Why Are Rental Property Mortgages More Expensive Than Primary Home Mortgages?

Rental Properties In Stockholm, Sweden

Rental properties in Stockholm, Sweden

In a previous article, I discuss why it’s important to refinance your mortgage before leaving your job. No job = no recurring income = high risk = no mortgage refinance for you! You won’t even have the ability to compromise and pay a higher lower rate than if you did have a job. When you lose your W2 income, you turn invisible to the banks. Think, “You are dead to me.”

The other important refinancing situation to consider is when you are planning to turn your primary property into a rental or vacation property. You might have outgrown your existing property, but don’t want to sell given you believe real estate is a great long term wealth builder. Perhaps your company is relocating you for a better opportunity and you plan to return one day. Finally, maybe you’ve been forced to downsize and have no choice but to become an accidental landlord.

Whatever the case may be, always, always, always refinance your rental property before it becomes a rental property! If you don’t, you may miss an opportunity to save thousands of dollars in interest costs. This article will explain to you why rental property mortgages are higher than primary property mortgages by a common spread of 0.5% up to 1.5%.

The Difference Between Primary And Rental Mortgages By The Bank

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 42% or less. Each bank is different. The number one goal for the bank is to earn a consistent spread over the life of the loan.

Rental 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: 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 Quicken Loans online, and the rate spread is consistently at least 0.5% higher for rental property mortgages.

REFINANCE YOUR PROPERTY BEFORE IT BECOMES A RENTAL

When I bought my first San Francisco property 10 years ago, I knew it was only a stepping stone for something nicer as my income grew. I was 25.5 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 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!

Recap: 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.

RECOMMENDATIONS:

Get the best home insurance possible. In order for your property to grow in value you must protect your property from damage. Fires, floods, leaks, theft, and other accidents happen all the time. If you have cut-rate insurance, you could very well pay way more than you should. I highly recommend checking with USInsurance.com online to find the best home insurance rates. They have a huge network of providers that will compete against each other to provide the most tailored home insurance coverage possible that is affordable. Mobile home insurance, renters insurance, condo insurance, and homeowners insurance are just a few of the options based on the type of home in which you reside. Leverage the internet to save money and protect your largest asset.

Check Your Credit Score: Take a moment to check your free credit score through GoFreeCredit.com, a company I trust. Over 30% of credit reports have errors which can really bring down your borrowing capabilities. I once had a $8 missed utility bill payment which crushed my credit score by over 100 points! Save yourself some serious mortgage hassle and delay by knowing what your credit score is beforehand.

Best,

Sam

 

Sam started Financial Samurai in 2009 during the depths of the financial crisis as a way to make sense of chaos. After 13 years working on Wall Street, Sam decided to retire in 2012 to utilize everything he learned in business school to focus on online entrepreneurship.

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Comments

  1. says

    We bought our rental with cash (needed a quick and easy close b/c it was a foreclosure), but then wanted to pull cash out later to buy another property. Financing it through a traditional loan was CRAZY expensive! We’re talking $4K-$5K in fees to get a 15 year conventional loan of about $50K.

    Instead, we went with a 10 year HELOC, which we got with just $200 in fees. Sure the max amount we can pull out is $38K, and the rate is higher than the conventional loan would have been, but we’ve almost paid it off completely (so it will have had a balance on it for < 18 mos), so even with the higher rate, we'll still come out ahead of all the fees on the conventional loans.

  2. says

    That is a good solid advice. I refinanced everything before I quit my job. My lender always used the W2 as the main source of income and didn’t even look at the rental income. When I refinanced the rental home, I got a pretty decent rate. Of course, the rate is lower now…

    • says

      Nice work Joe! Given your wife still has W2 income and you are growing your alternative income, you should consider inquiring again what the latest rate is for your rental. You never know.

  3. says

    This is the first cogent explanation of this issue, which is a question I’ve had for a long time. I always knew it was best to refinance a home you wanted to turn into a rental, but I never knew exactly why.

    Thanks, Sam.

    • says

      William, good to hear from you mate. Been a while! Sure, no problem. Definitely always try to refi before considering making a property a rental. Good luck with your own real estate endeavors.

  4. says

    ”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. ” Is that legal? Don’t you have a clause in your primary residence’s mortgage saying you can’t rent?

    • says

      Definitely legal. If you live in your property and it is your primary residence where you live most of the time and have your mail sent it is your primary resident.

      Life happens all the time. Let’s say after you refinanced your primary property your employer decided to relocate you or fire you. You decide to relocate to stay employed. Are you saying you and the bank wouldn’t allow me to rent out my primary property as a rental and just let it sit vacant while I’m somewhere else? Of course not.

      The great thing about America is that there is a lot of freedom to do what you want. Your question is quite fascinating given you are living in Guatemala. Are there more draconian laws there which say people aren’t allowed to move houses, rent em out, or refinance or else face severe penalties?

      Thx

  5. says

    If you know you are going to continue to have a hard time (not impossible just hard) getting a mortgage later on why not just go with a 15 or 30 year fixed? I know you have written in the past you aren’t a fan but your situation has changed since then

    • says

      That is a good point Evan. If one knows they will not have W2 income again for a while, but can afford the higher payments of 15-30 years and feels comfortable likely paying more, then fine.

      However, the irony is that if you don’t have W2 income, all else being equal, your income is lower. Hence, it helps to increase one’s chances of survival by having a lower payment with a 5/1 ARM or 3/1 ARM, or 1 ARM or even Libor floating. There are max interest rate increases anyway, and the most I see is around 7.5% after adjusting if there is hyper inflation, which there won’t be.

  6. Jersey John says

    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!

    • says

      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

  7. says

    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.

  8. says

    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.

    • says

      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?

      • says

        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%.

  9. Darwin's Money says

    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.

  10. says

    This was a great article. Goes along with my overall house hunting strategy. As I look around for potential primary residences, I focus only on those houses that I could easily convert to a rental. I work in a very labile field and hate the idea of commuting (which is in vogue here for some reason), so there is always the possibility of relocating. Now I have a better idea about how to include refinancing into any future real estate plans. Thanks Sam.

  11. says

    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.

    • says

      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.

  12. says

    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.

  13. Josh In Afghanistan says

    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.

    • says

      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.

      • Josh In Afghanistan says

        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.

        • says

          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.

  14. says

    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!

  15. TwoFamilied says

    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!

    • says

      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.

  16. Katie says

    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!

  17. Beth says

    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.

  18. Sam says

    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.

  19. Frank says

    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

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