Imagine this…
You just found the perfect deal. It is so great in fact, that it feels like a steal. You already contacted the seller and you’re formulating your future plans with this investment property. There is one key factor to making this deal come to fruition…
Funding!
One of the differences between seeing a deal and having a deal is paying for it. Money is one of the biggest barriers investors face when it comes to starting or growing their real estate investment business. The good news is that there are a lot of funding options available. The bad news is that a lot of investors don’t know all of their options and sometimes don’t choose the option that best fits their needs.
We’re here to help fill in the gaps! Learn which funding option may be the best choice for your next investment deal.
Let’s get started!
Cash
While you don’t have to have much cash for many financing options, a recent study revealed that 24% of investors use all cash for their purchases.
Benefits to Using Cash
Faster closing times: Investors using cash don’t have to wait on lenders and underwriters for financing to be approved.
Lower holding costs: If you’re buying the house as a fix and flip, there are holding costs involved while the house is being remodeled. These holding costs vary but can include mortgage, maintenance, HOA fees, insurance, and utilities. If you pay for the house in full, you can save a significant amount of money in holding costs since interest is usually paid on the front end of a loan.
If you plan to rent the house, then your savings increase even more since you’ll own the house for much longer. Usually, 70%-80% or more of the rent payment you receive is going towards holding costs, but if the house is paid for, all that money can go in your pocket or towards another property.
More options: The best real estate investment property deals are usually buying directly from a seller who is extremely motivated to sell their house. Sellers in these situations want to minimize risk and close as quickly as possible, so cash is ideal. If a seller can see you have cash in hand, they are much more likely to take less money or back out of another deal.
Challenges to Using Cash
Less Leverage: Funding a deal with cash is one of the fastest, most efficient ways to purchase — but it also limits how much leverage you have. For example, you can either buy one house with$100,000, or you can buy 5 houses with 20% down and increase your monthly cash flow.
Gathering Cash: The most obvious challenge with using all cash is…actually having the cash. Paying all cash is not an option for most new investors.
Hard Money Lenders
A hard money loan, sometimes called a “bridge loan”, is financing from a private business or individual for the purpose of investing in real estate. The loan is typically based on the value or the property rather than the creditworthiness of the buyer or the current state of the property.
Hard money loans are meant to be short-term, and are a good tool for investors who are flipping a property or planning to refinance the loan after repairs are made to the house.
Benefits to Using Hard Money
Little or No Credit Needed: With a hard money loan, the property and its ARV are used as collateral for the loan. Some lenders will allow you to also use retirement money or other assets to help secure the loan.
For more information regarding calculating ARV or pulling comps, click here.
Convenience: Hard money has the benefits of being both flexible and convenient. Applying for a mortgage can take months, putting you at risk of missing out on the deal. Hard money lenders can approve a deal within weeks, or even days if the circumstances are right.
Hard money is also flexible. Many lenders will allow you to negotiate the terms, repayment schedule and fees.
Challenges to Using Hard Money
Short repayment Window: Often times, you have to repay a hard money lender quickly. This can be an issue when you’re rehabbing a property. You need the rehab complete so you can resell the property and repay your loan. With a short repayment window you have to plan ahead and be realistic about the amount of money you can repay within a particular time frame.
Cost: Hard money loans are expensive. Interest rates are generally higher and you’ll often pay more points. The higher cost of hard money is a reminder that they loans for intended for temporary use.
Private Money Lenders
With a private money lender, you borrow from an individual versus a financial institution. Private lenders are attracted to private lending because they are looking for a higher return on their cash than traditional lending options. As the borrower, you get access to cash with more flexible terms.
This is a relationship-based agreement that seeks to be beneficial for both parties. Private money lenders tend to have lower than normal interest rates, fewer fees and points, shorter term length, and overall flexible terms.
Benefits to Using Private Money
Credit History: Typically when working with private lenders, your credit score is not a determining factor of whether you qualify for the loan or not. Borrowing private money may be a great option for borrowers who have less than perfect credit.
Cash: Borrowing from a private money lender gives you access to cash. This can be very beneficial when it comes to purchasing an investment property. Cash offers often win. Rehabs becomes easier to fund and complete when you have access to cash. This can really speed up the buy, fix, and flip process.
Flexibility: Because you’re working with an individual instead of an institution, the terms of the loan can be negotiated and are often flexible. The interest rate, the amount of the loan, the length of the loan, and the payment structure are all determined by the lender and borrower. Private money loans are often based on the relationship between the borrower and lender. This relationship helps determine the terms of the loan.
Challenges to Using Private Money
Finding a Lender: Private money lending is a relationship-based agreement. Sometimes it can take time to establish this relationship. Persistence and preparedness are key. You may reach out to 15 or more private lenders before you hear back from one. Be sure you have enough information about the deal and your detailed plans for the deal to present to the lender. You need to convince the lender that you and your deal are secure.
Looking for a private money lender for your next investment? Look no further.
