Buying a vacation rental home can be an exciting opportunity for lenders, investors, and entrepreneurs. The potential for significant returns on investment hinges on factors like strategic financing. Before taking the plunge into purchasing a vacation rental home, it’s essential to understand all the financing options. By doing your due diligence before signing any paperwork, you can help ensure your investment will be one that pays off in spades!
Let’s look at how real estate investors approach purchasing a vacation rental property in more detail.
Steps before financing a real estate investment
As always, it all comes back to your attitude and preferences as an investor. Some investors are okay with taking risks with their money to reap greater rewards, while others do. When financing a vacation rental, know your risk tolerance.
Decide how much you can realistically afford to put down as a down payment and pay each month. This will help narrow down what kind of lenders are willing to work with you and what type of short-term investment property makes the most sense for your goals.
Using your life savings as a loan for this business venture is not advisable, as there’s always a chance of loss. Remember that you will need additional money for property marketing, furnishings, or vacation rental software.
Know your markets
Researching the markets in which you are investing is essential. Understanding the local regulations, market trends, and other factors can help you better evaluate the associated risks of any potential investment. For instance, not all municipalities allow short-term rentals, while some regulate what specific neighborhoods short-term rentals are allowed. If you’re buying a condo, the homeowners association might limit how often you rent the property.
It’s not just available properties you’re looking at. Consider the economic state of the local marketplace. Are home prices appreciating rapidly? How about mortgage interest rates? After months of near-historic lows, they rebounded to over 7% in 2022. Markets can quickly shift, so pay attention to inflation, interest rates, buyer demand, and appreciation.
Not only do you want to mitigate your risk, but so do lenders. You can guarantee that the financial institution will do a comprehensive assessment. By being aware of all these market factors, lenders avoid taking too much financial risk while still getting a great investment return. In exchange, buying in a good area with a proven track record means they’re more likely to lend to you.
Set investment goals
Identifying your rental income goals is crucial when determining the type of short-term rental property best suits your needs. Some people buy vacation homes to occupy them for part of the year and rent the rest. In that case, the second home will need to cater more to the homebuyer.
When the goal is generating income, it’s about tailoring the purchase to the vacation rental market. Estimate the earning potential for an Airbnb or VRBO short-term rental versus a long-term rental before buying. Find the typical monthly income for comparable properties; your monthly mortgage payments should be under this figure.
What to consider when buying a vacation rental
Now that you have a better understanding of the rental market, you can start to look for your ideal vacation rental. Location matters, as do other factors specific to running a vacation rental business. Here are some key metrics any investor should be looking at when considering a potential short-term rental investment:
- Airbnb Rental Income: Will this rental cover all associated expenses? Is there enough monthly income to cover mortgage payments and other costs?
- Occupancy: What is the average occupancy rate of the rental property over time? Consider seasonality when measuring occupancy. Higher Airbnb occupancy means more rental income and less risk.
- Capitalization Rate: The cap rate (or capitalization rate) measures how well an investment property will generate cash flow compared to its initial cost. A higher cap rate typically indicates higher rental yields and lower risk.
Lenders will be looking at some metrics, too. Before you walk into a mortgage office, be aware of what numbers the lenders consider when approving you for financing:
- Debt-to-Income Ratio (DTI): What is the borrower’s ratio of debt payments to income? A low DTI indicates that rental and personal income are more likely to cover associated expenses, reducing the risk of defaulting on a loan.
- Debt Service Coverage Ratio: This measures how much rental income remains after paying for all related costs, such as mortgage, interest, HOA, and property management fees. A higher DSCR means more rental income to the investor, lowering their overall risk and making them more attractive to lenders.
- FICO: The borrower’s credit score is a significant factor when applying for real estate financing, and vacation rental financing minimum scores are higher than those buying a primary residence. FHA loans require a FICO score closer to 640. The higher the score, the more likely they will be approved and get better terms.
Understanding these key metrics and researching before investing in a vacation rental property can help increase your chances of success!
Understanding the lender marketplace
Financing a vacation home isn’t like financing a primary residence. Rental property mortgage rates are typically higher as lenders see it as a rental business. If borrowers find themselves in financial trouble, they’re more likely to foreclose on the investment property over their home.
