Chapter 6: Real Estate Financing
"A bank is a place that will lend you money if you can prove that you don't need it." -- Bob Hope
No matter what some late night infomercial might lead you to believe, there is no such thing as "free" real estate. Real estate is a commodity and must be paid for. As a real estate investor, one of the most important roles you will play is to put together your deals using a variety of different financing tools. This chapter is going to teach you the ins and outs of various methods you can use to fund your real estate investments.In This Chapter, You'll Learn About:
- Why You Need to Understand Real Estate Financing
- All Cash
- Conventional Mortgages
- Portfolio Lenders
- FHA Loans
- 203K Loans
- Owner Financing
- Hard Money
- Private Money
- Home Equity Loans and Lines of Credit
- Commercial Loans
- Other investment Tools
Why You Need to Understand Real Estate Financing
The purpose of this chapter is to fill you in on the many different types on real estate financing that you can use in your real estate investing. In chapter 3, we looked at the different investment vehicles you can take to invest in real estate (such as single family homes, commercial real estate, apartments, and more), as well as some of the different strategies (buy and hold, flipping, and wholesaling) you can use to make money in real estate.
This chapter is designed to help you turn those strategies into reality. If you have any questions about any of these real estate financing techniques, don't hesitate to search the BiggerPockets website for more information.
Finally, the following list is by no means comprehensive, but will give you a good idea of some of the financing methods used by real estate investors to finance their real estate. By having a good broad overview of these methods, you can combine an investment vehicle, an investment strategy, and a financing method to handle any real estate investment.
1.) All Cash
Many investors choose to pay all cash for an investment property. According to a recent joint study by BiggerPockets and Memphis Invest, 24% of US investors use 100% of their own cash to finance their real estate investments. To be clear: even when investors use terms like “All Cash,” the truth is, no “cash” is actually traded. In most cases, the buyer brings a check (usually certified funds, such as a bank cashier’s check) to the title company, and the title company will write a check to the seller. Other times, the money is sent via a wire transfer from the bank. This is the easiest form of financing, as there are typically no complications, but for most investors (and probably VAST majority of new investors), all cash is not an option. Additionally, the return given from an all cash deal will not be the same as when leveraged. Let’s explore this further via an example:
Real Life Example:
John has $100,000 to invest. He can choose to use that $100,000 to buy a house that will produce $1,000 per month in income or $12,000 per year. This equates to a 12% return-on-investment.
John could also instead use that $100,000 as a 20% down payment on FIVE similar homes, each listed at $100,000. With an $80,000 mortgage on each, the cash flow would be approximately $300 each month per house, which is $1,500 per month each or $18,000 per year. This equates to a 18% return-on-investment - 50% better than buying just one home.
2.) Conventional Mortgage
As you can see from the example above, financing your investment property can produce significantly better returns than paying all cash. Most investors, instead, choose to finance their investments with a cash down payment and a traditional conventional mortgage. Most traditional conventional mortgages require a minimum of 20% down, but may extend higher to 25-30% for investment properties depending on the lender. Conventional mortgages are the most common type of mortgage used by home buyers and generally provide the lowest interest rates. Click here to find interest rates in your area.
To learn more about mortgage financing and what you can qualify for, check out the BiggerPockets Mortgage Center.
3.) Portfolio Lenders
Conventional mortgage loans can originate from a variety of sources, such as banks, mortgage brokers, and credit unions. In most cases, these lending sources are not actually using their own capital to fund the loan, but are acquiring or borrowing the funds from another party or reselling the loan to government-backed institutions, like Fannie Mae and Freddie Mac, in order to replenish their own funds. As a result, most lending institutions must adhere to a very strict set of rules and guidelines when it comes time to financing an investment. These strict rules can make conventional financing difficult to obtain for many, especially for real estate investors and other self employed borrowers.
However, some banks and credit unions have the ability to lend from their own funds entirely, which makes them a portfolio lender. Because the money is their own, they are able to provide more flexible loan terms and qualifying standards. This means that they are able to make loans available at any terms acceptable to them. Oftentimes a portfolio lender will have funds available with less restrictive qualifications than a conventional lender.