Owner Financing
This type of loan occurs when the property buyer finances the purchase directly through the person selling the property. This is often an option for buyers who cannot obtain funding through a conventional mortgage lender. Also, sellers may agree to owner financing if have a hard time selling the property.
Benefits to Using
Fewer Barriers: The owner and the buyer can tailor the financing terms to work for both parties. The down payment can be negotiable, there are no loan points, origination fees, processing fees, or administration fees which overall reduces the closing costs.
Down Payment Flexibility: There is no minimum down payment required, as with a traditional bank loan. The down payment is whatever the seller and the buyer agree to. This can be an attractive option for buyers who don’t have a large sum of money to put towards a down payment.
Challenges to Using
Interest Rate: Buyers should expect to pay a higher interest rate. The interest rate has to be high enough that the owner wants to lend their money instead of investing it elsewhere.
Partnerships
Going into business with someone you trust is a great way to make your business more efficient — but you’ve probably heard some horror stories as well.
Benefits to Using
Resources: Involving another person in your investment opportunity doubles your resources. Not only will you both have more financing options, but you’ll also have more resources for tasks and analysis. Two heads are better than one!
Risk: By working with a partner, you expand your financing opportunities, but you also split the risk involved in the investment.
Challenges to Using
Trust: The most important thing when choosing a partner is making sure that working with them actually benefits you and the deal. Make sure that their credit or history will benefit you in the deal.
Federal Housing Administration (FHA)
This loan is designed for homeowners who are going to live in the property. Despite what some may think, you can still use an FHA-backed loan to buy an investment property. This loan is ideal for investors who want to buy a duplex, triplex, or fourplex and live in one of the units.
Benefits to Using FHA Loans
Lower rates: Overall, requirements for credit score and down payments are far lower than for conventional loans. Borrowers can qualify for an FHA loan with credit scores of at least 580 and a down payment of 3.5%.
Closing Costs: FHA loans allow sellers to pay up to 6% of the loan amount to cover the buyer’s’ closing costs. In conventional loans, sellers can only pay up to 3%. This is helpful for buyers who saved enough money for the down payment but don’t have enough to cover all closing costs.
Challenges to Using FHA Loans
Mortgage Insurance: There are costs required for the upfront and annual mortgage insurance premiums that are put in place to protect the lender. The upfront mortgage insurance premium is 1.75% of the loan amount. For a 30-year loan, the annual insurance premium is 0.85%, and for a 15-year loan the yearly premium ranges from 0.45% to 0.95% of the loan balance.
Property Restrictions: FHA loans are managed by HUD; therefore, HUD determines the type of properties that can be purchased with this loan. A HUD-approved appraiser will visit the property to ensure it meets all program requirements. Generally, a vacation home is not an approved property for this type of loan. There are specific guidelines about using this loan to purchase a condominium and the condo will have to be on the approved list.
203K Loans
An 203k loan is specific type a type of FHA loan. It’s backed by the federal government, but meant for buyers who want to buy a home and do repairs on it. Like an FHA, this type of loan is ideal for investors with a small multi-family property where they plan to live in one of the units.
This loan typically includes up to 20% contingency reserve so that you will have the funds to complete the remodel if it ends up costing more than the what is estimated. There is also a provision that gives you up to six months of mortgage payments so you can live elsewhere while you’re remodeling, but continue to pay the mortgage on the new home.
Benefits to Using 203K Loans
Minimal Down Payment: Your down payment of 3.5% (the minimum required by the FHA loan program) will be based on the full loan amount and the monthly payments will be higher since you’re including repair costs in the same loan.
Repairs: The second benefit applies to non-investors. Most conventional loans are loaned based on the as-is price. The 203k loan is the only financing for conventional buyers that allows them to borrow above the current sale price and value.
Challenges to Using 203K Loans
Repair Completion: The repairs need to start within 30 days of closing and be completed within six months. This can be difficult at times when working with contractors. Knowing your time constraints ahead of time will help you determine the best contractor for the repairs.
Using this type of loan requires you to pay mortgage insurance for a minimum of 11 years and usually for the entire length of the loan which can raise monthly payments higher than expected.
Qualifications: Not all properties or repairs qualify for this loan. The traditional 203k is for properties that need structural repairs, remodeling, a new garage or landscaping. The streamlined 203k is for energy conservation improvements, new roofing, new appliances, or non-structural repairs such as painting.
Conventional Loan
These loans have fairly conservative guidelines for credit scores, minimum down payments, and debt-to-income ratio (percentage of your monthly income that is spent on paying down debt). They are ideal for borrowers with good or great credit. Monthly payments on a conventional fixed-rate mortgage remain the same for the life of the loan, which is attractive to borrowers who plan to stay in the home for the long-term.
Benefits to Using Conventional Loans
Set Interest Rate: The interest rate will not change for the life of the loan which protects you from rising interest rates. Monthly payments remain the same for the life of the loan, which is attractive to borrowers who plan to stay in the home for the long-term.
