The Short Answer
Investing in a rental property is a powerful way to build wealth, and it’s achievable with the right strategies. Key steps include improving your credit score to secure better loan terms, saving for a 25% down payment, and leveraging a DSCR loan that focuses on the property’s income rather than your personal finances. Additional options, like forming an LLC for tax benefits and liability protection, or using creative financing methods such as co-borrowing, tapping home equity, or house hacking, can further simplify the process. With careful planning and these tools, owning your first rental property is within reach.
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How To Afford A Rental Property: Step-by-Step Guide
Rental property can be a successful way to build wealth through real estate investing, but purchasing your first rental property can be a challenge. Fortunately, with the right strategy, getting into the rental property game is achievable. By focusing on key financial milestones such as building up your credit score, saving for a deposit and using a DSCR loan, you can set yourself up for success in the rental real estate market once you buy a rental property. The guide below will walk you through each step, to get you on the path towards rental real estate investing success.
Step 1: Build Up Your Credit Score
Your credit score plays a crucial role in determining your eligibility for a rental property loan. It acts as a snapshot of your financial health, giving lenders insight into how well you manage debt. That’s why it’s such a key element of your loan application.
Most lenders require a minimum FICO score of 660 for rental property loans, but having a higher score doesn’t just improve your chances of approval—it can also unlock better loan terms. The reason is simple: the lower your credit score, the riskier you appear to lenders. And the riskier you are, the more expensive borrowing becomes. This could mean higher interest rates or additional fees, making your loan significantly more costly over time.
Improving your credit score isn’t an overnight fix, but it’s worth the effort. To boost your score, focus on living within your means, managing debt responsibly, and making all payments—whether it’s your mortgage, credit cards, or utility bills—on time, every time. Even paying the minimum balance on your credit cards helps to build trust with lenders. Regularly checking your credit report for errors is another smart move to ensure your score accurately reflects your financial habits.
With a strong credit score, you’re likely to be viewed as a low-risk borrower, allowing you to secure lower interest rates and more favorable loan terms. These savings can make a significant difference in the profitability of your rental property investment.
Step 2: Save Up For A 25% Down Payment
The next step on your journey to becoming a rental property investor is securing the funds for a down payment on a rental property. Generally, real estate investors who follow the “buy and hold” strategy aim for a down payment of around 20-25% when financing an investment property. The good news is that this down payment allows you to leverage debt in the form of a loan, so you don’t need to cover the entire purchase price upfront. This approach enables you to maximize your purchasing power while keeping more cash available for other investments or expenses.
For lenders, the size of your down payment directly impacts the loan’s risk profile. A smaller down payment—or a higher loan-to-value (LTV) ratio—means the lender is taking on more risk because the borrower has less “skin in the game.” This can make lenders wary, as borrowers with minimal investment are more likely to walk away if the investment property underperforms. By saving up for a 25% down payment, you can demonstrate financial commitment, which can make lenders more comfortable approving your loan.
Additionally, loans with higher LTV ratios typically come with higher interest rates and larger loan fees to offset the increased risk for the lender. Conversely, a larger down payment can reduce these costs, giving you access to more favorable loan terms, such as lower interest rates and reduced fees. Investors with a strong credit score and a substantial down payment often find they have more options available, making it easier to secure a loan that aligns with their investment goals. Saving for a 25% down payment is not only a smart financial move but also a strategic step toward building a successful rental property portfolio.
Step 3: Use A DSCR Loan To Finance Your Rental Property
DSCR loans are a popular financing option among rental real estate investors because they are specifically designed for real estate investment. Unlike traditional loans that rely heavily on the borrower’s personal income, DSCR loans focus on the debt service coverage ratio (DSCR) of the investment property. This means the loan approval is based on the investment property’s ability to generate enough rental income to cover its debt obligations, rather than the investor’s personal financial capacity.
At the core of a DSCR loan is the property’s cash flow. DSCR Lenders use the property’s net operating income (NOI) to assess whether it can sufficiently cover the loan’s annual debt payments. The DSCR is calculated by dividing the NOI by the annual debt obligations. For example, if a property generates $120,000 in NOI and the annual debt payments are $100,000, the DSCR would be 1.2.
Most lenders require a minimum DSCR of 1.2, meaning the property’s rental income exceeds its debt payments by at least 20%. A ratio above 1 indicates the property’s rental income can cover its debt, while a ratio of 1.2 or higher shows that the property not only meets its debt obligations but also generates surplus income. The higher the DSCR, the lower the risk for lenders, which can translate into better loan terms for investors.
