if you are looking to either port the mortgage to a different house, or sell the property. Fundamentally – Why accept a high penalty, when there is usually no additional cost for a lower penalty mortgage?
Do you know if the mortgage is registered as a ‘collateral charge’ or a ‘standard charge’?
A collateral charge mortgage will not let you renew with a different lender on the renewal date without going through a costly mortgage refinance. A mortgage refinance requires more legal work and is different than a simple lender transfer switch/on a renewal date. If it is more difficult and costly to change lenders at the renewal date, then the existing lender is positioned well to offer higher rates, and in this sense has the ‘upper hand’. The customer is in a much weaker negotiating position with a collateral mortgage, and this can be very costly over time. Like penalty cost differences – standard charge mortgages are usually offered at the same rates as collateral charge mortgages. So why go into a collateral mortgage?
As mentioned, these are the main things to watch out for in mortgage quality – however there are a myriad of other tactics lenders apply – including different compounding (not semi-annually as per the norm) and if you took a variable rate, then the lock in provision to a fixed rate can lead to a much higher rate than would be expected. Be on the lookout for such odd provisions, and ensure the mortgage professional you are working with explains the quality of mortgage commitment thoroughly.
Creative Strategies for Financing an Investment Property
Having seen some of the main differences with rental mortgages and what to look for when selecting your best mortgage, we will conclude this section on rental property mortgage by looking at some of the more creative strategies for financing your investment.
Using Your Existing Home and Mortgage: There are many individuals who move out of their property, because they feel that its time for an upgrade or change, or maybe because there is an employment transfer to a different City. In these cases, a buyer would be able to use as little as 5% down payment on the next house that they are moving into, while potentially converting the existing property into a rental property.
This may be a good strategy for you, especially if you are not able to save up for a sizable down payment. However, you should be aware of what the conditions are, within your existing mortgage contract. The terms of the mortgage fine print may not technically allow for this kind of activity. Even more importantly, your insurance should be modified to protect you from tenant liability if your owner occupied home is converted into a rental property. Finally, if you do convert an owner occupied property into a rental – you will be charged capital gains tax on the growth of the property from that point on. So while this could be an excellent strategy for you, there are a few things to look into here to do it right.
Accessing Existing Equity for Down Payment: Is pretty much as straight forward as it sounds. Given the explosion of equity that we have seen in existing properties over the past two decades, combined with ultra-low interest rates, many prospective property investors are finding that they have lots of equity available to potentially invest with. Prudent use of this equity can help jump start a rental portfolio in cases where the 20 – 25% down payment has not been accumulated in an investment or savings account. And accessing this money can be as simple as a mortgage refinance or opening a secured line of credit. Talk with your mortgage broker about which could be right for you – there can often be marked differences in savings here.
I will almost always recommend a mortgage refinances, as opposed to a home equity line of credit due to the lower costs involved with the refinance –even with a penalty. Also, a good deal of review and pre planning should take place with your mortgage professional at the outset of any initial financing to ensure that both the equity take out AND the rental purchase will close smoothly.
In reality, rental property investment mostly boils to financing – as at the end of the day, the whole range of thoughts and activities involved with the investment, is truly a financial endeavour. Many pros in the business will say that their biggest virtue as an investor has been the ability to either work with or become ‘a master of financing’. Accordingly, mortgage financing is a good first place to have a thorough understanding relative to your situation as you move forward in your endeavour. This can often be accomplished in the form of a good pre-approval. However once the property is owned, we need to ensure other variables are controlled properly in order to help ensure your ongoing success. So the article will conclude by reviewing tenant selection and some general ideas on property management.
Altrua Mortgages provides Mortgage Broker services across Canada, with a special focus on Kitchener-Waterloo, Cambridge, Guelph, Milton, Hamilton, Toronto, Ottawa, London, and Windsor. Do not hesitate to contact us anytime for a personalized conversation on how you can succeed in the rental property investment market.