One way to help beat the high price of buying a home is to buy an income property. The rent you collect can offset the cost of carrying a mortgage and give you the opportunity to live in a place you can call your own.
However, getting a mortgage for an income property isn’t as simple as getting a mortgage for a principal residence.
The first step is identification. Most lenders classify a residential investment property as having one to four units. Anything more than four, or if it has a storefront, is considered to be a commercial property. It requires a commercial mortgage, which has tougher qualification criteria and often a higher interest rate.
If you’re going to live in the property, the down payment is much lower. As of Feb. 15, 2016, the minimum down payment on an owner-occupied house is 5% of the first $500,000 and 10% of any amount above $500,000 up to $999,999. But if you tell the lender you’re borrowing for a non-owner occupied investment property, the minimum jumps to 20%.
With the average sale price of existing homes costing slightly more than $630,000 in the Greater Toronto Area, that means an average down payment of at least $126,000.
Anson Martin, a mortgage agent with Fair Mortgage Solutions in Hamilton, Ont., says about 25% of his business revolves around income properties. “I recommend it as a great way to get additional income to pay the mortgage,” he says.
Owning an income property has been a happy experience for Colin MacKenzie. He had owned an income property before but that didn’t turn out to be successful as he hoped. MacKenzie and his wife were both working and hadn’t realized the amount of time needed to keep up the property. Now that his two daughters are settled and on their own, MacKenzie didn’t feel he needed a five-bedroom home any longer. He also wanted a smooth path into retirement and he has more time. MacKenzie sold the family house and was able to put $1 million down on a fourplex in Toronto’s Annex neighbourhood.
“I have a long and steady relationship with TD Bank,” he says. “Though it took a little longer than normal to arrange the mortgage, they were happy to work with us to make it happen.”
What to consider before buying
Even though you, the borrower, expect to get cash flow from the property through rent, the lender will still insist on getting your credit history. Check your credit score before attempting a deal because it will affect the interest rate you pay.
While you might be optimistic about your chances of earning a living from your investment, lenders will want to know you can carry the debt if things don’t go as expected. They’ll review your application even more diligently than if you were borrowing for a residence without an income component.
Lenders will check your net worth, ask what other assets you have, and ask for pay stubs or an employment letter. If you’re self-employed, they’ll want to check your tax returns. In some cases, they may want to see reserves in the bank to pay for all your expenses for at least six months. Some lenders might not consider lending to you unless you have another way to meet your mortgage obligation if things go sour.
There’s added risk for lenders when financing a property that’s not owner-occupied. A tenant may not have the same degree of care for a place they don’t own. And what if the property sits vacant? How will you make your mortgage payments?
Lenders have different policies in recognizing the rent you collect from your income property. Some lenders include 50% of the rent as an offset, some 80% and some the full 100%. More lenders are asking to see a signed written lease, but others allow an appraiser’s estimate of a property’s rental value instead.
Lenders often factor in expenses—such as insurance, maintenance, utilities and projected vacancy rates—when deciding how much to lend you. Also, if the premise is not legally zoned and doesn’t meet the building code for rentals, lenders won’t recognize the income that would derive from it. Lenders may also add a premium if the owner doesn’t plan to live in the property.
Most lenders have a limit on how many properties a borrower can own, generally between four and six.
Lenders with the best rates often have the least flexibility. Sometimes it’s even worth paying more in interest in return for better terms. Here are some other things to consider:
- You can try to negotiate an open mortgage. This means there’s no penalty if you sell the property and pay off the mortgage early.
- If you can’t negotiate an open mortgage, see if you can get a portable mortgage that lets you move the mortgage to another investment property with no penalty or a reduced penalty.
- Find a lender who lets you have a 30- to 35-year amortization period. This will lower your monthly payments to maximize your cash flow. A longer amortization period means that a higher proportion of your monthly mortgage payments goes to interest instead of principal. You end up paying more interest in the long run, but with an income property, the interest paid is tax-deductible and the lower monthly payment cuts your carrying costs.
- Find a lender who lets you hold your property in a company name for liability protection. This also lets you write off the depreciation of all the major appliances on the property.
- Find a lender that lets you add a second mortgage or a line of credit with your mortgage for maintenance and improvements.
Rental financing is a specialty and finding the right lender is a challenge. Some lenders don’t offer mortgages for investment properties at all. In that case, shopping around is a must.
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