Buying rental properties is a smart move. Interest rates are still relatively low, which means the value of rental income has gone way up. Therefore, there's good value in owning rental property, especially with inflation so elevated.
However, getting a rental property mortgage is more expensive than getting a primary residence mortgage. In this article, I will explain why rental property mortgages are more expensive than primary home mortgages.
As the Federal Reserve embarks on a multi-year interest rate cut cycle, more landlords and homeowners will seek to refinance their mortgages.
Why Rental Property Mortgages Are More Expensive
To understand why rental property mortgages are more expensive than primary home mortgages, put yourself in the lender's shoes.
Let's first take a look at review a primary mortgage and then a rental property mortgage.
Primary Mortgage
The primary mortgage is underwritten based on the assumption that your day job income + other alternative incomes will be around so that you can comfortably pay every month.
Your W2 income viability is the ANCHOR that propels a bank to move forward and give you a new mortgage. After assessing your W2 income will the bank then account for your alternative income streams if needed.
The most important ratio your bank will look at is your debt to income ratio. They ratio they are generally looking for is roughly 33% or lower. That said, my recent loan modification required just a D/E ratio of 43% or less. Each bank is different, but the percentage is roughly around there. The number one goal for the bank is to earn a consistent spread over the life of the loan.
Rental Property Mortgage
Your rental property mortgage is underwritten based on the assumption of the feasibility in collecting rental income. The bank then looks at your W2 income to arrive at your total income.
W2 income is preferred, however underwriters try to match income sources with the types of mortgages they are lending. The main issue is the viability of your income streams.
If you are refinancing an existing rental property, you've got to come up with a lease and rental history. No lease and a sketchy rental history full of missed payments will probably end your rental property mortgage refinance.
Rental property mortgages often require a 30% or more downpayment compared with your typical 20% downpayment for a primary residence.
Risk Reward Between Rental And Primary Mortgage
It's all about risk assessment for a bank. From the bank's point of view, they are making a default assumption that you as the landlord require rental income to pay the mortgage.
Even if you have a huge salary and lots of money saved in the bank with the existing institution, the mortgage underwriter does not put as much weight as the rental history of the property.
For rental mortgages, they are essentially making a derivative bet.
Last Property Standing
In a housing downturn, the first properties to go are vacation homes followed by rental properties. A primary residence is the last mortgage a multi-property owner will default on since s/he has to live somewhere.
The primary home mortgage is presumably more affordable once the multi-property homeowner gets rid of other debt. Banks know this and are more stringent in their rental mortgage lending practices.
The last thing a bank wants is to repossess a property. Banks are not in the business of buying and selling properties!
Think Like A Banker When You Borrow Money
Now that you understand why a bank places a higher risk on rental properties, you now know why rental property mortgage rates are often 0.5%-1.5% higher than the SAME primary property mortgage rate. Due to higher risk, banks demand a higher return on their investment in you. Banks have tighter lending standards post crisis.
Take my current San Francisco rental for example. My 5/1 ARM rate for a conforming rental loan (<$417,000) is 3.375%. Meanwhile, my 5/1 ARM jumbo primary resident mortgage is only at 2.625%.
My primary home mortgage is more than double my rental property mortgage and my rental property income is more than quadruple my rental mortgage interest payments, yet the rental property mortgage is still 0.75% higher.
If my rental property mortgage was a jumbo loan, making the comparison apples to apples, then the rate would probably be closer to 3.875% (from 3.375%) vs. 2.625% for my primary mortgage.
I've checked multiple banks, including my favorite online mortgage lending marketplace, and the rate spread is consistently at least 0.5% higher for rental property mortgages. Always check online for the latest mortgage rates. You'll get multiple real offers for free.
Refinance Before Your Property Becomes A Rental
When I bought my first San Francisco property in 2003, I knew it was only a stepping stone for something nicer as my income grew. I was 26 at the time and the place was a cozy two bedroom, two bathroom apartment overlooking a park in a great part of town. As it was my first and largest purchase ever at the time, I wanted to be conservative and purchased at the bottom of my range.