In the United States, Fannie Mae and Freddie Mac set the rules and guidelines for lenders. These two government-sponsored enterprises are responsible for expanding the secondary mortgage market by securitizing loans in mortgage-backed securities (MBS). The US Congress created these companies to help boost the marketplace in the 1990s. They are now regulated by Federal Housing Finance Agency (FHFA).
Remember, lenders want to reduce their risk. It’s up to you to present a robust package showing you are a reliable and trustworthy buyer. By making a 20% down payment, the lender and the borrower are at less risk. Not to mention, vacation rental financing is generally more expensive than securing a new mortgage for a primary home. Suppose you can put more money down upfront. In that case, you’ll have much better chances of being approved for financing with lower interest rates.
Your vacation rental loan options
Traditional lenders are an option for a second home loan. Typically, lenders will require you to provide up to 20% of the purchase price as a down payment and may have other requirements such as proof of income or good credit history.
The advantage of working with traditional lenders is that they often offer lower interest rates and secure financing for long-term investments. The lenders will want proof that the borrower can comfortably afford floating two homes.
Asset-based loans, also known as commercial loans, are another viable option for investing in vacation rental properties. These loans use the investment property (the actual value or its equity) as collateral to secure the loan from lenders. Instead of DTI, they assess the actual or potential income of the property using the Debt Service Coverage Ratio.
Suppose the vacation rental you’re considering is a multi-unit property. In that case, an asset-based loan may be the way to go. These loans are underwritten using the property’s income. They often have a faster closing process and less documentation.
However, asset-based loans typically have higher interest rates and shorter repayment terms, making them less ideal for long-term investments. If the borrower defaults on the loan, the lender takes control of the property. They also often require a 20-25% downpayment to mitigate the lender’s risk.
Hard money loan
A hard money loan, or a short-term bridge loan, is primarily offered by individuals or companies for real estate transactions. These loans are typically used for financing real estate investments such as vacation rentals or house flips that need a quick close with no personal or property-level income requirements.
Hard money lenders offer significantly higher interest rates than traditional lenders and require borrowers to use the property as collateral to secure the loan.
It’s important to note that these loans usually come with short repayment terms, as short as 1-3 years. The lender may require a more significant down payment to offset their risk. Lenders may be reluctant to lend on a property if they don’t believe it will produce enough income for them to recoup their investment quickly.
Some investors opt for creative financing options to finance their second home mortgage. Cash-out refinancing is a popular option that allows you to borrow against the equity in your existing property and use it as a down payment on your new vacation rental property.
Similarly, a Home Equity Line of Credit (HELOC) is a loan in which the lender agrees to lend a maximum amount of money over an agreed time, allowing borrowers to access funds as needed. This home loan can be used when purchasing a second home using the equity in the primary residence. The interest rates can be negotiated depending on your creditworthiness but are likely higher than conventional loans.
Private money lenders come from a source you know that may be willing to invest in the vacation rental with you. These could be family, friends, fellow investors, or other people you have a relationship with. These individuals lend their money to investors and usually do not require perfect credit.
Although interest rates may be higher than what a traditional lender would offer, private lenders can be more flexible regarding repayment schedules while providing quick access to capital.
You can borrow up to 50% (or $50,000) of your retirement savings without paying any taxes or penalties. Borrowers will pay interest on whatever amount they withdraw. Still, on the upside, that interest goes back into the 401k and not a mortgage lender.
Although this can be a great way to access funds quickly, it’s essential to consider the long-term impact of taking out a loan from your retirement savings.
What to keep in mind
Research your options and keep an open mind. Take some time to explore what financing would work best for you. Look at local lenders, big institutions, and online opportunities to see what might be the best fit for your future investment. Compare your loan options and understand what each one will mean for you regarding repayment schedules, interest rates, and other essential factors for running a short-term rental.
Financing takes time, but you’ll want to move fast once you source a good investment deal. If you use a conventional lender, 401k, or hard money source, get ready with a pre-approval. Having money at the ready gives you an advantage over other buyers.
Finding your second home financing options
Regardless of your financing route, assessing your risk tolerance and comparing different loan options is essential. Remember to factor rental income into the equation when calculating returns to ensure you make a sound investment decision. Think like a real estate investor to maximize your chances of a successful vacation rental business.
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