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What Is Creative Financing And How To Use It In Real Estate

Chad Carson
16 min read
What Is Creative Financing And How To Use It In Real Estate

Whether you’re just starting out in the real estate business or you’re a long-time investor, you may need to look beyond the traditional financing strategies. Learning to use creative tools, such as seller financing, private loans, self-directed IRA loans, lease options, and more, can lead to success when buying real estate. Bank loans are great when they make sense, but creative financing is a preferred tool for many people in the industry. In this article, we’ll go over why we prefer creative financing and share 14 creative financing tools that you can use when planning your real estate investment strategy.

What is Creative Financing For Real Estate?

If a lending institution such as a bank turns you down for a loan for a real estate investment, you may need to seek other options. Creative financing for real estate comes into play when you don’t have the credit or collateral to qualify for a bank loan. Many investors also prefer creative financing options when interest rates are high. Using a creative method for obtaining financing means you go to alternate sources to get the money you need to do a real estate transaction.

Sources like private lenders, other investment accounts, and loans against the assets you currently own are just a few of the ways professional real estate investors get the money they need to purchase real estate. Some investors even opt to use creative financing over a traditional bank loan because of this strategy’s benefits.

Understanding Creative Financing For Real Estate

Buyers must understand each piece of a typical transaction to grasp creative financing and explain it to a skeptical attorney, real estate agent, or seller.

There are four primary entities involved:

  1. The seller.
  2. The buyer (you, if purchasing an investment).
  3. The bank or lender.
  4. The closing agent (an attorney or title company).

Let’s say the buyer and seller signed a purchase and sale agreement at some point before closing. The price was $50,000. Also, before closing, the buyer and the bank signed a loan commitment agreement. The loan was $40,000; the buyer provided $10,000, or 20%, as a down payment.

The closing attorney or title company uses these preclosing agreements to oversee the closing transaction (escrow) to ensure the other three parties are treated fairly per the terms of their contracts. The items actually exchanged between the parties include:

  1. Money from the bank to the buyer (a loan).
  2. Two contracts — a promissory note and a mortgage (or deed of trust in some states) — from the buyer to the bank.
  3. A deed from the seller to the buyer.
  4. Money from the buyer to the seller.

For those already investing, this may seem basic. But it’s important to start here before doing transactions that are a little more creative because these creative financing tools use the same basic format.

14 Creative Financing Options for Real Estate Investors

Consider these 14 creative financing options for real estate investors so you can get started on your path to building wealth:

1. Seller financing

With seller financing, there is no bank!

Technically, there isn’t even a loan. The seller never gives the buyer any money as a bank would. Instead, the seller agrees to let the buyer pay the purchase price over time in monthly installments. In exchange for this owner financing arrangement, the seller — not a bank — receives the promissory note and mortgage as security.

The beauty of this arrangement is that there are only two parties: the buyer and the seller. The seller doesn’t have loan committees, underwriters, or Fannie Mae–conforming rules. The buyer makes an offer to the seller, the two negotiate, and if it makes sense for both parties, they move forward.

But how common is seller financing, really? Ben Leybovich, a well-known creative financing writer here on BP, once wrote that seller financing is rare and usually only used on ugly pig properties. Indeed, seller financing isn’t as common or easy to obtain as traditional tools. It’s also true that seller financing doesn’t magically turn a bad deal into gold. But don’t let its difficulty dissuade from its ultimate value.

Seller financing is an incredible tool that’s well worth the effort. And it’s one of the clearest win-win transactions in real estate.

For example, say you recently bought an income property using seller financing with a 10% down payment in a hot market and a desirable location. Once stabilized and rented, this property will likely make you over $1,500 per month in net income for decades to come, not including the benefits of future capital gains.

In this deal, the seller is happy because he loves monthly checks without the hassles of being a landlord. You saved him the trouble of putting a big chunk of his money into investments like stocks or bank CDs, and he receives a much larger income than he would with most traditional investments.

2. Self-directed IRA

A self-directed IRA is a creative financing tool that’s structurally very similar to closing with a bank loan. The only difference is that the lender is a self-directed IRA (individual retirement account), not a bank.

