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How to Finance a Short-Term Rental Property

Short-term rental properties are a great way to build wealth with real estate.

A short-term rental with regular bookings can outperform a long-term rental property. It gives you a convenient place to vacation. And if it’s located near a popular destination, you can expect decent appreciation.

For many, it’s a real estate investing dream.

The trick is funding that dream.

Securing a loan for a second home is a bit more nuanced than borrowing for your primary residence.

In this guide, we’ll look at how to finance a short-term rental property with five different strategies — each with distinct advantages and disadvantages.

But first, let’s look at some important market trends.

Beach-house

Is a vacation rental property a good investment?

The overall demand for short-term rentals is booming.

Vacation rentals have been around since the 1950s. And with the rise of platforms like Airbnb and VRBO, popularity skyrocketed.

Then came the pandemic.

People started working from home, then realized “home” could be anywhere — like a cozy Airbnb property up in the mountains.

In fact, the number of digital nomads in the U.S. has more than doubled over the past couple of years. Remote workers are using short-term rentals to work while traveling the country.

Compared to a hotel, a quality Airbnb rental offers more amenities, convenience, and comfort for remote workers. It’s also easier to keep clean and sterile, which is a dealbreaker for many renters.

Combine these ingredients, and you have the perfect recipe for vacation rental investment success.

According to AirDNA, short-term rental occupancy hit an all-time high of 79.4% in July 2021. With high demand and limited supply, Airbnb prices are soaring — up 35% from Q1 2020 to Q1 2021.

In other words, it’s one of the best times in history to own a short-term rental property.

That said, not every vacation rental property is a good investment, so always evaluate your opportunities on a case-by-case basis.

Frio River in Texas
Frio River in Texas

5 ways to finance a short-term rental property

So, you’re convinced now is the time to invest, and you’ve done your due diligence:

  • You’ve taken into account the larger downpayment requirements and costs to furnish.
  • You’ve researched how to manage a rental property.
  • You’ve estimated property management expenses, occupancy rates, and your total potential Airbnb rental income.

Now for the fun part — financing.

Here are your best options.

1. Conventional loans

A conventional loan is one of the most affordable ways to finance a second homeif you qualify, that is.

Banks and traditional mortgage lenders offer some of the best rates, but they also have the strictest lending requirements.

To get approved, you’ll need to jump through even more hoops than you did for your first mortgage. Requirements vary by lender, but many look for a strong income history, a debt-to-income ratio below 45%, and a credit score of at least 640.

Some lenders are willing to flex on these requirements if you put more money down. At a minimum, you’ll need a 10% downpayment, but to avoid paying mortgage insurance, it’s 20%.

Lastly, to qualify as a second home, the IRS states you must live in it for at least 14 days per year and 10% of the days you rent it out. If not, it’s considered an investment property, which typically comes with less favorable loan terms.

Some lenders prohibit you from renting out a second home altogether, so make sure to clarify before signing anything.

Pros:

  • Best rates for low-risk borrowers
  • Primary residence isn’t used as collateral

Cons:

  • Long closing process
  • Strict lending requirements
  • Not all lenders allow second home rentals
  • Limit to number of conventional mortgages you can take out
Godbold mill in Marfa Texas
Historic Godbold mill in Marfa, TX | now home to the Marfa Spirit Co

2. Home Equity Line of Credit (HELOC)

Equity is the difference between your home’s market value and the amount you owe on it.

Your equity increases when you make mortgage payments or add value to a property through home improvements. Your equity also increases as your home appreciates over time.

A HELOC is a special type of second mortgage that homeowners can use to tap into this equity.

The amount you can borrow is largely determined by the equity you’ve built in your home. But it also depends on your credit history, income, debts, and property characteristics.

For example, if you owe $300,000 on a house valued at $500,000, you’ve built $200,000 in equity. Banks typically set your max HELOC line of credit at 80% to 90% of your home’s value, minus what you owe on your original mortgage. In this case, you’d get a $100,000 to $150,000 revolving line of credit.

It’s like a giant credit card. During your draw period — which usually lasts 10 years — you can repeatedly borrow against your line of credit, hold a balance, and make interest-only monthly payments. After your 10-year draw period, your loan balance locks into a 20-year repayment term.

Pros:

  • Low closing costs (if any)
  • Option to make interest-only payments during your draw period
  • Can use your funds as you please
  • Flexible revolving line of credit — can make a downpayment now and pay for renovations later
  • Lower interest rates than unsecured loans

Cons:

  • Only works if you’ve built significant equity
  • Most lenders require good credit scores
  • Variable interest rates that could increase in the future
  • Primary home acts as loan collateral

3. Home equity loan

A home equity loan is often confused with a HELOC, but they’re actually quite different.

