If you’re just starting out with short-term rental investing, you might not have the funds available to purchase real estate for cash. Even if you do have the money to buy real estate without a loan, you might not want to. Debt, when used properly, is your friend. Using debt will make it easier to buy multiple properties so that you can diversify your portfolio (instead of sinking your entire life savings into a single investment). And, debt has the power to magnify investment returns.
However, it’s a bit more complicated than just running out to your local bank and picking up a shiny new loan. Different types of loans have different down payment requirements, different interest rates, and require different levels of creditworthiness. Additionally, certain loan types are more attractive to sellers and can either help or hurt you as you try to win a deal.
With this quick primer, I’ll show you the basics of five different loan types, empowering you to make decisions that fit your budget and investment strategy.
FHA loans are mortgage loans insured by the Federal Housing Administration. These loans are made by FHA-approved private lenders. FHA insurance protects these lenders if a borrower fails to make payments. With the added security of FHA insurance, lenders can make loans that they would normally consider too risky. This includes loans for borrowers with less-than-stellar credit and loans with small down payments (as low as 3.5%).
To buy a $300,000 home with an FHA loan, you would need a downpayment of $10,500. ($300,000 is a rough estimate of the current median existing-home sales price in the U.S.)
Compare this to the standard down payment for a conventional loan — around 20%. To buy the same $300,000 home with a conventional loan, you'd need to put about $60,000 down.
There's a catch with FHA loans: They can only be used to purchase a primary residence, and not an investment property. So, why even mention FHA loans in an article focused on short-term rental investing?
The trick is to use your primary residence as a short-term rental while continuing to live there yourself, which can be accomplished in a few ways:
- Rent out spare rooms of a single-family house.
- Rent out your entire house while on vacation or business.
- Buy a duplex, triplex, or fourplex, and live in one of the units (this is called “house hacking” and is one of the best ways to get started with short-term rental investing).
FHA loans come with some significant drawbacks. As mentioned earlier, FHA loans can only be used on a primary residence. As a result, FHA loans have minimal investment potential outside of the three strategies discussed above.
Additionally, FHA loans have stricter inspection requirements and usually take longer to close. For these reasons, FHA loans are rarely a seller’s first pick. FHA loans can make your offer less competitive, and in the sea of qualified buyers flooding the market today, you may find it challenging to win a deal with an FHA loan.
Conventional loans are offered by private institutions, including mortgage companies, banks, and credit unions. Unlike FHA loans, the government does not insure conventional loans. Also, conventional loans don't have the primary residence requirement of FHA loans and can be used to purchase investment properties.
Conventional loans come with less paperwork, and approval is faster for qualified borrowers. However, conventional loans are more challenging to qualify for than FHA loans. You will need a solid credit score and proof of income that meets the bank's required debt-to-income (DTI) ratio. Rental income, future or projected, is not always factored into debt-to-income calculations for conventional loans, making it hard to scale and build an Airbnb portfolio.
The typical down payment for a conventional loan is 20%, but a lender may require a higher down payment to finance an investment property. With the $300,000 house from earlier, a 20% down payment would cost $60,000. But you would need more than $60,000 to get this deal done. For an investment property, the bank could require you to hold up to six months of expenses as reserves. The bank will also require you to have insurance. Depending on the amount of time you plan to use the property yourself, you’ll either need to add short-term rental coverage to a standard homeowners policy, or purchase a specialized short-term rental policy [LINK: Short-Term Rental Insurance].
According to The National Association of Realtors, 94% of sellers prefer offers that use conventional loans. Sellers like conventional loans because they close quickly and have less stringent inspection requirements than FHA loans. Because it's more difficult to qualify for a conventional loan, sellers view buyers who can secure conventional financing as more reliable.
Short-Term Rental Financing
Specialized lenders have begun to offer financing tailored to short-term rentals. The loans made by these groups can broadly be categorized as "asset-based loans." Unlike FHA or conventional loans, asset-based loans factor in the income generated by the property as part of the qualification process. The borrower's personal income is given considerably less attention with asset-based loans and is sometimes not considered at all.
These lenders better understand the risks and rewards inherent in Airbnb and VRBO investing and are more likely to grant qualified investors favorable loan terms.
Asset-based loans make it much easier for a short-term rental business to scale. Because conventional and FHA loans qualify borrowers based on their personal income, it is difficult for borrowers to grow a multi-property empire if their income outside of real estate investing does not increase. It is sometimes possible to qualify for a conventional loan using short-term rental income, but this usually only works if your short-term rental has a proven track record over several years. If an investor wants to acquire multiple properties over a shorter time horizon, a dedicated Airbnb lender is more likely to help them achieve their goals.
Home Equity Loans and HELOCs
A home equity loan allows you to borrow against the equity in your current home. A home equity line of credit, or HELOC, is another type of loan secured by the equity in your home.
The main difference is that a home equity loan provides you with one lump sum to be paid back over time and with interest. A HELOC functions like a credit card — you can draw from it as funds are needs, with the maximum draw based on the amount of equity in your home.
If you have a significant amount of equity in your home, home equity loans and HELOCs could be an attractive option. But there is one massive risk with using these types of loans: you’re putting primary residence on the line. If you fail to make payments, the lender can take your house.
Family Loans and Gifts
If you’ve just received an inheritance or large cash gift from a family member, one of the smartest things you can do is invest that money in real estate. Alternatively, you might have a family member who is willing to let you borrow money but wants you to pay them back with interest — a “family loan.”
There are many advantages to family loans. For one, many family members are willing to lend at a lower interest rate than a bank would charge. Some benevolent family members might even forego interest entirely. Additionally, most family loans won’t have the same stringent income and credit requirements as banks or mortgage companies. However, these types of arrangements can strain family relationships, especially if payments are missed. Therefore, it’s essential to put the terms of the family loan in writing and make sure that everyone is on the same page. You may even consider using an attorney to help set up the loan.
Which Loan Type is Right for You?
FHA loans make it easy to get onto that first rung of the property ladder and begin experimenting with short-term rentals. Conventional loans are harder to qualify for, but are preferred by many sellers. Conventional loans also don’t come with the primary residence requirement of FHA loans. If you are a serious investor looking to use investment income to finance additional deals, you’ll want to explore dedicated short-term rental financing.
Once you’ve settled on a loan type, your next steps will be to choose a specific lender and get preapproved. Not all lenders are created equal; you must do your due diligence to ensure that you get the best terms and are treated fairly. Do research online, and talk to investors in your area about their experiences with different lenders.