Most retirement accounts invest in traditional assets, like mutual funds or bonds. But a self-directed IRA is a way to use retirement savings to invest in alternative assets, like real estate, notes, tax liens, and more. Specialized custodians who allow self-direction hold the assets, process transactions, and keep records for the IRS.

The point of this tool is to borrow the IRA funds from other individuals, not from the investor’s own IRA. Investors need to be very careful not to engage in IRS-prohibited transactions. Loaning money to yourself or your business is clearly off-limits.

But as long as the investor follows the rules, they have enormous opportunities to find sources of funds for their real estate deals. Investors should look at their local network. Chances are there is someone who has funds available and would be willing to become an IRA lender. Some of the best candidates are other real estate investors who cannot loan that money to themselves. This kind of deal allows them to invest in local assets they know and understand.

3. Private loans (outside of an IRA)

The only difference between this creative financing method and the one mentioned above is that the private lender uses funds outside of an IRA.

The most likely candidate for this type of loan is an individual with a large net worth. And if you understand the principle of books like “The Millionaire Next Door: The Surprising Secrets of America’s Wealthy,” this person won’t be the one driving the expensive car or wearing fancy clothes. So, don’t underestimate anyone you meet!

A good way to find these individuals is at real estate networking events like BiggerPockets meetups or local real estate clubs. Attend these events and get to know people. Find experienced investors in the back of the room. Ask questions. Make friends. Once you get to know people, they may be willing to loan you money.

Borrowing from high-net-worth individuals also brings more benefits than just getting the money. In addition to the loan, borrowers can learn from their expertise and experience. A private lender can become a mentor and close adviser. While they may have an interest in your deal anyway, the fact that you have their money will likely make them very interested in your success. They may offer you invaluable tips, feedback, and encouragement, which could be essential to your success.

4. Master lease with option to buy

The creative financing tool of master leasing is where we begin to really start thinking outside the box. Let’s illustrate this point with an example:

A burned-out landlord named Jane owns a quadruplex. Jane has let the building get run down, and she hasn’t even filled two vacancies from bad tenants who recently moved out. She’s just too tired.

Jane then gets a letter from an energetic entrepreneur, Chris, who offers a creative solution to her problem. Chris offers to lease her building for five years for the same amount she currently receives in rent from two tenants — $1,000 per month. He also offers to perform immediate cosmetic repairs like painting and carpeting, which will cost him $5,000.

Jane will continue to pay taxes and insurance and handle any major capital expenses, such as the roof, heat, air systems, and structural issues. Chris will be responsible for all vacancy, turnover, and maintenance costs.

Because Chris’s lease gives him the right to sublease all four units, his gross rent collected in this case is $2,000. As you can see, if his vacancy and maintenance expenses are $400 per month, he receives a positive cash flow of $600 per month — or $36,000 over the next five years!

Stacking up a few deals like this could make for some very lucrative side income for Chris, or he could really ramp it up with more deals to completely replace his income from a job.

But why stop there? Let’s see if Chris can make it even better using another tool: the option to buy.

If Jane was willing to give Chris a master lease, might she also be willing to give him the option to buy the property? There’s a good chance.

An option to buy would essentially give Chris the right (not the obligation) to purchase the property for a set price for a certain period of time. In exchange, Jane receives consideration for selling him the option.

In this case, Chris’s consideration is the $5,000 he spends to spruce up the cosmetics of the property. Jane will give him a $5,000 credit when he finally executes his option. Chris’s option strike price is $120,000. Once he gets the building rented and looks good, he will have the chance to make money from the option at any time during his five-year option window.

5. Master lease + option (with a credit partner)

This tool will provide a different way to use the previous technique. Instead of lease optioning the property from a seller, a borrower lease options it from a credit partner.

Here’s an example:

Let’s say an entrepreneur named Karla finds a great rental property deal worth $150,000 that can be bought for $100,000. The only problem is that she doesn’t have the money to close. She knows a private lender named Jim with $20,000 cash, but that’s obviously not enough.