A couple years later, I found a house that I currently reside in and made my first property a rental. I refinanced my first residence as a primary residence, locked in the lowest rate at the time and subsequently moved out three months later and converted it into a rental.
I didn't anticipate to move out so soon after my refinance, however, when I found my new house, I just knew it was the one. I was able to make the transition work because I gave a three month rent back to the old owners of my new home. Consider the same strategy to lock in a lower rate. It's all about flexibility and planning.
Due to refinancing my first property mortgage before moving out, I estimate to have saved over $50,000 in interest expense in the past 10 years all things being equal. That is real money that went towards savings, investments, and ultimately allowing me to no longer have to work today. When you are trying to retire early, every dollar savings counts.
Repeat The Refinance Cycle And Build Wealth
There might be a point over the next five years where I will also want to rent out my current primary residence and move to a new property. I'm not sure if I'll get a better rate than 2.625% for a five year fixed jumbo. If I plan to rent out my house, I will certainly try to at least re-lock a 2.625% rate for five years or get the best rate possible at the time.
The biggest issue will be my lack of W2 income. As such, I will be working hard to build my passive income streams. Thanks to Bernanke's quantitative easing efforts, I'm bullish that mortgage rates will stay low and rents will continue to rise.
Not only is refinancing a primary home mortgage easier than refinancing a rental property mortgage due to less documents needed (e.g. rental history, rental contract, HOA info), the rates are also much lower. The median homeownership duration of 5.6 years is too short to build real wealth. Buy, hold, refinance, and hold some more. You will be glad you did!
Bottom line. You should refinance your property now if you: 1) feel your job is at risk, 2) feel there is a chance you will be relocated, 3) plan to upgrade or downgrade and still keep your existing property, 4) want to save money and haven't refinanced in the past twelve months.
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Why Are Rental Property Mortgages More Expensive Than Primary Home Mortgages is a Financial Samurai original post. FS has been around since 2009 and is the leading personal finance site in the world.
I like the idea of refinancing a primary residence with a cash out and using the money as a source to pay off a rental property completely. I am with a 3.5 fixed rate on my primary residence since 2013 and like others, did not realize I should have refinanced my first home prior to turning it into a rental property, only then realizing I could only refinance that home to 4.375 fixed in 2013 because now it is a rental. Seven years later, I am wrapping my head around the idea of paying of a mortgage and how to do it. I have $374,261 left to go on my primary residence and $242,575 left to go on the rental. With about $192,000 reserve cash to pay off a mortgage, I am tempted to refinance my primary residence with cash out about $100,000 and use it to pay the rental off completely. I would have a small cushion left in my accounts and I imagine would build it back up fast considering I would not have to pay a mortgage for the rental anymore. However, one thing that makes think I will just wait a few more years and pay off the rental without any borrowed cash is how both mortgages, my primary home and the rental, are affecting my taxes. The interest of the rental reduces my taxes paid each year, while the primary home no longer does due the increase in the standard deduction that makes the primary home interest paid no longer reduce my taxes as well as the $10,000 cap on property tax (i am in California). Also, another factor is if I pay off the rental my income from rent will increase my total income each year on top of the income from the jobs my wife and I have. This is a problem only in the way that I want to keep making contributions to our two Roth IRAs but we would be getting very near the maximum income limits for making those contributions. So even if in a few years I could, I may just be keeping up regular payments on both mortgages, just so I can make Roth IRA contributions and also still be fine with deducting the mortgage interest on the rental to offset the rent collected. Thoughts or feedback on this would be appreciated.
Oh and the rental was first my primary in 2010 and refinanced already when i bought my next home in 2013. Rate went from 5.75 to 4.375 percent.
So smart on refinancing before turning your primary residence into a rental property. I will definitely keep this in mind as I’m hoping to buy a new house next year and turn my current home into a rental. Thanks for the tips!
Hey Sam,
Big fan of FS! Been reading for a year or so and learned so much.
