A Guide to Vacation Rental Financing

Investing in a short-term rental property is an incredibly exciting endeavor and can help you earn money on the side or become a full-blown business. However, before you start picking out color schemes and looking at interior design ideas, you need to run the numbers before making the decision to invest money into a property. 

One of the avenues you may be considering is vacation rental financing or vacation rental loans. In this post, we’ll take a look at all the aspects you have to consider before applying for vacation rental financing and how to ensure that you get the best return on investment (ROI) possible. 

Why Vacation Rental Financing?

Applying for financing products or seeking investors is the first step in establishing whether or not a short-term rental business is viable for you, your capital, and your current income. To ensure that you secure the financing you need from one place or another, you need to make sure that your financing strategy is watertight.

Any financier will take a look at your business proposal, with the return on investment (ROI) being their top priority. Your financing plan will also help you determine which option will best suit you and your short-term rental business plan. If you want to secure financing that will ultimately elevate your business and not result in you incurring large amounts of debt, then you need to ensure that you have a well-planned financing strategy. 

Aspects to consider in this strategy include: 

• Property value
• Competitor businesses
• Average day rates (ADRs) for the area
• Property availability
• Start-up costs (e.g., renovations or connectivity installation)
• The downpayment you can afford to put down
• Marketing and advertising costs
• Overheads (staff payment, ideal monthly repayment figures, water, and electricity bills)

Once you have an idea of the above points, this will give you a clear numerical path and define the financial targets you want to hit. This will also give your investor or loaner a better idea of how you plan on repaying the money they lend you to acquire the property. 

Bear in mind getting these points down is a lot easier to do when you have a property in mind already or if you have existing equity in a property. If you do not yet have a specific property from where you will run your short-term rental business in mind, you can research similar homes that match your vision. 

Understanding Different Financing Options

When you apply for finance for a short-term rental property, you are essentially applying for a business loan or investment. This is because the whole point of owning a short-term rental property is to bring in additional income. Before you commit to a financing solution, you have to understand that multiple options are available to you. There are several benefits and downfalls to each of them, but the right one will ultimately make your life much easier. 

Let’s explore the different financing options for those looking to break into the short-term rental market or acquire a second property. 

Pros and Cons of Each Financing Option

There are four main financing options available to vacation rental home buyers. You will have to choose which one will best suit your business plan and which one will ensure that you and your investors get the best ROI. Let’s examine the pros and cons of each vacation rental financing option below. 

Traditional Mortgages

Mortgages are loans that are specifically there to help you acquire a property. This is the most straightforward financing option available. Mortgage interest rates depend entirely on the property market’s health and trends. If you want to explore a traditional mortgage option, then you need to ensure that your credit score aligns with the requirements of the lender if you are the one looking to borrow the money. Lenders will also look at the income the borrower makes. 

Pros

The pros of traditional mortgages are, therefore, as follows: 

• Straightforward process
• Perfect in a buyer’s market as interest rates tend to be lower
• Lowest interest rates of all financing options
• No restrictions on the area of the property of the property type

Cons

Now, let’s look at the cons: 

• Not ideal for anyone who has a low credit score
• The Debt limits the amount you can borrow to Income Ratio (DTI)
• Entirely based on numbers, but business prospects

Home Equity Loans 

Ideal for someone who has established themselves in the property market, home equity loans allow existing homeowners to use the equity they have already generated by a property and use it to purchase another one. Loans granted on this basis are done so by looking at the property's value that holds the equity less than the due balance of the existing mortgage. For this reason, home equity loans are also known as second mortgages.

Pros

Let’s take a look at the pros of home equity loans: 

• A good way to convert equity build up into cash for reinvestment.
• Usually have a fixed-interest rate
• Lower interest rates other than when compared to traditional mortgages

Cons

The cons you should also consider when thinking about taking a home equity loan are: 

• Cash is given in a lump sum which means you may accumulate more debt than you need to
• Larger risk of losing your home
• Lengthy application process

Investment Property Loans

This type of loan is the ideal solution for anyone who is already on the property market and wants to expand their portfolio. Financing under this scheme depends entirely on the income the property will generate or already generates. 

Lenders will look at the current income or projected income and work out the Debt Service Coverage Ratio (DSCR). This is the gross income divided by aspects like interest, taxes, and insurance. If there are any fees like homeowners association fees, then these will also be taken into consideration before a loan is granted. If you’re considering this avenue, you need to consider the pros and cons before proceeding.

