Dreaming of beach houses and mountain cabins filled with happy vacationers?

Vacation rental loans make financing these short-term rentals possible. These desirable properties promise great profits thanks to high travel demand. However, financing them can stop many real estate investors in their tracks without the right loan.

This comprehensive guide will equip you with key knowledge to understand vacation rental loans, weigh the pros and cons of different loan types, and follow a step-by-step process to get approved. Unlock the potential of captivating vacation rentals with this specialized financing.

The vacation rental gold rush awaits—let’s get you staked.

TL;DR

  • Vacation rental loans are specialized financing for short-term rental properties, but often come with higher interest rates.
  • Plan your investment strategy: define goals for income or appreciation through short or long-term rentals.
  • Strengthen borrower credentials with factors like expected rental income, occupancy rate, and FICO score.

What is a Vacation Rental Loan?

A vacation rental loan is a financing option designed for real estate investors looking for help in purchasing properties intended for use as short term rentals. These loans are typically financed by a bank or private lenders in exchange for interest rates.

Since these loans cater to the unique (and often unstable) financial considerations and operational characteristics of vacation rental properties, lenders typically charge higher rates than financing for a primary residence.

However, the rate will depend largely on your property type, down payment, and credit score.

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Properly Financing a Vacation Rental Property: Step-by-Step Instructions

While funding a vacation rental property might look similar to financing your primary residence, there are slight differences.  Here’s a step-by-step outline to help you out:

1. Plan Out Your Investment Strategy

The first step in successful vacation rental financing is to establish your objectives at the start. This will not only help provide you with a clear roadmap of your investment strategy but will also help what type of loan program fits best with your future investment property.

First, you should ask yourself what type of property are you going for — is your goal to generate income through short-term rentals (STR) or are you content with property appreciation through long-term rentals?

2. Understand Your Available Financing Options

A vacation rental loan program is a specialized financing option for investors or businesses looking to invest in or manage short-term vacation rental properties. These programs cater to the unique characteristics that short-term rental properties carry.

Learning about these programs, as well as their pros and cons, will enable you to open up many financing options tailored to your vacation rental investment. Here are 5 types of loan programs you can use as a short-term rental loan:

Vacation rental loan options: Home Equity Loan, Private Money Loan, Conventional Loans, Cash-Out Refinancing Loan, Hard Money Loan, FHA Loan

Conventional Loans

A conventional loan is the most common vacation rental loan typically offered by non-government financial institutions such as banks, credit unions, and private lenders.

If you’ve already used a traditional mortgage loan to acquire your first property, I recommend going at it for a second try with your vacation rental property. Why? It’s easy, it’s secured, it has the lowes-interest rates, and has flexible loan terms — all you need is a good credit score and around 20% down payment to get started.

However, if your down payment is less than 20%, you may need to pay for Private Mortgage Insurance (PMI) until you build a certain level of equity in your vacation home.

Pros

  • ✅ Very competitive interest rates
  • ✅ Somewhat flexible loan terms

Cons

  • ❌ Down payment required
  • ❌ Strict qualifying requirements
  • ❌ Rigorous documentation requirements
  • ❌ Long approval process may tie up buyers who are looking to source funds quickly
  • ❌ Borrowers may need to pay for private mortgage insurance if down payment is ≤20%

DSCR Loan

A DSCR (Debt Service Coverage Ratio) loan is a type of loan that looks primarily at the property’s net operating income rather than the borrower’s credit score or income to determine eligibility

Since this loan type looks at the property’s projected net operating income so that they can work for any type of cash-flowing investment property – whether it’s a small multi-family rental, Airbnb rental, or other short term rental used for vacation rentals.

The key qualifications and requirements are based on the property’s financials and ability to cover the debt payments rather than the personal credit profile of the borrower..

Pros:

  • ✅ Lower down payment requirements
  • ✅ Flexible qualifying since they are based on the property, including factors like occupancy rates and cash flow. Personal credit scores or debt-to-income ratios carry less weight.

Cons:

  • ❌ Higher interest rates
  • ❌ Balloon Payments – Many DSCR loans are interest-only, with balloon payments in 3-5 years. The remaining balance must then be fully paid or refinanced to extend the loan. This can create cash flow issues and uncertainty in a few years.