Situation: currently have a 30-yr VA loan for 3.75% (2 years in and have $414k left, with 80%LTV), thinking to refi this to a 5/1 ARM at 2.675%–renting it out, then buying another property with available VA loan (0% down 0 PMI, has to be fixed) and then rent that out too, for a total of 2 rentals. Will live with my girlfriend. Then maybe rinse and repeat every few years, and using my VA loan as the 0% down workhorse to accumulate a few more rentals in Denver area. Thoughts?
We are trying to buy a rental property and we are already preapproved for a loan with a 20% down, 5.5% for 30 years with another lender company. We plan to keep it just for a couple of years hoping to make some money and then sell it and pay off our primary house or just keep the liquid for another investment property at sometime. We also plan to shop around with my bank who holds our primary loan to ensure we are getting the best offer since we are planning to put down 20%. Is this the best approach getting a loan for 30 years with an interest of 5.5%? In my opinion 5.5% is an it too high considering we are putting down 20%. Should we refi our primary property? If we refi we will lost the opportunity of buying another property and turn that into a rental property since we would have to put all our liquid into the refi fees. I am conflicted on what to do. If we refi, I did the math already and we would be saving $400 a month, and that is good but we do that we will not be able to buy an investment property (rental property).
I honestly think it is a terrible plan to buy now and hold for only two years to try to make money.
Taking out a 30 year fixed also makes no sense based on your holding period.
Related: https://www.financialsamurai.com/30-year-fixed-mortgage-loan-vs-adjustable-rate-mortgage-arm-the-choice-is-obvious/
I have a 30 year fixed on my rental property at 4.25% (got it in 2015). This was a lot higher than I wanted to pay, and after reading this article and some of your others on getting the best interest rate, I feel as though I should have gone with a 5/1 arm. I think I still have that fear in the back of my mind of interest rates skyrocketing, which I know you don’t believe will happen. It’s an unsubstantiated fear. After housing prices come down a bit, and interest rates rise, perhaps I’ll consider the 5/1 for my next property.
just be mindful of committing bank fraud. you’ll want to note clauses that protect their interest (switchg to rental from primary use).
this is helpful plus great re site in general:
https://www.biggerpockets.com/forums/51/topics/74512-legal-repercussions-of-renting-your-primary-residence
that said, I’m sure the chance of getting caught may be hit/miss. however, it wouldn’t be THAT hard for them to check…all they have to do is do an automated check of mailing address to see if it goes to a diff residence (can also flag if its a rental box address and investigate further to verify actual residence too).
just be careful… don’t want your next residence in jail with a few new roommates in orange!
Hi Sam
It’s such an awesome post there. I learned a ton. I’m currently in process of buying 4 unit property served as also my primary residence. I planned to take out FHA loans which probably around $250k. I’m planning to move out probably in less than 2 years and turned this into 100% rental property. Do you recommend I take out as a 5/1 ARM of 30 year fixed (i know that you are a big fan of 5/1 ARM)? I’m still confused to which route i should take. I really appreciate your input.
Hi Ton,
Without knowing your financials and desire for work, it’s hard for me to say.
But I think a 5/1 ARM is more suitable for 80% of the homebuyers out there given I think rates will stay low for a long time and any increase won’t be much more than 1-2% if there is one after the 5 year period is over.
[…] Why It’s Harder To Refinance A Rental Than A Primary Home […]
I own property in tx and have been renting it to my brother who can not get financing to buy it. In turn I can’t get financing to my a new home for my new family. What should I do to clear this mortgage from my name so a lender will give me a new mortgage? Must keep brother their cause my mom has a house on same land and can’t move. I have three lots and home on this loan and mothers house she owns and sets on one lot.
Hi, there. I’m currently in the process of buying a new home and at the same time, refi. my current home and then renting it. I met with my LO on my new home (different LO from my current home to take advantage of incentives :p ) and he said everything is on track to be good, just don’t pull out any new requests for new credit cards or car loans and we should be fine when we close. But then I mentioned we are currently refinancing and he gave a discerning look. Reason being are,
1) refinancing registers as pulling out a new loan and can affect approval, even though we’ve been pre-approved already knowing our exisiting loan on our current homebefore we refinance, I know stupid. 2) having to prove occupancy for one year after refi. others wise it’s mortgage fraud.