Mortgage insurance: If you pay at least 20% down for the home, you will not have to pay mortgage insurance . This will eliminate the upfront and annual costs that come with mortgage insurance.
Challenges to Using Conventional Loans
Good Credit: You need very good credit to qualify for the best interest rates. Those who haven’t established good credit or who have poor credit may have a difficult time qualifying for a conventional loan.
Overall Costs: Between the closing costs, down payments, mortgage insurance, and points, the borrower has to show up at closing with a large sum of money out of pocket.
Commercial Loan
A commercial loan is a debt-based funding arrangement between a financial institution and a business. These loans typically assist with short-term funding needs for operational costs or for the purchase of equipment to facilitate the operating process. Commercial loans are common for businesses that are just getting started.
Benefits to Using
Ownership: While utilizing a commercial loan, you retain total ownership over your business. When you borrow from a venture capital investor, you will likely have to sign over a portion of your company. With a commercial, your company remains all yours.
Length of Loan: The loans are long-term, often between 3 and 10 years, allowing you to pay the money back slowly as you work to increase business profits. This can be very beneficial for a young company. A longer repayment period reduces the concern of loan payments eating into all profits.
Challenges to Using
Application process: The lender requires a detailed financial report of the business, an assessment of projected revenues, and information about all associated business risks. Essentially, you need to convince the lender that your business will not fail. You typically have to present documentation that proves the company has a favorable and consistent cash flow.
Personal Finances: As part of the process to obtaining a commercial loan, you’re required to provide information about your personal finances. You’re required to provide your credit score, annual income, and unpaid debts. Any issues with your personal financial history can prevent you from qualifying for a commercial loan.
401(k)Retirement Fund
The 401(k) loan typically allows a person to borrow up to 50% of the account balance up to a maximum of $50,000. This loan is required to be repaid within five years, but the schedule can be adjusted if the money is for a down payment on a home. This type of loan does not go through the same approval process as working with a bank. There is no credit check and the interest rates can be lower than standard bank loans.
Cutting out some of the red tape, some people find it more attractive to borrow money from themselves than from a bank.
Benefits to Using
Convenience and Speed: Requesting a loan from your 401(k) can be a quick and painless experience. There are no lengthy applications or credit checks and borrowing from your 401(k) won’t affect your credit rating. Basically within a few days you can have a check in your hands.
Flexible Repayment: Most 401(k) loans are on a 5-year repayment schedule, but you can repay the loan faster without a penalty, if you choose. Loan repayments are typically through payroll deductions, which is convenient.
Challenges to Using
Changing Jobs: If you leave or are let go from your job, you will have to repay the entire loan within 60 days or deal with penalties. Be sure that you’re secure in your job before you decide to borrow from your retirement account, or the costs will outweigh the benefits.
Earning potential: Your retirement money doesn’t earn any interest until it is back in the account. The money you save with a lower interest rate may not be enough to make up for the loss of earnings by pulling money from your retirement account.
Home Equity Loans
With a home equity loan the borrower uses the equity of his or her home as collateral. The loan amount is determined by the value of the property.
This loan creates a lien against the borrower’s house and reduces the home equity. The funding is often used for major expenses such as repairs. Home equity loans, also called second mortgages, are secured against the value of the property just like a traditional mortgage.
There are two types:
Fixed-Rate Loans:
A lump-sum payment to the borrower, which is repaid over a set period of time at an agreed-upon interest rate. The payment and interest rate remain the same over the lifetime of the loan.
Home-Equity Lines of Credit (HELOC):
A loan that works more like a credit card. Borrowers are pre-approved for a certain spending limit and can withdraw money when they need it. Monthly payments vary based on the amount of money borrowed and the current interest rate. The HELOC has a set term and when the end is reached, the outstanding loan amount must be repaid in full.
Benefits to Using
Cash: These loans provide an easy source of cash for funding major renovations and repairs.
Tax deduction: 100% of your home equity loan interest payments may be tax deductible, which may not be the case with credit card debt.
Lower interest rates: Home equity loans typically have much lower interest rates than credit cards. This type of loan is secured by the collateral of the property. Therefore, lenders are confident in your ability to pay the debt.
Challenges to Using
Debt to Asset Ratio: This is the amount you owe to lenders compared to how much to how much you own in personal assets. Home equity loans increase your debt, raising your debt to asset ratio.
Adjustable Interest Rates: It is uncommon to receive a fixed-rate loan based on your home equity. With interest rates that changes over time, it may be difficult for you to control the overall cost of the loan. It is important to be aware of interest rates and how that will impact your payments over the long-term.
Final Thoughts…
A smart investor is an educated investor. Stay informed about all of your funding options when it comes to financing your next investment deal. Different lenders may be appropriate for different deals, and it’s up to you to determine the best fit. When in doubt, do your research (or re-read this post!) and ask questions. Good luck!
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