Home Equity Loan

Home equity loans or Home Equity Line of Credit (HELOC) allow investors to leverage the equity they have built in their homes to finance real estate investments.

This type of loan works by applying through a lender. Once approved, the borrower receives the funds as a lump sum and must repay the loan monthly.

Pros:

  • ✅ Interest paid on a home equity loan is tax-deductible in some cases
  • ✅ Draw funds anytime

Cons:

  • ❌ Primary home acts as collateral to secure the loan
  • ❌ May involve high closing costs
  • ❌ Most lenders require good credit scores and loan-to-value (LTV) ratios
  • ❌ Requires significant equity to finance while simultaneously reducing the homeowner’s equity in the property

Cash-out Refinance

Cash-out refinancing is a popular financing option for investors because it allows them to borrow against the equity of their existing property and use the funds as a down payment for a new vacation rental property.

Cash-out refinancing works by replacing the old mortgage with a new loan higher than the current amount and pocketing the difference in cash with the mortgaged property serving as collateral.

Pros

  • ✅ Investors tap into the equity of their property and convert it into cash
  • ✅ Interest in the cash-out portion is tax-deductible in some cases

Cons

  • ❌ Reduces the investor’s property equity
  • ❌ Interest rates and repayment terms are reset, which can lead to a higher overall loan amount and longer repayment terms
  • ❌ May increase the risk of foreclosure for struggling investors

Private Money Loans

A private money loan is a type of mortgage loan that is provided by private lenders or non-banking institutions willing to fund your investment property in exchange for higher interest rates.

Private lenders can be friends, colleagues, relatives, or fellow investors willing to provide you with short-term loans with minimal credit score requirements.

This type of loan is great for investors who need a lot of flexibility and have a great network they can utilize and tap into.

Pros

  • ✅ Quick way to access funds in a short amount of time
  • ✅ Asset-based lending, which opens up opportunities for investors
  • ✅ Relationship-focused approach, which can lead to very flexible terms

Cons

  • ❌ Short loan terms
  • ❌ Higher interest rates compared to traditional lending
  • ❌ Unlike traditional lending, private money loans carry a high-risk nature due to limited regulation

Hard Money Loan

A hard money loan is a flexible financing option primarily offered by institutional lenders. Because of their quick approval process and lenient qualification requirements in exchange for significantly higher interest rates than traditional lenders.

Hard money loans are commonly used for time-sensitive investment opportunities like flipping homes..

Lenders may require borrowers to provide a more significant down payment due to its high-risk nature. Additionally, since hard money loans are asset-based, lenders can disapprove you if they believe your property won’t quickly recoup their investment.

Pros

  • ✅ Relatively quick approval process
  • ✅ Lenders tend to focus more on property value rather than credit history, which opens up an opportunity for borrowers with poor credit score
  • ✅ Hard money loans can be used for various real estate investments, tailored to the needs and strategies of the investor

Cons

  • ❌ Short repayment terms
  • ❌ Higher-interest rates compared to financial institutions
  • ❌ Lenders will require borrowers to use the property as collateral and take over if they default

FHA Loan

A Federal Housing Administration (FHA) loan is insured by the federal government to make housing more accessible for first-time homebuyers.

FHA loans are specifically designed for primary residences, you can still use them to finance a future vacation rental property.

How? You need to follow a specific eligibility criteria:

  1. Live in the home for 1 year
  2. The property must be located within a 100-mile radius of your primary residence
  3. The borrower must have a stable 2-year employment history

As long as you follow these, you can either House Hack and rent some spare rooms or do STR and make a sizeable rental income.

Pros

  • ✅ Lower down payment requirements than most loans
  • ✅ Less restrictive credit requirements than conventional loans

Cons

  • ❌ Your property needs to meet certain standards set by the FHA, which can limit your property choices
  • ❌ Borrowers will need to live in the property for a year to due to primary residence restrictions

3. Strengthen Your Borrower Credentials

Before you visit any of your local lenders and dive right into investing in short-term rental types like vacation rental properties, keep in mind that there are key metrics lenders will look at. Here are six main factors you should always consider as an investor:

Expected Rental Income – Investors should if your expected monthly income from your rental property covers all primary expenses, such as mortgage payments, and other ancillary costs, such as maintenance and cleaning services.