One way we are looking to get around this is for my wife to refi, the current mortgage in her name with primary rates, and the new home to just be under me. But the occupancy clause still scares me because she will be living in my “primary” residence.
Anyone have any insite on this? I live in Illinois and this is all making me sick to my stomach. :(
Thanks
I’m still caught up on the “three months” part. If you sign your refi with an intent to stay for 12 months, or otherwise notify the lender, couldn’t that be fraud. Won’t the lender find out when you change your insurance policy to a landlord policy? Thanks.
I’m also, too questioning that as well…
Any insite would be truly helpful.
Thanks!
Hi there,
We did a loan modification several years back under Making Home Affordable to get 5 year rate of 2% with a $1,000 payoff on our principal balance over those 5 years. Then or rate increases over the following three years and locks at 4.75%. The 2% is over at the end of 2014. We moved for hubby’s new job out of state, and rent our home at double our mortgage payment. It made little sense to refi on that mortgage because of our low rates and the amount knocked off the principal each year.
Now we rent, but found a short sale we’d like to purchase. We are stuck though as we can’t pull equity from our rental without the long rental history, we’re only at three months now. The house is in Baltimore which has a solid rental market. The bank won’t count our rental income, so our debt/income ratios are too high.
So frustrating to have money tied up and no access to it. Maybe in a couple years…sigh.
Perhaps get a bridge loan or a loan from a family?
Not sure though as it’s usually always better to buy what you can afford.
Boy do I wish I had found this article/your site before we rented out our primary residence (at the time) last year! We moved into a great new house (that is now our primary home) but we have a 5 year ARM on the rental, and that expires in a year. Wish I did my homework – just now finding out we need 25% equity!! Some credit unions will approve it for 20%, but still. Gonna have to save up in order to pay down the equity in the next year. Argh. Thanks for all the great advice!
Awesome article, thanks for taking the time! We own/live in a 2family (our primary residence), and should be closing our refinance on/around June 1, shaving 2% off our current rate!!
We have young children and a somewhat tenuous situation with regard to local options for school. Given this, we might want to make a quick decision before September to up and move somewhere else. If we do that, we would (ideally) keep our 2fam and rent both units.
I am a bit unclear on the three month part of your post “…locked in the lowest rate at the time and subsequently moved out three months later and converted it into a rental. I didn’t anticipate to move out so soon after my refinance, however, when I found my new house, I just knew it was the one. I was able to make the transition work because I gave a three month rent back to the old owners of my new home. ”
Let’s say the ink dries on our refi on June, 1. Can we go elsewhere (e.g. seek a pre-approval for a new primary residence) on June 2? July 1? August 1? June 1 + a year?
You noted 3 months from your scenario. I have yet to find any kind of guideline/regulation/rule of thumb for “when” it’s ok to do this…should we need to do so.
Any thoughts much appreciated!
Hi there, you can move out of your primary residence the day after your primary mortgage refinance is finished if you wish and convert your property into a rental. Three months is an arbitrary figure that was my own case.
Is it better to pay off primary home first or rental?
I have the same question, which is better to pay off first rental or primary home? How will this choice affect my taxes? Would it depend on my tax bracket?
The rental property issues are that you can practically buy a house for the same monthly price. But in Roanoke, they have done a good job of tracking the differences.
I don’t have a rental, but hope to turn my current primary into one. Just ReFi’d to a 30-year fixed at 3.25%. Hoping as the market improves and rates rise over the next 10 years, rents go up as well, so when we move upgrade (7-10 years from now), we still have a low rate and the rents bring in a positive cash flow.
Great article here, and all around sound advice. Thanks Sam!
3.25% really is a fantastic rate for a 30 year conforming fixed. Congrats for saving lots of money!