Pros

For investment property loans, the pros include: 

• Loans are granted based on the properties income rather than the individual borrower’s income or credit score
• Loans are typically acquired faster, and there is less administration involved in the application and granting process.
• Ideal for anyone who wants to expand their property portfolio or scale their short-term rental business.

Cons

When looking at an investment property loan, the cons you should consider are: 

• Interest rates tend to be higher
• You need to be prepared to make a down payment of 20% - 25% of the total loan amount.
• The lender may be more restrictive in terms of the location and property type owing to their emphasis on the property's income.

Private Lenders and Crowdfunding

Although this is definitely the most flexible vacation rental finance solution, it is also the most difficult option to secure. The money you obtain from private financing has to come from a source that you know and trust. 

Although you can have loan contracts drawn up, this loan method is also entirely unregulated. Therefore you need to ensure that the source of the money you use to invest in your short-term rental property is completely trustworthy. 

Crowdfunding is when multiple investors are willing to give you money to invest in a property. They are usually found through online platforms or can be friends or family too. Those who contribute to a crowdfunded project usually get rewards, although the property owner may also offer shares in the short-term rental business.

Pros

When looking for private lenders or crowd funders, it could benefit you in the following ways: 

• Flexible interest rates, down payments, and loan terms and conditions.
• Does not restrict you in terms of property type and area.
• Scalable if the initial business prospect works out

Cons

As always, it’s equally essential to look at the cons associated with private lenders and crowdfunding: 

• Because these loans are not granted by practicing underwriters, they are often unregulated and therefore put you more at risk.
• Private lenders are difficult to come by
• You put the personal relationships you have on the line

How to Choose the Right Financing Option

Before you make a decision on the financing option you go for, you need to consider which one you will get the most benefit out of and which ones will ensure that you continue to make a profit from your business while repaying the agreed monthly rates. When making a decision on which financing option you apply for, you have to consider the following factors:

• The terms and conditions of the loan agreement.
• Whether or not you will be losing money on the interest rates you agree to
• What is at risk should the short-term rental business not work out
• Consider whether you are adding to your portfolio or only just breaking onto the short-term rental market.
• How flexible do you need lenders to be when it comes to extending the loan agreement or adjusting interest rates?

When you consider the above factors, it will make it easier for you to choose the right vacation rental finance option for you. There is no one-size-fits-all solution when it comes to getting capital to start out your business. It’s important that you weigh up all the factors involved in the financing solution you choose to ensure that you get the most out of your service provider and the capital you get to start you out.

What Lenders Look for in Vacation Rental Financing

Depending on the financing option you choose, there are several aspects that lenders look at before they can grant you a loan. In every case, you will need to provide the bank, investor, or private lender with some sort of guarantee that they will get their money back with interest, or at least back in full, should the business not work out. This guarantee is usually known as collateral. 

You may also have to submit a business plan which contains figures like projected income and value added to the property. If an investor can see that they will make a decent return on investment after they give you the agreed funds, then this will prove your credibility to them and make you a good candidate for a loan or investment. 

Lenders will also want to make sure that you will be able to make the agreed repayments in line with the terms. This is why most lenders will look at the borrower’s credit score and payment history. Looking at previous payment records and credit scores reassures lenders that they can trust you to follow through with any financial commitments you make.

Additional tips for vacation rental financing

To ensure that you get the most out of your financing option, we’ve compiled a list of additional tips that you can use. When you consider vacation rental financing, the following will help you in the application and initial stages: 

• Prepare a clear and concise business plan and overview before you approach lenders or investors.
• Understand the market and analyze competitors in the area.
• Have an idea about the terms and conditions surrounding the individual financing solutions.
• Try to get pre-approved for a loan by getting all the paperwork in place in advance and applying early, as this gives you a competitive edge.
• Try banking locally, as you may be able to get more favorable interest rates and payment terms from those who understand the local market more in-depth.
• Make sure you have a strong credit score before going through the banks.
• Make sure you have some savings in reserve to offer as additional collateral. It will also help you to increase the down payment, which may help to reduce the payment durations.

If you follow these tips, you will be fully prepared to choose the right vacation financing solutions for you and start developing your short-term rental business dream.

Conclusion

Getting financing for your vacation rental property is a great way to ensure you realize your dream of running your own vacation home. Obtaining the capital you need to buy the property and implement your short-term rental business is easy to come by when you know what to look for and understand the options on offer. You need to remember that there are several financing options available to you that will ensure you get the best deal possible.