Most banks or lending institutions don't advertise that they are a portfolio lender, but you can find these individuals through referrals and networking with other investors. You can also simply grab a phone book, call each one, and ask if they offer portfolio lending.
4.) FHA Loans
The Federal Housing Administration (FHA) is a United States government program that insures mortgages for banks. If you have health insurance or car insurance, you already understand the concept: pooling money to spread the risk for everyone. FHA loans are designed only for homeowners who are going to live in the property, so you cannot use an FHA-backed loan to buy a pure investment property. However, you can take advantage of the exception to the rule that allows the FHA-financed home to have up to four separate units. In other words, if you plan to live in one of the units, you could buy a duplex, triplex, or four-plex.
The benefit of the FHA loan is the low-down payment requirement: currently just 3.5%. This can help get you started much sooner, since you don't need to save up 20%. However, every blessing comes with a curse. While the low down payments the FHA offers are great, the FHA does require an additional payment, called "Private Mortgage Insurance." This "PMI" insurance protects the lender and is required when the down payment on an FHA loan is less than 20%. The extra PMI payment can make your monthly payment slightly higher, thus reducing your cash flow.
To read more about using an FHA Loan to get started investing, check out New Investor Strategy: How to Buy Your First Multi-Family Investment Property & Live Rent Free
5.) 203K Loans
A sub-set of the FHA loan, the 203K loan is a loan that allows a homeowner to purchase a house that is in need of some rehab work and gives them the ability to finance those repairs or improvements into the loan itself. Like the normal FHA loan, the 203K loan still allows for the low down payment requirement allowed by the FHA (currently just 3.5%). This loan type is also applicable for duplexes, triplexes, and fourplexes, but maintains the same requirement for only being for "owner occupants" and comes with Private Mortgage Insurance demands for loans under 20%.
Real World Example:
John found a small duplex for $100,000 that he wants to move into, with plans to live in one half and rent the other half out. The property is in need of about $12,000 for new paint and carpet. John is able to include that $12,000 into the cost of the loan and pay just a 3.5% down payment on the total amount for a total of $3,920 down. John can now get the new paint and carpet (paid for by the loan), move into his renovated home, rent out the other half, and begin making cash flow and building wealth. John is a happy camper.
6.) HomePath Mortgages
Another government backed loan, the HomePath Mortgage was introduced by the government-owned mortgage giant Fannie Mae in an attempt to help turn their non-performing loans (properties they have foreclosed on) into profitable loans again. Like the FHA loan, the HomePath program allows for smaller down payments (currently as low as 10%), but unlike the FHA, no mortgage insurance is required, and the loan is available for investors and "non-owner occupied properties." The HomePath program also includes the ability to finance repairs into the purchase like the 203K FHA loan we talked about earlier. The catch, however, is that these loans are only available on Bank Repos owned by Fannie Mae. To search for homes available for the HomePath program, visit the HomePath website at HomePath.com.
7.) Owner Financing
Banks or other giant lending institutions are not the only entities that can finance a property for you. In some cases, the owner of the property you want to buy, can actually fund the property, and you will simply make your monthly payment to them rather than a bank. Typically, the only time a property owner will do this for you is if they already own the home free-and-clear, meaning the seller cannot have an existing mortgage on the property. If the seller does have another loan and then sells the home to you, the seller's loan must be paid back immediately or face foreclosure.
This is due to a legal clause written into nearly every loan called the "Due on Sale" clause. This clause gives the former lender the right to call the note immediately due. If that amount can't be paid, the lender has the right to foreclose on the property. Some investors choose to ignore this clause and still purchase "subject to" the other loan, risking that the bank won't foreclose.
If the conditions are right, owner financing can be a great way to gain ownership of real estate without using a bank. Owner financing can also be a good tool for selling your properties in the future as well, which we'll cover more in chapter 8 when we look at "exit strategies."