Good post Sam but I have to disagree on some points. The equity required is based on your market. I am closing a refi on a rental property next week in Virginia. The required equity is 25%. Also, I believe you miss a major reason for increased rates. I’ve talked to many people about this subject and have found the “last house standing” reason to be primary. A close second and correlated reason is upkeep. The bank assumes that you will maintain and even IMPROVE your primary residence. In contrast, they assume that you will, at best, maintain your rental property but that, more likely, it will deteriorate as issues arise and are ignored by renters.
My only other comment would be about ARMs vs. traditional loans. You are obviously an ARM guy. As you have property in SF, I imagine the closing costs represent a very small percentage of the loan and are thus a small factor. However, for many of your readers, like Mrs. Pop, the loan value is so small that closing costs make frequent refinancing a poor economic choice. I warn that you do not imply that ARMs are better than traditional as this decision should be made on a case by case basis.
Hi Josh, are you saying rates are higher for rental properties due to upkeep expenses? Not sure if I follow you. Share your thoughts on your rental mortgage situation and experience so I can get a better idea of where you are coming from.
As per closing costs, they are largely fixed or based on a flat percentage so it doesn’t cost more to get a 30 year vs an ARM. Refinancing on the other hand will have less wiggle room and a longer breakeven point with a smaller loan.
No, not upkeep expenses thenselves. Similiar to the “last house standing” principle, rentals are often the last to get upgrades. If I bought two houses in the 80s, one primary and one rental, it’s a safe bet to say that the primary no longer has yellow bathroom tile and salmon formica countertops….not necessarily true of the rental. Banks understand that. They know that rentals that go up for sale tend to get less than primary residences as they don’t get as much TLC.
You’re missing my point regarding refinancing costs. Let’s say you are refinancing a 150k loan. Fixed fees includes appraisal (~$500), document prep (~$100), underwriter (~$600+), etc. As you say, these fees are the same for ARM or fixed. However, if you take the 5/1 ARM route, you’re taking on these fees every 3-5 years. Let’s say closing costs are $4,000. For a smaller loan like this, it is likely that the better interest rate on the ARM only saves you a couple bucks each month. For instance, on that 150k loan, a 3.5 fixed loan payment is $673/mo. A 2.75% ARM payment is $612/mo. This is $61 in savings. Now, if we expected to “re-ARM” after exactly 60 months, you would have “saved” $3,660. If your closing costs to “re-ARM” are again 4k, you’re $360 worse off than had you gone with the fixed. Also, you’d be spending time and effort on the new loan and assuming that the new ARM rate is better than the 30yr fixed you could have locked 5 years earlier.
If the loan is 500k, the closing costs are nothing…the aforementioned rates would save you $204/mo ($2245 for 3.5% vs. $2041 for 2.75%). This saves you $12,240 over the 5 years. In that case, the 4k in closing costs still leave you with over 8k more than had you taken the fixed rate.
The conclusion is that, for smaller loan balances, the closing costs represent a larger percentage of the loan and thus may make frequent refinancing a bad choice, especially with fixed rates as low as they are today.
Gotcha Josh. Makes sense the costs for a smaller loan will be higher if one does have to refinance every 5 years for a 5/1 ARM.
The luckiest mortgage holders over the past 15 years have actually been those who were able to take 1 month libor loans. For those who took out 7/1, 5/1, 3/1, 1/1 loans, when their fixed rates expired, their rates actually stayed flat or went down further. They didn’t need to refinance. In my case, I refinanced several times b/c the rates were lower and the costs were baked in. So although it wasn’t free, it was a no cost refi, which perhaps a smaller loan has less wiggle room to have to your point. If I was smart, I would have just let my 5/1 ARM from four years ago just float.
I just don’t think inflation and rates are going to rise a meaningful amount. And if they do, based on rates today, they are capped at around 7.5% max.
Thanks for your points.
