Getting mortgage approval for an investment property is harder than getting approved for an owner-occupied home. Because lenders view rental properties as carrying more risk than a place of primary residence. As a result, investment property mortgage has more stringent requirements.

But, even when lenders are willing to lend for a rental property, they are more careful if that property is a vacation rental. As Bighorn Rentals explains, this is because:

  • A profitable rental apartment may be vacant for a few weeks in the year. But a vacation rental will have many months in a year when it is empty.
  • Vacation rentals typically cost more than other investment properties. This means a bigger loan and bigger risks for the lender.

If you are thinking of getting a mortgage on a vacation rental, you should be ready to do more to convince your lender. Getting approved for the loan is not impossible, but it does require you to do your homework before you approach the bank.

Failing to do this might result in a rejected application. Or, if you do get approved, the loan terms may be adverse to the success of your business.

The following five steps will greatly reduce the chances of any of these two unfavorable outcomes happening.

1.   Build a strong credit

The highest credit score lenders typically require from people borrowing for their primary residence is 620. But for a vacation rental, you can expect it to be much higher. The majority of lenders will want to see a minimum score of 720. This is extremely high; if you consider that the maximum credit score is 850. But it does not stop there.

In addition to having a high score, your score must be equally high in the reports of all three major reporting agencies. To be accepted, there can be no records of late payments in the reports and accounts must have good balances. This means you should have started working on your credit years before your loan application.

2.   Get ready to put more money down

The standard down-payment for single-family owner-occupied homes is 20%. In some cases, borrowers can even make a down-payment as low as 3%, if it is their first home. But for a vacation rental, down-payment hovers in the region of 30%.

For a $200,000 house, you should expect to provide $60,000 of your own funds. Additionally, the funds must have been liquid in your accounts for a minimum of sixty days or two months. In short, you must have money lying around that you are under no pressure to spend.

Although it is possible to avoid this sizable down payment, it comes at a cost. You will be obligated to accept a higher interest rate and bigger private mortgage insurance payments.

3.   Look at your debt-to-income (DTI) ratio

This is a measure of how much income you are earning versus the number of monthly payments you are making. The bigger your income is and the fewer your monthly payments, the better the ratio is going to be. This is important because you are looking to add another monthly payment to your expenses.

Lenders need to assess your income to know if you have enough room to manage it. Most lenders require a DTI of less than 45%. A major problem here is that the projected income from the rental is not going to be factored into the calculations. That is unless you have a signed lease in place. Otherwise, the new payment is entered as a debt, without an additional income to offset its impact on the ratio.

4.   You need to have reserve assets

In addition to putting more money down, lenders also require that you have reserve assets when borrowing for a vacation rental. In short, you must demonstrate the capacity to keep up with the monthly payments, even if you lose your job or income. This usually means having enough cash reserves to cover the full monthly payments – plus insurance and taxes – for a period of six months to one year.

The actual amount of reserves required will depend on your credit score and down payment. But the minimum is usually six months. However, unlike your down payment funds, this reserve does not need to be liquid. It only needs to be in a preexisting account.

5.   Provide an appraisal of potential income for the rental

The rental must show good potential for earning income. This will depend on the market conditions in the locality and the type of property. Factors that should be considered during the appraisal include; the popularity of the destination; the existence of nearby attractions in the location; the ebb and flow of the market; and the area’s appeal in winter versus summer.

The particulars of the property also play a key role in its earning potential. What is the average rental price and how much do comparable properties in the area earn? Note that, at the most, only 75% of projected earnings will count in the lender’s assessment.

Although doing the above those not guarantee that you will get approval – that decision ultimately lies with the lender – it greatly improves the odds that you will.