8.) Hard Money
“Hard money” is financing that is obtained from private business or individual for the purpose of investing in real estate. While terms and styles change often, Hard Money has several defining characteristics :
- Loan is primarily based on the value of the property
- Shorter term lengths (due in 6 – 36 months)
- Higher than normal interest (8-15%)
- High loan “points” (fees to get the loan)
- Many hard money lenders do not require income verification
- Many hard money lenders don't require credit references
- Does not show on your personal credit report
- Hard money can often fund a deal in just days
- Hard money lenders understand when the property needs rehab work
Hard money can be beneficial for short term loans and situations, but many investors who have used hard money lenders have been placed in tough situations when the short term loan ran out. Use hard money with caution, making sure you have multiple exit strategies in place before taking out a hard money loan.
To find a hard money lender, try the following tips:
- Ask a Real Estate Agent
- Ask a House Flipper
- Check out BiggerPockets' Hard Money List
- Google It
- Mortgage Broker
9.) Private Money
Private money is similar to hard money in many respects, but is usually distinguishable due to the relationship between the lender and the borrower. Typically, with "private money," the lender is not a professional lender like a hard money lender, but rather an individual looking to achieve higher returns on their cash. Oftentimes, there is a close relationship with a private money lender ahead of time, and these lenders are often much less “business” oriented than hard money lenders. Additionally, private money usually has fewer fees and points, and the term length can be negotiated more easily to serve the best interest of both parties.
Private lenders will lend you cash to buy property in exchange for a specific interest rate. Their investment is secured by a promissory note or mortgage on the property which means if you don't pay, they can foreclose and take the house (just like a bank, hard money, or most other loan types). The interest rate given to a private lender is usually established up front and the money is lent for a specified period of time, anywhere from six months to thirty years.
A private lender typically does not receive any equity stake in cash flow future value outside of their pre-determined interest rate, but there are no hard-and-fast rules when it comes to private capital. Generally, private money is financed by one investor. These loans are also commonly used when you believe you can raise the value of the property over a short period of time, so you can take on the debt from that private money, refinance the property after adding value, and pay back the private lender. Just like with hard money, private money should only be used when you have multiple, clearly defined exit strategies.
If you are trying to build relationships for private capital, developing credibility is a MUST. Whether it’s through blogging about your real estate endeavors online, posting your real estate updates on Facebook, talking about real estate investing in casual conversation, or attending your local real estate investment club, you need to be visible. Are you maximizing your visibility? Are you creating opportunities to highlight your investing experience to others? You don't need to be a braggart, but next time someone asks what’s new in your life, share a few details of your real estate endeavors. You never know what might transpire.
10.) Home Equity Loans and Lines of Credit -
Many investors choose to tap into the equity in their own primary home to help finance the purchase of their investment properties. Banks and other lending institutions have many different products, such as a Home Equity Installment Loan (HEIL) or a Home Equity Line of Credit (HELOC) that allow you to tap into the equity you've already got. For example, an investor may purchase a property, but instead of going through the normal hassle of trying to finance the investment property itself, they can instead take out a HELOC on their own home to pay for the property.
In order to obtain a home equity loan or line of credit, you must first have equity in your home. Banks will typically only lend up to a certain percentage of your home's value in total. This percentage differs between lenders, but it is not uncommon to find a lending institution that will offer to lend up to 90% of the value of your home.
Real World Example:
John's current home is worth $100,000. John visits with his local bank and learns that they will allow up to 90% debt on that home. Therefore, John can borrow a total of $90,000 on the house. If he already owes $50,000 on a first mortgage, the home equity line or loan would be capped at $40,000 to ensure the total loans didn't exceed 90%.
Using home equity loans and lines of credit have multiple benefits over traditional loans, including:
- Loan is based on the value of your primary residence - not the newly purchased property. This means that the bank that is providing the loan won't typically even look at the new property. They don't generally concern themselves with what your intent is with the money, only your ability to pay it back. As such, the new property can be in terrible condition, and the bank likely won't care.
- When you have a home equity loan or line, the money is yours to do with what you want. It's not dependent on the new property - so you can offer "cash" when making offers on new properties, and as a result, you will have a higher chance of getting your offers accepted.
- Home equity lines and loans may have certain tax benefits, such as the ability to deduct the interest paid on that loan, allowed by the IRS. See a qualified CPA or attorney for more information on this.