By using a DSCR loan, investors can focus on the strength of their property’s cash flow rather than their personal finances, making it an excellent choice for building a rental property portfolio.
Bonus Tip: Set Up An LLC To Unlock Major Tax Benefits
Using a Limited Liability Company (LLC) to purchase rental properties is a smart strategy for maximizing tax advantages and protecting your personal assets. This legal structure offers several key benefits for real estate investors, making it a popular choice for those building rental property portfolios. Here’s how an LLC can work in your favor:
Tax Deductions: Operating your rental property through an LLC allows you to take advantage of various tax deductions. You can write off expenses such as maintenance, repairs, property management fees, utilities, and even depreciation, reducing your taxable income and boosting your bottom line.
Limited Personal Liability: With an LLC, your company, not you as an individual, becomes the official landlord. This separation significantly reduces your personal liability. If legal issues arise—such as tenant disputes or accidents on the investment property—your personal assets remain protected, as only the LLC’s assets are at risk.
Pass-Through Taxation: Unlike corporations, LLCs benefit from pass-through taxation, meaning the business itself does not pay income taxes. Instead, profits or losses are reported on your personal tax return, avoiding the double taxation that can occur with a corporation. This streamlined tax structure helps keep more money in your pocket.
Operational Management: An LLC allows you to formalize roles within your property operations, such as assigning responsibilities for property management, maintenance, and record-keeping. This structure can streamline decision-making and clarify responsibilities, especially if you’re managing multiple rental properties or working with partners.
Credibility with Lenders and Tenants: An LLC also adds a layer of professionalism to your rental property business. Lenders may view your operation more favorably, and tenants may feel more comfortable working with a formal entity rather than an individual landlord.
Additional Strategies You Can Use To Purchase Your First Rental Property
While a DSCR loan is an excellent financing option, there are other creative strategies to help you secure your first rental property. Let’s explore a few key approaches that can make this goal more attainable and give you an edge as a new investor.
1. Bring on a Co-Borrower
If your credit score isn’t quite where it needs to be, or you’re finding it challenging to get financing as a first-time investor, bringing on a co-borrower can help strengthen your application. A co-borrower with strong credit, a reliable income, and experience in real estate investing can balance out your financial profile, making you a more attractive candidate for lenders.
Not only does this reduce perceived risk for the lender, but it also creates a shared financial responsibility for the loan. This can help mitigate your burden as you navigate your first real estate investment. For example, if your co-borrower has already been through the process of securing and managing rental properties, their expertise can guide you through potential challenges, making your real estate investment journey smoother. Just be sure to establish clear agreements on financial contributions, ownership splits, and responsibilities to avoid conflicts later on.
2. Tap Into Your Existing Home Equity
If you already own a home and have built up equity over time, this can be a valuable resource for financing your first rental property. By opting for a cash-out refinance, you can borrow against the equity you’ve accumulated, receiving the difference between your home’s value and your remaining mortgage balance as a lump sum.
This lump sum can be used in multiple ways:
- As a down payment for your rental property.
- To cover closing costs or initial renovations to get the property rental-ready.
- To reduce the purchase price of the investment property outright, potentially allowing you to avoid additional financing.
Using home equity means you’re leveraging an existing asset to expand your portfolio, which is a common strategy among experienced investors. However, it’s important to approach this method cautiously. Refinancing increases the debt on your primary home, so make sure you can comfortably manage the payments alongside the costs of your new rental property.
3. Use House Hacking to Your Advantage
House hacking is one of the most accessible strategies for new investors and offers multiple benefits. By renting out part of your primary residence—whether it’s a spare room, basement, garage, or an additional unit in a multifamily investment property that isn’t your primary residence—you can generate income that helps offset your mortgage payments and improve your overall cash flow.
Here’s how house hacking can help you not only offset your mortgage payments, but also buy a rental property:
Accelerate Savings: The rental income can be funneled directly into your savings for a down payment, allowing you to reach your goal faster.
Landlord Experience: Managing tenants and maintaining your investment property gives you valuable hands-on experience as a landlord, preparing you for the challenges of managing a standalone rental.
Tax Advantages: Depending on the portion of your home you rent out to earn rental income, you may be eligible for certain tax deductions, such as a share of investment property taxes, utilities, and maintenance expenses.
House hacking isn’t just about financial benefits; it’s also a low-risk way to dip your toes into the real estate investing world. Plus, if you choose a multifamily investment property, you can transition from living in one unit and renting the others to eventually converting the property into a full-fledged rental when you’re ready to move on.
If you are interested in this option, it may be worth checking out our in-depth guide on house hacking loans.
