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Passive rental income is a dream for many investors looking to achieve financial independence. A 2019 Gallup poll found that real estate was the favorite investment option for Americans, more so than stocks or savings.
The reality, though, is that purchasing a multiunit home is a serious financial undertaking with unique lending requirements that can often mean a bigger down payment. Plus, experts say you should have a great credit score and significant liquid savings before you try your luck at being a landlord. The ongoing expenses and headaches of being a landlord actually landed NextAdvisor contributor Jannese Torres-Rodridguez in therapy, she recently wrote.
In addition to saving your down payment, make sure to save a healthy emergency fund for home maintenance. As the owner of a multifamily home, you’re responsible for covering repairs in your tenants’ units.
One of the steps in exploring rental properties is to get familiar with the types of loan products they require, and what qualifications you’d need to meet. Here’s an overview of how to finance a duplex, multifamily home, or commercial property.
Duplex, Multifamily, or Commercial Property: What’s the Difference
- A multifamily home could be used to describe larger apartment buildings. It’s most often used to describe buildings with two to four units.
- A duplex is a multifamily home with just two units.
- A commercial residential property is one with five or more units.
The financing available will depend on the number of units. Properties with four or fewer units are usually considered residential, experts say.
“For most banks that I’ve worked with and talked to, everything from a single-family up to a four-family they would consider residential in nature,” says Andy Madden, general partner of the Pittsburg real estate firm McIntosh Management, LP. “They would look at it and qualify somebody the same way a residential mortgage would be looked at. Only when they look at five units or more do they consider it a commercial property and look less at comparable sales and more at the potential income the building can bring in.”
Loan Options for Duplex and Multifamily Property
1. Conventional loans
Just like purchasing a single-family loan, a conventional home loan is a popular option for buying a multifamily home with two to four units. Loans are generally available in amounts ranging from $702,000 for duplexes to more than $1 million for four-unit buildings. Limits are higher in high-cost areas. Down payment and credit score requirements differ slightly depending on the size of the home.
For a multifamily home with three or four units, buyers must have a downpayment of at least 25% and a credit score ranging from 660 to 680, depending on the borrower’s DTI.
These numbers are based on Fannie Mae’s requirements, which lenders often use as the standard.
2. FHA & VA loans
For an FHA loan, borrowers must have a down payment of at least 3.5% and a minimum credit score of 580. For larger down payments, a credit score can be as low as 500. VA loans, available only to current and former service members, don’t require a down payment. The VA doesn’t set a minimum credit score requirement, but individual lenders are likely to.
For both the FHA and the VA loan, at least one borrower must plan to occupy the property. Additionally, HUD requires that multifamily homes purchased with FHA loans be self-sufficient.
“For an FHA loan, you have to follow the rule of self-sufficiency,” said Jeffrey Loyd, mortgage broker and founder of Mortgage Acuity in New Jersey. “It means the rental income for all of the units must be enough to carry the payment – principal, interest, taxes, insurance. In some markets, that’s harder to do. Mortgage underwriting is assessing the risk of default. The bank wants to know that if you default, the rental income will cover the monthly costs.”
3. Commercial loans
The rules change for multifamily homes with more than four units. For an individual seeking a commercial real estate loan, financing is usually available up to $6 million with both fixed-rate and ARM (adjustable-rate mortgage) options. These loans require a down payment of at least 20% and a credit score of at least 680.
“You can still get a fixed rate, and you can still do ARMs,” Loyd said. “ARMs are more common for commercial loans. The down payments are larger. The loan amount is based on what the rental income is. The rents have to cover the debt.”
Why It Matters If You Live There or Not
The financing process will look slightly different depending on whether you plan to live in the multifamily home you’re purchasing. Whether you’ll be a resident or an investor will impact your down payment, interest rate, and the type of loan you’re eligible for.
“Primary residence occupancy when you will be living in one of the units offers better interest rates and lower down payments,” said Paul Carini, division president of Dash Home Loans. “Investment occupancy when you won’t live there requires more down payment and offers worse interest rates.”
Purchasing a property as an investor rather than as a resident also limits your loan options. FHA and VA loans are only available when the buyer lives in the home, so you’ll be limited to a conventional mortgage.
Rental Income as a Qualifier for a Loan
One of the aspects of purchasing a multifamily home is that rental income from the property — both current and prospective rental income — can help you qualify for the loan.
“For traditional home loans on investment properties, income from leases can be used minus 25% and can offset the mortgage payment when qualifying,” Carini said. “Leases generally have to be at least 12 months to count. You can also use an appraisal to appraise market rent; a 25% vacancy rate will usually be built into this number as well.”
Hurdles When Financing a Duplex or Multifamily Home
There are a few hurdles you can expect to run into when financing a multifamily home.
“The appraisal can be an issue sometimes,” Carini said. “Appraisals use comparable sales to value a home. Since a multifamily can be a unique property type, there may not be many comparable sales available for consideration. If you get an undervaluation, it could mean you have to bring more money to the closing table.”
The appraisal could also be a concern since it helps determine how much rental income can be considered a qualifier for the loan. The lower the appraiser deems a single unit’s market rate, the less rental income the lender will be willing to consider.
Another potential hurdle is the down payment. Multifamily homes often require larger down payments than one for a single-family home. According to Loyd, duplexes will generally require at least 15% down, while three and four-unit properties will require a 20% down payment. It’s considerably higher than the 3% – 5% you could put down for a conventional mortgage on a single-family home.