Occupancy Rate – Occupancy rate is a key performance metric that assesses how well your rental property is being utilized by calculating the number of units currently occupied divided by the number of units available.

A higher occupancy rate means your property performs well, which translates to more rental income. Conversely, a low occupancy rate indicates that you need to adjust pricing and reiterate marketing strategies to attract more bookings.

Capitalization Rate (Cap Rate) – The cap rate is a performance metric used with other financial and market analyses to make better decisions that measure how well your rental property will generate cash flow (ROI).

You can calculate your cap rate by dividing your property’s Net Operating Income (NOI) by acquisition cost. A higher cap rate typically indicates higher potential rental income and lower risk.

Debt-to-Income Ratio (DTI) – DTI compares a person’s total debt payments to their gross income and is commonly used by lenders to assess borrowers’ ability to manage their debt relative to their personal income.

You can calculate your DTI by dividing your monthly debt payments by your gross income. A low DTI indicates that your income can cover expenses, which will tell lenders that you are less likely to default on a loan, while a higher DTI will label you as a high-risk borrower — making qualifying for a loan harder than it is.

Note: Keep in mind that lenders prefer borrowers with a DTI of around 36%.

Debt Service Coverage Ratio (DSCR) – DSCR measures how much net rental income remains after paying for all expenses, including, but not limited to:

  • mortgage
  • interest
  • HOA fees (if applicable)
  • property management and maintenance fees

DSCR is commonly used by lenders to evaluate a borrower’s creditworthiness, specifically when they are applying for commercial loans.

A higher DSCR means more net rental income, which translates to a lower risk of defaulting on your monthly mortgage payments. The higher your DSCR, the more attractive your proposition is to your lender.

FICO Score –  A FICO score is a numerical representation of an individual’s creditworthiness, calculated based on credit history data.

The higher your score, the more trustworthy you are as a borrower– which increases your chance of getting approved and negotiating for better terms. The score ranges are commonly categorized as follows:

  • ≥800: Exceptional
  • 740-799: Very Good
  • 670-739: Good
  • 580-669: Fair
  • ≤579: Poor

Note: The minimum scores for a vacation rental loan are typically set higher than those buying a primary residence.

Vacation Rental Loan Key Considerations

Unlike a mortgage loan on a primary home, vacation rental property mortgage rates are higher since lenders see it as a profitable investment. If your real estate business stops being profitable and you miss out on payments, the more likely a lender will foreclose the property you put up as collateral.

Down Payment

It’s a given that lenders want to get mileage for their investment while carrying the least amount of risk possible. As the borrower, you can show potential lenders they can trust you with their money by sweetening the pot – making a sizeable down payment.

Making a down payment of 20% or more helps lessen the risk for the lender while providing great benefits for the borrower. Plus, the more money you put down, the better your chances of getting your loan approved with lower interest rates and avoiding PMI.

Wrapping Up

A vacation rental loan opens the door to a potentially lucrative investment. This guide has equipped you with key insights on loan options—from weighing the pros and cons of different

types to building a strong borrower profile.

Armed with a deeper understanding, you can now confidently seek out the best loan for your next property. As you calculate expected returns and meet qualification metrics, your beach house dreams inch closer to reality.

Rental income awaits those who can secure smart financing. Now go stake your claim in this thriving market! Vacation rental investing is within reach if you leverage these funding approaches.

FAQs

Is buying a vacation home to rent a good investment?

Absolutely. Not only does a vacation home offer a consistent flow of monthly rental income, but the property could also appreciate over time.

If your property is located in a tourist hotspot, even better — you can even make more money renting it out to travel tourists. Plus, it’s a great vacation home for you and a potential place to visit.

Is the vacation rental business profitable?

Even as consumers have struggled with increasing inflation, short-term rentals are still profitable (and even thriving) as of 2023 thanks to growing demand for travel tourism.

Can I Airbnb with a residential mortgage?

Yes. It is possible with House Hack. Your lender won’t have any issues with you if you only rent out a portion of your home.

However, if you’re planning to move out and rent it out entirely, check with your lender first before putting up your listing. You might be doing something that’s not in the original terms and agreement with your lender, which can land you in hot water.