The Secrets of Financing Rental Property

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Just a little over four years ago, you could buy an investment property with no down payment at all, and still get the best interest rates on the market.

That was then. Today, the situation around financing rental property is completely different. To get a mortgage to buy a small property (up to 4 units) for rental purposes, you'll need to put down at least 20% of the total purchase price. And even then, you won't always get access to the lowest available mortgage rate.

Given that tenants generally tend to take less care of a property than its owners do, and with the global credit crisis still fresh in everyone's memory, the government and the banks treat financing for rental property as inherently riskier.

As a result, it's now harder to qualify for a mortgage to buy a rental property - especially compared to the period before April 19, 2010. (That's the date federal legislation put an end to insuring this type of mortgage when the down payment was less than 20%.)

So, if you're thinking about buying a rental property and you'll need a mortgage soon, here are a few things worth keeping in mind.

You'll Need a Substantial Down Payment

If you're buying a property you won't be living in yourself, and you plan to rent it out, virtually every financial institution in Canada will require a down payment of at least 20%. On a home priced at the average of around $300,000, that comes to $60,000.

If you're buying a condominium, or buying in a market considered higher-risk (Vancouver, for instance), the bank may in some cases require an additional 5% on top of that.

Tip: If you don't have that much cash on hand, don't lose hope! You can always tap into the equity in the home you currently live in and use that borrowed money as the down payment on your investment property.

Choosing the Right Financial Institution Matters More Than Ever Here

To get a mortgage, your total debt ratio needs to fall within whatever limits a given bank sets. Put simply, this ratio is your total monthly expenses divided by your total monthly income from all sources, including rental income.

That sounds simple, but it really isn't. A borrower's ability to qualify often comes down to how much of their rental income the bank is willing to recognize.

You might assume that if a tenant pays you $1,500 a month, you can add that full $1,500 to your income when qualifying for a mortgage. In most cases, though, the bank will only recognize 50% of that amount, which creates additional hurdles when it comes to qualifying.

There are four different methods financial institutions use to calculate your debt ratio, but that's a story for another time. Suffice it to say that a knowledgeable mortgage broker will match you with banks using whichever calculation method works most in your favour, given your situation.

There's one more thing worth keeping in mind here. Different banks set different limits on the debt ratio. Some allow up to 42%. Most others only allow 40%. That extra 2%, by the way, can end up making all the difference, especially for borrowers who already carry several mortgages.

Tip: which bank you choose has an enormous impact on your chances of getting approved. Not all of us have a six-figure salary and a perfect credit history, and if you're running into trouble qualifying, you'll need a financial institution that's more open to common sense and willing to make exceptions. Your neighbourhood bank branch probably won't be much help here, and this is exactly where an experienced mortgage broker becomes invaluable.

So How Many Properties Can You Actually Finance?

Most banks won't finance an unlimited number of homes or units purchased for rental purposes. The good news is that for clients with stable income and excellent credit, there are a handful of banks that will finance up to 16 properties (including the one you live in) at the best rate available, with just a 20% down payment!

Many financial institutions, while they may not openly forbid you from buying a large number of properties, won't let you count 100% of your rental income toward your debt ratio calculation, which can make qualifying for each subsequent mortgage quite difficult, and sometimes practically impossible. As a result, borrowers with a large portfolio of investment properties often end up renewing their mortgages with their existing banks, frequently at less favourable rates and without the best possible contract terms.

In other words, if you're planning to build and finance a small rental empire, look for a mortgage broker who already has at least a few clients with five or more rental properties. That kind of experience is essential for a broker to help you find the right bank for your situation.

Tip: financial institutions offering the best mortgage rates often come with the strictest rules. If you want the best terms, approach the banks with the strictest requirements right at the start of building your "empire," and save the more flexible options for later. That way, you'll still have good options left once your portfolio has grown.

In our next issue, we'll continue walking you through the finer points of financing rental property. You'll learn which documents you should prepare in advance, whether the lowest mortgage rate really matters most for rental property, and which mortgage features you should never compromise on, no matter what.