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Understanding the Complexities of Investment Property Financing: 4 Key Pitfalls to Avoid

Expert tips for securing the best mortgage terms and avoiding common financial mistakes in real estate investing.

Luke Babich //May 13, 2024//

The hand stops wooden dominoes falling to house model, real estate protection concept background. Hands stop the domino effect before destroying a home.
The hand stops wooden dominoes falling to house model, real estate protection concept background. Hands stop the domino effect before destroying a home.

Understanding the Complexities of Investment Property Financing: 4 Key Pitfalls to Avoid

Expert tips for securing the best mortgage terms and avoiding common financial mistakes in real estate investing.

Luke Babich //May 13, 2024//

It’s easy to get swept up in the excitement of buying an investment property, especially with so much social media hype over potential profits. With proper research and vetting, you can find an investment property that diversifies your portfolio and earns you extra income.

But, before you take the leap, there are some essential things you should know about investment property financing.

Buying an investment property can be more challenging than purchasing a home to live in yourself for a variety of reasons, from higher initial costs to the need to forecast and evaluate market conditions. However, one of the most unexpected for many investors is the difference in financing. Let’s take a closer look at some potential pitfalls to avoid for a smooth transaction. 

READ: 8 Strategies for Weathering Real Estate Market Volatility for Investors

Pitfall #1: Interest rate fluctuations

Mortgages for investment properties often have a steeper interest rate than loans for primary residences, which reflects some of the added risk to the lender. And with interest rates already far higher than just a few years ago, the precise rate matters. 

Real estate investors should lock in as low a fixed interest rate as possible when securing investment property financing.

Variable rates are unpredictable and risky, whereas fixed ones enable investors to budget and plan for the future. Even just a few fractions of a percentage point can make the difference between a good deal and a potential money loser. 

Pitfall #2: Hidden fees and charges

According to recent research, the price of homes has increased at double the inflation rate since 2013.

That’s why it’s so important to know how much it will actually cost to purchase a house in total — all fees and charges included.

Many lenders include a whole suite of additional fees and charges as part of the investment property financing process. Some may be appropriate and necessary, while others may be less so. Take the time to learn as much information as possible when working with a lender so you know all potential extra expenses when buying your investment property.

Some specific ones to look out for include origination fees, rate lock fees (which some lenders charge to “lock in” a designated rate during the financing process), prepayment penalties, appraisal fees and other costs related to underwriting or escrow. 

READ: 8 Questions to Ask a Potential Real Estate Investing Partner

Pitfall #3: Not understanding crucial loan terminology

Every investor prefers to save money when possible, often through tactics like using low-cost brokers and negotiating purchase prices. However, not understanding crucial loan concepts and terminology can be far costlier in the long run. 

Here are some loan terms that are vital to understand during the investment financing process:

  • Debt service coverage ratio (DSCR): This is a metric lenders use to determine if a property will create enough income and profit to cover the mortgage payment. Lenders typically have minimum DSCR requirements.
  • Loan-to-value ratio (LTV): This is a term that describes the ratio of the mortgage loan to the appraised value of the property. A low LTV is less risky.
  • Adjustable-rate mortgages (ARMs): Many new investors might be interested in a mortgage with an adjustable rate because they typically have lower interest rates than conventional loan mortgage rates — at first. However, investors should understand the risk of ARMs, including when the interest rate starts adjusting, what their options are when that happens and how it might affect the future profitability of their investment property.

Pitfall #4: Unexpected shifts in market trends

Your investment property financing is always subject to change if there are unexpected shifts in the mortgage market due to broader economic factors. 

For example, lending regulations can change, the Federal Reserve can adjust interest rates and even supply and demand varies.

It’s a good idea to ask your real estate broker about market conditions. If they are an experienced agent, they should be able to connect you with lenders and financial advisors who can walk you through the financing process. 

Ask your broker if there are any local factors, like demographic trends, that could impact your investment financing process or affect the value of the property you want to buy.

Better safe than sorry with investment property financing

Buying an investment property can be a great way to grow your net worth, but there are many pitfalls that can drain your hard-earned profits over time. Doing your research before you buy can save you time, money and a lot of headaches.

Take the time to compare mortgage lenders and choose one that gives you the best terms. Then, ask questions to make sure you’re aware of all potentially hidden fees. Lock in a fixed interest rate if possible, and keep an eye on market trends that might impact your mortgage financing before closing. 

With a bit of knowledge and diligence, you’ll secure the perfect loan for your new property and set your investment off on the right track.

 

Luke Babich HeadshotLuke Babich is the Co-Founder of Clever Real Estate, a real estate education platform committed to helping home buyers, sellers and investors make smarter financial decisions. Luke is a licensed real estate agent in the State of Missouri and his research and insights have been featured on BiggerPockets, Inman, the LA Times and more.

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