So you’ve decided to add vacation rentals to your investment portfolio. Proper has a great, comprehensive insurance solution for you. But, what about financing? This article lays out your basic financing options to start and grow your vacation rental portfolio.
Vacation Rental Financing Solutions
You have five main options to finance the purchase of vacation rental property: Second home loan, agency investment property loan, jumbo loan, bank loan, or business purpose loans. A second home loan or an agency loan are great for getting started on your investment journey. Bank and jumbo loans are the middle ground options, and a business lender loan is going to be tailored specifically to investors. Keep reading to learn more about the options.
Second Home Loan
Your least expensive option is going to be an agency second home loan. To use this option, you must occupy the property some portion of the year, the home must be single-unit and suitable for year-round occupancy, you must be the exclusive owner, and the property cannot be subject to an agreement that gives a management company control over-occupancy. Moreover, to qualify, you’re going to need enough personal income to support all of your monthly debt obligations, including the new second home loan, without the rental income you expect from your new vacation rental property. Finally, to qualify your loan amount cannot exceed the conforming loan limits that are periodically adjusted by the Federal Housing Finance Agency, or FHFA. You can find more information on those loan limits here.
Agency Investment Property Loan
Your next least expensive option will be an agency investment property loan. Let’s say you’re purchasing a vacation rental property that has been operated by the current seller as a vacation rental property for the past two years. And let’s further assume your loan amount is within the conforming loan limits. In that case, you may qualify for an agency mortgage where you can include the expected rental income in your income for qualification purposes.
With agency second home and investment property loans, you’re required to own the rental property in your personal name. While this is simple and straightforward, experienced investors often prefer to own their rental properties in legal entities, such as limited liability companies, to segregate their assets from potential liability claims. Let’s say someone gets hurt while staying at your vacation rental property. First, setting up your business as a limited liability corporation can give you peace of mind that any claims that exceed your insurance policy limits will be limited to the value of your vacation rental property, not your personal net worth. Second, you’re going to want to make sure you have an insurance policy that is specifically written to cover the unique risks of short-term rental properties. Talk to Proper.
So how do you finance a vacation rental property if: (1) you don’t have enough personal income to qualify for a second home loan; (2) your loan amount exceeds the conforming loan limits; or (3) you want to own the property in an entity to protect your personal assets.
If your loan amount exceeds the conforming loan limits, you still may be able to get what is called a jumbo loan. Unlike agency loans that can be “guaranteed” by Fannie Mae or Freddie Mac, jumbo loans either are held on banks’ balance sheets or refinanced in the bond market. Historically, jumbo loans were more expensive than agency loans. That is not so much the case anymore because the typical qualification requirements for jumbo loans tend to be quite stringent. You’ll need a strong credit score, good assets and a history of consistent personal income. Depending on your credit, income and net worth, you may be able to buy one or more vacation rental properties with non-agency jumbo loans.
If you’re willing to do the leg work, you likely will find local and regional banks that will entertain financing vacation rental properties. Banks typically are more flexible on how they will qualify you for the loan, including how they account for your income, assets and any potential rental income from the property. They also will allow you to finance the vacation rental property in a legal entity to protect your personal assets. So what are the drawbacks? First, these loans typically are more expensive than agency second home, agency investment property and jumbo loans. Second, because these smaller banks make a variety of different types of business and commercial loans, their internal processes often are not particularly well ironed out. This means you may encounter delays or unexpected documentation requests. Moreover, if you intend to grow your portfolio, most regional banks will want to grow their exposure to you slowly. This will limit how fast you can grow your portfolio. Finally, regional banks typically include “balloons” in their mortgage loans. These balloons require that you either sell the property and pay off the mortgage within a set period of five, seven, ten or 15 years, or refinance it.
Business Purpose Lenders
Last, but not least, are the business purpose lenders. These are lenders that specialize in financing single-family investment properties, including vacation rentals. Loans from these lenders typically are 100 to 150 bps more expensive than agency loans and 50-100 bps more expensive than jumbo and bank loans. But they offer awesome flexibility. First, they will qualify you based on your personal credit, but not your personal income. Most won’t even ask for your pay stub or tax return. Second, when evaluating your loan, they will take into account the cash flow your property generates or could generate as a vacation rental. Third, they prefer that you finance your investment property in an entity. Fourth, their loans have full 30 year terms and many even offer interest-only options for ten years. Finally, since this is what these lenders do for a living, they have well-developed systems and processes for financing vacation rental properties.
Which Vacation Rental Financing Solution is Best for You?
The answer depends on your financing needs. If your primary goal is to utilize the property yourself and you have high income, reserves, and credit, start with a second home loan. For an agency investment loan, you are going to need the same high income and credit, yet you have the flexibility to rent out the home more often. Keep in mind, you can only purchase the vacation rental in your own name, leaving your personal assets at risk.
A jumbo loan comes into play when the loan amount exceeds the limit set by Fannie and Freddie. Many vacation rentals fall into this category, yet like a second home loan or an agency loan, there are going to be stringent requirements. For those who don’t qualify for agency or jumbo loans, bank loans provide more flexibility. Bank loans enable investors to finance through entities, though are typically only available in shorter terms with balloon payments.
Professional investors looking to build a portfolio of vacation rental properties, should consider a business purpose loan. They can expect a smooth experience with 30-year terms and qualifications based on property cash flow rather than personal income.
Protect Your Investment
Regardless of your financing method, it is crucial to make sure your vacation rental is properly insured. After putting a lot of your hard work and money into this investment the last thing you want to happen is get into the unfortunate situation where a guest has thrown a party and created an immense amount of damage and you’re left paying more out of pocket to repair the damages. This is why we recommend that you have a policy like Proper Insurance to protect your investment, as they provide coverage for malicious acts of damage or theft and more.