Instead of receiving a flexible line of credit to draw on for 10 years, a home equity loan is a lump sum. And instead of variable interest rates, you repay your home equity loan in predetermined fixed installments, with terms ranging from 5 to 30 years.

Similar to HELOCs, the max loan-to-value ratio (LTV) on a home equity loan varies by lender, typically ranging from 80% to 90%.

Since HELOCs and home equity loans carry higher interest rates than conventional loans, they make the most sense if you are house-rich but cash-poor.

Pros:

  • Fixed interest rates are easier to manage
  • Less complicated than HELOC for a one-time home purchase
  • Can use your funds as you please
  • Lower interest rates than unsecured loans

Cons:

  • No interest-only period
  • Primary home acts as collateral
  • High closing costs
  • Most lenders require good credit scores
  • Requires significant equity to finance a second home
Texas Gulf sunrise

4. Cash-out refinance

Cash-out refinancing is yet another strategy that taps into your primary home’s equity.

It’s similar to a home equity loan, except you’re not taking out a second loan. Instead, you’re refinancing with a new mortgage for a higher amount. This new loan pays off your original mortgage plus a lump sum of cash to use as you please.

Back to our previous example — a $300,000 mortgage on a home worth $500,000. The maximum LTV for a traditional cash-out refinance is typically 80%. That means you can take out a new mortgage for 80% of your home’s appraised value. In this case, that’s a $400,000 loan. Of that $400,000, $300,000 pays off your original mortgage and $100,000 goes in your pocket.

You’ve essentially cashed out some equity from your primary residence to help finance your rental property.

You can choose whether you want your new loan to have a fixed or variable interest rate, with terms ranging from 15 to 30 years.

Pros:

  • Lower interest rates than a HELOC or home equity loan
  • Potentially lower interest rates than your original mortgage (market dependent)
  • Consolidates debt to a single loan

Cons:

  • High closing costs
  • Lengthy closing process
  • Higher mortgage payments increased foreclosure risk on primary home

5. Private lending

Private loans are faster and more flexible than traditional mortgages. And if you don’t meet conventional lending requirements, they may be your only option.

Private lenders offer various loan programs you can use to finance a short-term rental property.

Short-term bridge loans

A short-term residential loan (or “bridge” loan) is another type of hard money loan you can use to finance a vacation rental property.

Bridge loans are especially useful in competitive markets. The conventional loan process can take months, and if you’re competing with cash buyers, you won’t stand a chance. To prevent anyone from snatching up your dream property, Longleaf can fund a bridge loan in as little as 48 hours.

These are short-term interest-only loans, so eventually you’ll have to refinance your hard money loan with a rental loan or conventional mortgage.

Short-term rental loans

The second option is a short-term rental loan (or vacation rental loan). In some ways, these are similar to conventional mortgages. You can choose a fixed or adjustable rate, with up to a 30-year repayment term.

The difference lies in the criteria private lenders use to approve a loan. While creditworthiness comes into play, they are more interested in the investment property itself.

That means you aren’t limited by your income. And when you aren’t limited by income, it’s easier to scale. As long as a property’s short term rental cash flow can easily cover its loan payments, private lenders will be interested.

Since private lenders have fewer requirements, they take on more risk. This added risk translates into slightly higher borrowing rates. You can expect rates to start at around 4%.

Longleaf Lending can help refer you a short-term rental lender.

Pros:

  • Scaleable
  • Faster closing times
  • Fewer hoops to jump through
  • Flexible options to fit your needs
  • Your primary residence isn’t used as collateral

Cons:

  • Slightly higher interest rates
  • Can only choose properties with sufficient cash flow

Things to consider before financing a vacation rental property

Accurate real estate appraisals are vital

Many appraisers focus on owner-occupied properties and long-term rentals. Banks may send an appraiser who does not know how to accurately calculate short-term rents. This may affect your odds of approval.

For best results, search for a lender with experience financing short-term rental properties.

Turnover affects investment property profitability

Short-term rentals are different from long-term rentals. You can’t compare them apples to apples. Just because a short-term rental generates more revenue doesn’t mean it’s more profitable. Vacation rentals have higher turnover and maintenance costs, and they’re also more prone to seasonality.

Make sure to account for these differences when evaluating your investment, then choose a lender who will do the same.

Regulations can complicate your investment

The vacation rental boom has brought with it new regulations. Before pulling the trigger on a property, research city, neighborhood, and building rules regarding short-term rentals.

Remember, regulations are subject to change. If your rental is near a popular tourist attraction, you’re probably safe. But if it’s in a private, wealthy neighborhood, you might want to think twice.

Need rental financing for a vacation home?

At Longleaf, we offer competitive rates on both rental loans and bridge loans. If you need fast and flexible financing, give us a shout at 979-200-2823 or info@longleaflending.com.

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