Vacation rentals are considered a viable option for passive income, but securing the right financing can be challenging. With several financing options available, it’s essential to understand which methods best suit your needs and financial situation.
Based on our research, we have curated a list of 12 ways to finance a vacation rental, ranging from traditional loans to more creative strategies.
Conventional Loans
Conventional loans are a popular choice for financing vacation rentals. They are similar to loans used for primary residences but typically have stricter requirements. To qualify, maintain a debt-to-income ratio of 50% or less (ideally 41%).
First-time buyers might need just 3% down, or even 1% with some programs; others typically need 5% and will require private mortgage insurance (PMI). The bare minimum FICO credit score required is 620.
Home Equity Line of Credit (HELOC)
A home equity line of credit (HELOC) allows you to borrow against the equity in your primary residence. This option is beneficial if you have significant home equity and prefer not to refinance your current mortgage.
While the average interest rate is 9.32% as of August 21, 2024, HELOCs typically have variable interest rates and are ideal for borrowers who want flexibility in their repayment plans.
Cash-Out Refinance
This method involves refinancing your existing mortgage for more than you currently owe and using the excess funds for your vacation rental. A cash-out refinance has a lower interest rate than other financing options, making it an attractive choice for those with strong credit and low existing mortgage rates.
Investment Property Loans
Investment property loans, including vacation rentals, are specifically tailored to finance rental properties. Meeting specific criteria is essential to secure favorable rates on an investment property loan. A high credit score is crucial, with lenders viewing scores of 740 or above as low-risk, which can lead to lower interest rates. You can qualify with a lower score, but it is likely to come at higher rates.
A significant down payment, usually around 20% or more, can help you obtain a better rate. The property’s condition and location, along with your experience as an investor, will also influence the loan terms.
Personal Loans
Personal loans are a brisk solution to funds without collateral, which makes them a flexible option for those needing immediate financial assistance. However, the flip side is that the interest rate is generally high, and the repayment terms are shorter than other loan options. In 2024, the average interest rate for personal loans is about 12.38%, which is expected to vary with factors like credit score, lender type, etc.
This makes them more suitable for individuals who require a smaller loan amount and have strong credit scores. A personal loan might be a good choice if you need a swift solution and can handle higher costs.
Commercial Real Estate Loans
A commercial real estate loan might be the ideal option if you’re looking to purchase a multi-unit vacation rental, like a bed and breakfast or a villa. These loans are commonly issued to various business entities, such as corporations, developers, limited partnerships, investment funds, and trusts.
Commercial loans generally have varied loan terms ranging from five to 20 years, with amortization periods often extending beyond the loan term. Loan-to-value ratios for commercial loans typically fall between 65% and 80%, reflecting the amount of financing relative to the property’s value.
Seller Financing
In seller financing, the property seller acts as a lender, allowing buyers to bypass traditional financial institutions. This can be especially advantageous for those with poor credit or other obstacles that make conventional financing challenging.
In this case, there’s no bank involved; the buyer and seller handle the terms themselves. They draft a promissory note detailing the interest rate, payment schedule, and consequences of default. Unlike a traditional mortgage, the principal isn’t transferred upfront; instead, the buyer repays the amount over time based on the agreement.
Short-Term Rental Loans
These specialized loans are designed specifically for properties intended for short-term rentals, such as those listed on Airbnb or Vrbo. Unlike traditional mortgages, short-term rental loans often consider the potential rental income from the property, alongside the borrower’s regular income, when assessing loan eligibility.
This approach can significantly ease the qualification process for investors looking to finance properties for short-term rental purposes, offering a more tailored solution for those entering this market.
401(k) Loans
Borrowing from your 401(k) can provide a quick financing solution for purchasing a vacation rental. No credit checks are required, and interest payments are directed back into your retirement account, which can be advantageous.
However, it’s crucial to understand the risks, as failure to execute timely repayment can lead to penalties and taxes, potentially impacting your retirement savings.
Reverse Mortgages
Senior citizens have a trump card option for financing in the form of a reverse mortgage. This loan is available to homeowners aged 62 or older with significant home equity. It allows seniors to access cash by tapping into their home’s equity. This loan relieves aged investors who wish to purchase a vacation rental without depleting their savings.
While it provides access to funds, it’s important to note that interest accrues over time, which can decrease the property’s equity and affect the amount of money available later on.
VA and FHA Loans
Veterans can use VA loans to finance vacation rentals, often requiring little to no down payment, which can be a significant advantage. Similarly, FHA loans offer up to 85% cash-out refinancing, allowing borrowers to access a substantial portion of their home’s equity.
VA and FHA loans have unique benefits, including low interest rates and flexible qualification criteria. These features make them excellent choices for eligible borrowers seeking to invest in vacation properties.
Local Bank Financing
Financing through a local bank can be a strategic choice. These institutions often provide competitive rates and customized services to meet your needs. Local banks typically have a deeper understanding of the regional real estate market, which can result in more favorable loan terms for vacation rental properties.
Their familiarity with local trends and conditions may improve loan options and terms, enhancing your overall financing experience.
