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Why Are Interest Rates Higher on Investment or Rental Properties?
If you’ve looked into mortgage loans for buying multiple properties, you know the rates can vary wildly from one property type to the next. When it comes to mortgage rates for a second home vs. investment property, for example, you might be surprised to see that the interest rates differ despite the similarities in the type of property purchase you’re making.
Second home investment mortgage rates are often lower, but a second home often has to meet a number of restrictions, like being in a tourist area or being at least 50 miles from your primary residence. Otherwise, that home is seen as investment property, even if you have no plans to rent it out. But why are mortgage rates for second home vs. investment property so different? The short answer is that it all has to do with risk to the lender. Here’s what you need to know.
What are interest rates?
Interest rates are the percentage of the total loan amount that a lender charges to borrow the money for your purchase. These rates are affected by the overall economy and the lending market, including demand for loans and variations in the bond market, as well as the costs the lender incurs, from overhead to personnel, because interest is how lenders make money.
Much of the mortgage rate calculation rides on the Federal Reserve, which has a particular method of impacting interest rates. This is a national interest rate called the Federal Funds rate, which is a rate that banks pay each other to borrow back and forth. While this rate doesn’t directly impact mortgage rates, it does trickle down. When the Fed Funds rate goes up, it impacts the bank’s costs, which makes other interest rates go up on the loans they make to regular borrowers. That includes mortgage loans. The same is true for when rates drop.
All of this is to say that interest rates change due to a lot of factors, but a large part depends on how the economy is doing overall. When recessions are likely or are occurring, lowering interest rates can persuade people to borrow money and buy things rather than save their cash for a rainy day. This keeps the economy moving.
[Read: How to Invest in Real Estate ]
When the economy is riding high, higher interest rates keep people from taking out too much debt and having issues paying it back in the future.
Why are interest rates higher on investment or rental properties?
Another factor that impacts the interest rate you’ll be offered is the purpose of the loan. Part of a mortgage lender’s risk assessment is to calculate whether you’ll be properly motivated to pay back the loan in full. For example, lenders see a higher likelihood that you’ll keep paying a loan on your main home that you occupy. There’s less likelihood that you’ll make on-time payments if you have rental or investment properties that could be unoccupied for long stints between tenants or flips.
Due to the higher perceived risk, investment properties are often financed at a higher rate. Lenders assume you’ll pay other debts first — including your own home mortgage — if you fall on hard times. The higher interest is the lender’s way of making sure it doesn’t lose money through risky lending.
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Imagine that you are a property investor paying $1000 a month on your home mortgage as well as $1000 a month on a rental property mortgage. If you lose your day job right at the same time that your rental tenant moves out, you might be forced to choose whether to pay your home mortgage or your rental property mortgage. It’s likely that you’d choose your home mortgage first, since that’s where you live. That would leave the lender for your rental property without payment.
Another reason these loans are more expensive for borrowers is that buying your home that you occupy isn’t a business venture. It is to put a roof over your head and earn equity.
An investment property, on the other hand, is a business venture. Your goal is to make money off of the property you’re buying in some form or fashion. As a result, the bank wants to earn a solid return on their willingness to “invest” in your business.
Investment loans pros and cons
Buying a property with an investment property mortgage loan may come with a higher interest rate, but it is often worthwhile for the borrower. Here are some benefits and drawbacks on investment loans.
- Make the purchase sooner than you could with cash: It takes a long time to save the money to buy a home in cash, even if it is a rental property. Getting a loan gets you started in the rental business and helps you establish a long-term income stream sooner than you could if you had to save up the money.
- Build equity in a property through rental income: Even if much of the rental income goes to paying the mortgage on the home, you will eventually be left with a valuable asset, which is the property itself. You’ll build equity in it just like you do with your own home, and you can borrow against the equity or sell the property if need be.
- Use liquid assets to purchase more properties: If you have the cash to buy a property, you may still opt to get a mortgage when interest rates are reasonable. If you do this, you can use your cash for other property purchases or to invest in your business. A mortgage loan leaves you with more options for how to spend your liquidity rather than tying it all up in the house.
There are also potential pitfalls when buying an investment property. Some drawbacks to the process include:
- Dependent on demand: If you can buy a rental property with cash, the stakes are lower when it comes to keeping it renter-occupied all the time. When you need the rent to pay a mortgage investment loan, you’ll want to work very hard to avoid vacancies. Having a rental with no tenants isn’t ideal even if it’s paid off, of course, but it will give you more of a cushion.
- Increases your overall debt: As with any debt, you’ll have a higher total amount of debt if you take on more loans that you’ll eventually have to pay back. This can temporarily lower your credit score or make it difficult to take out other loan products, so be aware of this risk before you take out a loan.
- More expensive than paying cash: Paying investment loan interest cuts into the profits of your investment property as compared to paying cash. It could be worth it to you to get a loan for the property, but keep that in mind. Keep the closing costs in mind too — you’ll be paying those when you close on your loan. Those charges are on top of the interest you’ll owe for your loan.
[ Read: ‘Good Debt’ vs. ‘Bad Debt’ ]
Tips on getting the best rate
- Evaluate your potential rental income and present it with your application. If you know what property you want to buy as investment property, you can sometimes count a portion of the projected rental income in the calculations of what mortgage loan and interest rate you qualify to receive. There are generally rules, though — including a current rental agreement — for counting the rental income as income on your loan application.
- Time the market and monitor available properties. While people who find their “dream home” may be willing to buy when interest rates are high, you’re looking for investment property, so you might not need to be quite as picky. Monitor a few different listings so that you have something in mind when interest rates fall. Once this happens, then you can apply for a loan.
- Offer a high down payment. Meeting the highest standards for down payments (often between 10% and 25%, depending on the property, the lender and the loan) is one way to increase the confidence of the lender and thus bring the interest rate down. The more you can put down, the higher your chances of getting a low interest rate.
- Work to increase your credit score: Investment property loans are hard to get without stellar credit scores. If you see issues on your report, work to increase your credit score before applying for a loan. You’ll have a difficult time getting loan approval with anything less than a great score.
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