Great article and like many have said will save lots of money and pain when dealing with lenders. Maybe as a follow up to this article you can talk about how individuals can gain entrance into the investment property through financing. Discuss the varios financing options when purchasing an investment property. Example: We did a refi on our primary residence to tap the equity in the property to make an all cash offer on the investment property. That way you own the investment property outright, quality for all the perks of primary residence loan and dont have to worry about the hastle of dealing with lenders and unlimited documentation. Looking forward to reading about something like this in the future.
Sounds like you want to write a guest post about your situation. Let me know. I’m sure it’ll be insightful!
Great explanation, Sam. Refinancing the house BEFORE you turn it into a rental is sage advice that will save your readers thousands of dollars.
Great post, Sam. I made the mistake of not refinancing my house before converting it to a rental. I didn’t realize until a year later when I went to refi just how much stricter the lender had to be because it was an investment property now and not my primary residence. They refused to lend anything over 80% of my home value, and they weren’t interested in negociating on the points and fees either.
Hank, thanks for sharing. Yes, at least here in California, banks want 25# down or an LTV of 75% or lower before giving the best rate on a rental/vacay property. I know it’s quite similar everywhere in the country. Things do vary by income, relationship with bank etc of course.
When we bought our college campus real estate, they put us in the “commercial” real estate bucket so we had to do 25% down, 25 year amortization, but at a lame 5.5%. No 3.5% for us like residential! For whatever reason, I guess due to multi-units or some other factors, multiple banks said these weren’t eligible for the typical residential rates. The mortgage isn’t really a big factor in our cost structure oddly. It’s very high income, high expense from damages/upkeep. As I recall, debt service is maybe 1/3 income. So, a better rate may not make a huge difference, the investment either made sense or it didn’t.
Gotcha. Sounds like a great rental yield if the mortgage at 5.5% is just 1/3 of income so quickly! Just gotta keep those college kids in line!
Excellent advice! I am just curious why you refinanced for a 5 year ARM? It is the lowest rate, but interest rates are expected to increase in the next few years unless you expect to sell.
Pretty easy reason. I don’t expect interest rates to rise by any meaningful amount. They’ve been going down for 30 years in a row. Are you expecting a rise? And if so, for how long already?
We are at the lowest rates of the last 60 years. I do not expect it to stay this l ow for much longer. My best guess is 1-2 years, then it should start increasing. I do not know how much, but I expect it to increase. Perhaps, the 30 year mortgage rate would drift up to 5%.
Cool. Let’s bet a conforming 30 year fixed with 0 points can be had for under 5% at more than three places or via Quicken loans in 1.5 years. What should we bet?
We refinanced our rental properties within the past year or so to take advantage of incredibly low interest rates. The rates were slightly higher than my primary residence mortgage but we still saved a ton by refinancing. It was a no brainer.
I think we will be downsizing to a smaller home in a few years with the plans of also turning that home into a rental. I will definitely be taking advantage of primary residence mortgage rates even though it will be a rental in the future.
Good stuff. A like for like refi is great too. Definitely refi before you downsize to a smaller home and save some cash.
We are going to pay this house off before we move! I don’t mind owing on rental properties but I don’t want to have any personal debt.
We are doing a no fee refinance on our primary as we speak! 4th one!
Great article. I have become an avid reader of your site since discovering it a couple of months ago. Keep up the good work.
After getting pretty lucky in the stock market I want to use my profits to buy my first property. As of now I’m pretty set on getting a two family home and renting one half out, so I have to use as little of my money as possible to pay the mortgage. This way, I can continue saving aggressively, and allocating those savings to build more passive income (dividends or cash flow from a rental property).
From what I gather, this is considered owner-occupied rental property in the eyes of a bank. Is this treated as a primary mortgage? I assume it is, but you know what they say when you assume…
Anyone care to take a crack?
Thanks!
Hi John,
Good to have you. I guess it depends on whether you are buying a property with a tenant already there or a vacant property.
If the two unit place is vacant, then why not ask for a primary property mortgage? Although, I believe banks have different mortgage assumptions for multiple unit properties (Read higher interest rates) because they’ve seen it all before.
Does hurt to shop around at all.
S