How to Avoid Becoming Overleveraged When Investing in Real Estate

Without a doubt, smart financing can help you become a successful property investor. When you buy a home, you typically apply for a mortgage—but that might not be the best choice if you're investing in real estate.

Overextending yourself with several large loans, combined with the costs of maintaining a rental property or multiple properties, can add up. Ongoing repairs, long-term vacancies and late-paying tenants are just a few of the challenges property investors face. If you fall behind, or become overleveraged, you might have difficulty securing credit in the future.

Financing rental properties

Generally, loans for rental properties are viewed as higher-risk than a mortgage on your primary home. Banks may not consider income from rental properties when reviewing loan applications. Instead, you'll need to show that you have adequate income and savings to support the new mortgage. As an investor, you should also expect your interest rate to be higher than the rate for a primary home loan.

Your long-term objectives should be considered when choosing between loan options. A longer-term loan with a lower monthly payment may increase your cash flow, but you'll pay more in interest over the life of the loan. A shorter-term loan increases your payment, but you'll build equity faster and pay less in interest.

Types of loans available

When starting out, you may choose to finance a rental property similarly to a primary home with a mortgage loan. For serious, long-term investors, additional options are worth considering. Some of the alternatives include the following:

• Fixed-rate mortgage loans: Investors may prefer a fixed-rate loan with steady payments for ease of expense management.
• Adjustable-rate mortgage loans: If you plan on selling the property within 5 years, an adjustable-rate loan offers lower rates upfront.
• Zero-down loans: Experienced flippers may be able to qualify for a short-term, zero-down loan, giving them time to buy a fixer-upper, renovate it and sell it for a higher price.
• Home equity loans: You can leverage the equity in your primary residence when you use a home equity loan to finance a rental property.
• Lines of credit: Access to a line of credit allows investors to act quickly when they find a property that fits their investment criteria.

How to avoid becoming overleveraged

Before you purchase an investment property, consider using one or more of the following strategies to avoid becoming overleveraged:

Make a larger down payment

Increasing your cash down gives you more equity from the get-go and allows you to keep your debt-load manageable. A higher down payment may also be more attractive to sellers.

Focus on building equity over cash flow

You may be tempted to use the income from your rentals for personal spending. However, in the early years, your focus should be on building equity, not generating excess cash flow. The more equity you build, the less you'll owe to others. If you find yourself with excess cash, it's a good idea to pay down or pay off some of your loans—or save the cash to invest in another property, if a good deal comes along.

Restructure existing loans

When you're first starting out as an investor, chances are you may not qualify for the best interest rates. As you build your portfolio and show steady income from your properties, you may be able to restructure or refinance some of your loans and find better terms.

Calculate costs before buying

An experienced investor will investigate the average rent charged for a property, along with maintenance costs and expected renovation expenses. Combined with financing costs, this data allows you to analyze the profitability of a specific investment. You'll need to understand the costs of bringing the property into a habitable condition compared to how much a tenant will be willing to pay to live there.

Set profitability standards

When you're scouring the market and not finding what you want, sitting back may be the best alternative. Rather than overpay for a rental, you may want to look at your existing portfolio and focus on increasing property management revenue. This strategy will help ensure you're able to weather the ups and downs of the market without being forced to buy a property that might not give you the return you need.

Prioritizing long-term thinking

Investing in residential rental properties can provide a supplemental income stream to carry you into retirement. Understanding your risk tolerance and risk capacity will help determine the right timing and type of real estate investment that works best for you. Aim to structure your financing to reduce your leverage, which can help you achieve long-term success as you grow your portfolio.