Down payment or ‘Loan to Value’
The minimum down payment on a rental property is 20%. However, with a higher down payment also comes lower mortgage interest costs, which, irrespective of the mortgage rate, can positively affect cash flow.
While some are comfortable with less cash flow or even negative cash flow, it’s important to determine how sustainable the property is to carry. For example, with 20% down payment, the cash flow might be – $500 monthly. However, with a 25% down payment the cash flow may be closer to breaking even which creates a much more sustainable long term holding.
Often, a down payment is borrowed from an existing property, and when combined with the mortgage placed on the investment property, results in a 100% mortgage. This can be much harder to cash flow on, adding risk, even if rates drop.
With this said, if the main goal is capital appreciation, a negative cash flow may be acceptable to the borrower until the property appreciates and can be sold for a profit. As long as the borrower can comfortably afford the situation for longer periods (potentially 5 years or more) then risk can be reduced.
Use of Rental Income for Approval
There is a common misconception that banks and other mortgage lenders will use 100% of the lease income/ rental income for a rental property application. On the contrary, lenders typically will only use 50% – 80% of rental/ lease income. In other words, if the property is breaking even using 100% of rent in reality, it can still show as cash flow negative on mortgage applications.
Given this, depending on the application, it’s easier to work with mortgage lenders that use/work with a higher rental income.
In some cases, with 25% down payment, up to 100% of the lease income can be used. However, these lenders may offer higher rates, and even with 100% use of rents, it’s important to note that expenses will be deducted from the lease income, including:
- Vacancy rate (0% – 5% of rents)
- Property Tax
- Maintenance cost
So even in cases where 100% rents can be used, these factors will still lower the lease amount that can be used.
For application purposes, there are other more specific aspects to calculating the rental income. We compare rental add-back vs rental offset.
Rental Add Back
With rental add back, a % of the rental income is added to the total income. From here, the lender applies its maximum lending ratios based on income and expenses.
For example, if the rent is $1000 per month and the lender uses 80% of rents, this means $800 per month or $9,600 per year is added to income. But lenders will only allow a certain % of income to be used for real estate, expenses and other debts. This is known as the ‘Total Debt Service’ ratio or ‘TDS’. A common TDS maximum is up to 44% of income can be used for approval purposes. So even though were able to add $9,600 of rental income, by using a maximum 44% of rental income, the net result is we really have just added $4,224 of income.
This type of conservative approval is very common and leaves many applicants scratching their heads about why the mortgage approval is so much lower given the total rent received.
The rental offset method for calculating renal income in a mortgage application typically leads to higher approvals. It starts by using a lender set % of the rental income, then deducts rental property expenses (ie. mortgage, property tax, insurance, vacancy allowance…). The net income or loss from the property is then added to income OR liabilities depending on the cash flow result.
For example, if the rent is $1,000 per month and the rental offset is 80%, then $800 of rents can be used to deduct expenses. If expenses are $750 per month in total then, for application purposes, there is $50 per month added to regular income. In this example, the rental property added income to the application and is more easily approved. However, if expenses were instead $850 per month, based on $800 of rents, there is a $50 liability payment each month. So in this case, we would need to check if the overall application can support the added monthly liability.
If affordability is a non issue and there is significant employment income in the application, these details may not matter. However, for many applications, selecting the lender with the best mortgage rate AND best treatment of rental income can be imperative.
TOP TIP: If moving out of an existing owner occupied property and turning it into a rental property, lenders will typically allow for a more flexible use of rental income on the newly created rental property because in this case, the mortgage application is for an owner occupied property.
Other Approval Requirements
Lenders typically like to see a healthy employment income alongside the rental purchase. This isn’t to say that rental income can’t help an application to a significant extent, but there comes a point where, if there is too much rental income in an application relative to the employment income, the lender will decline based on this income ratio alone. For example, some lenders will decline if more than 50% of application income is rental income. The lender’s reasoning is that high use of rents in an application is more of a commercial operation than a personal investment.
However, many lenders will allow for more rental income flexibility, possibly at higher mortgage rates.
Credit requirements for purchasing a rental property are higher than for purchasing an owner occupied property. Typically, credit needs to be in good shape or in the 680+ range. This does not mean that credit needs to be perfect, but there should be at least 2 years of credit history and a demonstration of consistent willingness to make payments as agreed.
For rental property mortgage approvals, lenders are more sensitive with regard to the condition of the property. If there are signs of structural damage, or if extensive repairs and updates are needed to bring the property up to a reasonably high living standard, this can potentially lead to a decline based on the property condition alone. In other words, income is strong and credit is great, resulting in a ‘bullet proof’ pre approval. But if the lender doesn’t like the property, that strong pre approval won’t matter.
Applications for properties that need significant updating can be approved, but often this is done with a construction or development mortgage that is then refinanced with a standard rental property mortgage after the updates are complete.
If the property is in good shape but just hasn’t been updated in many years, this is usually OK. But when there are extensive updates needed, or worse, structural issues that could easily become worse, beware.
Rental Mortgage Fine Print Costs
The fine print of the mortgage can have a major impact on the profitability of the investment.
What is the mortgage term? Is it 1 year or 5 years? If looking to sell in 1-2 years, a 5 year rate could easily add $10s of thousands to the selling cost (if rates drop). Maybe for unforeseen reasons, the property needs to be sold sooner than 5 years.
The penalty calculation is a major factor to consider. Some lenders are far lower in penalty cost than others. The length of the mortgage term can substantially impact the penalty, as noted.
Is the interest compounding semi annual, monthly, or weekly? At 2% interest rates, this didn’t really matter too much. But with rates in the 5% – 6% range, the difference in mortgage compounding can be significant. It’s easy to quote a lower rate just to have the interest compound more frequently, benefiting the lender at the nearly hidden expense of the borrower. Semi annual compounding is standard and should be an expectation along with the best rate.
How about portability? Collateral charge vs standard charge? Is there a sales clause in the fine print? There are many ‘special’ / restrictive clauses that can be added to the fine print that may or may not add significant extra cost to the mortgage.
The mortgage rate may even be slightly lower for a mortgage with several ‘special’ clauses in it. But the lenders have all the numbers worked out, statistically, and know that they will profit more off a lower rate given certain clauses in the fine print.
Given this, it’s important to have a good understanding of the fine print for your investment property mortgage to ensure its the best fit.
Income Tax Treatment
Formally, income tax questions and advice should be sourced for an accountant or income tax specialist. However, from a general perspective, it’s important to note what interest might be written off and what interest may not be. Income tax deductions are an important aspect of rental property ownership and is closely related to mortgage planning,
Technically, interest that is paid for an income-producing investment may be written off. In most cases, mortgage funds used to buy an investment property may be written off.
However, there are cases where funds are borrowed from a rental property and used for down payment to purchase an owner occupied property. If the funds are used to purchase an owner occupied property, they are not allowed to be written off, even if the source of the borrowings is a rental property.
It’s important to familiarize yourself in detail with what can be written off from a mortgage perspective and what can’t be. An error here may result in substantial losses over the long term. If the tax aspect is managed well on the other hand, it can result in savings.
Connect with us at Altrua Financial, Mortgage Brokers, for a personalized review of your best options today.