- Because the loan is secured by your primary residence, the interest rate on home equity loans and lines is typically very low compared to hard money or private money. To learn more about what current rates are on these products, visit the BiggerPockets Mortgage Center.
Another strategy often used by investors is to use a small bit of their home equity to fund the down payment on their investment property.
Real World Example:
Sarah, an investor, wants to buy an investment property for $100,000, but doesn't have any additional down payment. She does, however, have a lot of available equity in her own primary house (she owes $50,000, but the home is worth $100,000). Sarah opens up a $20,000 home equity loan on her personal home to fund the down payment and then get a conventional mortgage from a bank for the remaining $80,000 on the investment property.
Finally, home equity loans and lines come with both fixed and adjustable interest rates. Be sure to look at your goals, timetables, and financial position when determining which home equity product you want to use to further your investing career.
We touched briefly on the use of "partners" in chapter 4, but another part of that discussion that we didn't cover is their ability to help you finance a deal. If you want to invest in a piece of property, but the price range is outside of your pocketbook, an equity partner might be a welcome addition to your team. An equity partner is someone that you bring into a transaction in order to help finance the property. Partnerships can be structured in many different ways, from using a partner’s cash to finance the entire property, to using a partner to simply fund the down payment. There are no set “rules” with equity partnerships, but each situation and deal requires its own analysis of how the deal will be put together, who makes the decisions, and how profits will be split at the end.
Depending on the operating agreement signed by both parties, the equity partner may have an active or passive role in the property. The ownership stake provided by the equity partner may allow that partner to actively participate in nearly all aspects of property ownership. Additionally, as a partner, they typically receive in accordance with their ownership percentage a return on their investment that includes cash flow, appreciation, depreciation, and eventual profit when the property is sold.
Unlike a private lender, an equity partner does not receive an agreed upon interest rate on their money. Instead, they receive only a percentage of what the property generates. If it makes a lot of money then, their return will be higher, but if the investment loses money, they may have to contribute money to keep the property afloat. Equity partners take a higher risk than a private lender might, but in return, they have the potential of making significantly more when the investment is successful. Also, unlike in private lending, the equity partner's investment is not secured by a mortgage or promissory note, but by an operating agreement between the partners.
12.) Commercial Loans
While most of the above options focus primarily on the residential side of loans, the world of commercial lending may also be viable option for your investing. In fact, if you are looking to buy a property other than a one to four unit residential property, a commercial loan is probably exactly what you'll be needing.
Commercial loans typically have slightly higher interest rates and fees, as well as shorter terms and different qualifying standards. In the world of residential lending, the income of the borrower is valued above almost every other area; commercial lending, however, is much more focused on the property instead. The logic behind this is simple: if you own a ten million dollar apartment building and things go wrong, you aren't going to be able to make that mortgage payment if you make $20,000 per year or $200,000 per year in personal income. The commercial lender will still look at your income, credit, and other personal financial indicators, but only to gain a picture as to your skills financially. What's more important in the vast majority of cases is the amount of revenue a property generates.
Additionally, commercial lenders can often extend a “business line of credit” to finance flips or other investments. Some investors are able to obtain a large "business line of credit," which allows them access to cash for house flipping and other real estate ventures.
13.) EIULS, Life Insurance, ROTH IRAs, and Other Sources
There a multitude of other investment and savings products out there that you can use to invest in real estate. While we don't have the time to cover each of these in detail, be sure to speak to a qualified financial advisor about ways that you can use these products in your investing career.
Also be sure to check out:
As you can see, there are many different ways you can finance an investment property. One of the most valuable roles you play as an investor is in your ability to find creative ways to continually move forward with your investments. As every deal is different from one another, you will find yourself using many different financing strategies throughout your career, so being able to understand the different options will help you throughout your entire investing journey.
Another valuable and equally important role you will be playing as an investor is the role of marketing professional. Chapter 7 will look at the concept of real estate marketing in detail and will give you ideas and strategies to use to supercharge your investment opportunities. Marketing is important not only for buying properties, but also for selling and renting.
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