After further questioning, Karla learns that Jim has excellent credit and can get a mortgage loan. So the two of them agree to the following:

  1. Karla, the entrepreneur, assigns the purchase contract to Jim, the credit partner.
  2. Jim applies for a traditional bank loan and purchases the property for $100,000.
  3. Karla immediately master leases the property for five years at $525 per month net-net-net rent, meaning she pays all expenses.
  4. She also retains an option to repurchase at $110,000.
  5. She manages the rental until future exit strategies are available.

Karla then proceeds to rent to a subtenant for $1,200 per month. Her net income looks something like this:

$1,200 – $500 (operating expenses) – $525 (rent) = $175 per month net income

While $175 seems like a nice cash flow, Karla would be wise to set aside a good portion of her cash in reserve for capital expenses and vacancies. Meanwhile, Jim uses the $525 rent from Karla to pay his $425 mortgage payment, and he still has $100 leftover to put in his pocket.

6. Crowdfunding

Over the past few years, peer-to-peer (P2P) lending has gone from a cute little niche strategy that many successful real estate investors use to finance deals.

P2P lending is essentially an investment version of crowdfunding. Large pools of people come together online and contribute varying sums of money until the entire deal is financed. The investors then get principal plus interest back in return. This allows someone with limited resources to purchase a piece of real estate.

7. Partnerships

Investors can also consider taking on a partner who supplies the money for the deal. As part of the partnership, the investor may find the deal, manage the deal, or provide knowledge or experience. In return for equity, their partner puts in the money needed to purchase the deal.

This is a very common way to grow and scale a real estate business — using other people’s money. The partnership can be structured in many different ways, and there isn’t any right or wrong way to structure the equity, but everything has to be legal.

Partnerships can be a valuable tool when investing in rental properties because two people can work together to cover for each other’s shortcomings and do some amazing things.

For example, if one person is great at getting a mortgage but has no time to find or manage deals, they could partner with someone who struggles with getting a loan but has more flexibility and knowledge to handle putting the deal together and managing it. Or perhaps both parties put in 50% of the income and split the responsibilities 50%, making less work and less income for both partners.

Whoever plans to use a partner to invest in real estate must pick the right partner. The investor should never choose a partner based on convenience; rather, the person should be someone the investor would enjoy working with and who has something the investor needs, and vice versa. 

This is especially true when investing in long-term buy-and-hold real estate because the investor will be attached to this person for many years. The investor needs to be sure that their partner’s goals and work ethic are in near-perfect sync with their own and that each role is carefully defined on paper before buying a single piece of property together.

A lawyer can write a partnership agreement to protect both parties because, as my friend Chris Clothier says, “Every partnership will end. You decide at the beginning how it is going to end.”

8. Home equity line of credit

An obvious creative financing in real estate option is using the equity you’ve built up in a current property or property. This includes your primary residence. If there’s equity available, you can leverage property to pull out cash.

For example, an investor can use a line of credit, a home equity loan, or a cash-out refinance on the property. They can use all of these three things to tap into equity.

A majority of banks will loan from 85% to 95% of a primary residence’s value with a line of credit. For example, if the property is valued at $100,000 and the investor owes $75,000 on their current mortgage, they could potentially receive a line of credit of $20,000 — 95% of the home’s value — to draw from.

That may not be enough for a down payment on a property, but everyone will have different amounts of equity available.

If an investor owns their own home, they may be able to use some of the equity in their home to purchase rental properties. Equity means the spread between what is owed on a property and what the property could sell for. In other words, if a property owner owes $80,000 on their primary residence but it could sell for $200,000, they have $120,000 in equity. This equity can be borrowed at very low-interest rates through a home equity loan or a home equity line of credit at a local bank or credit union.

These loan products are also referred to as a “second mortgage” because the lender will place a lien on the property in second place to the primary loan on the house.

A home equity loan and a home equity line of credit are similar but have major differences.

The home equity loan is typically taken out at once and paid back in installments until it is paid off, much like a typical mortgage or car loan. The interest rate and payment are generally fixed for the life of the loan (but it doesn’t have to be).

On the other hand, a home equity line of credit is a revolving account that works much like a credit card. Property owners can borrow as much as they want up to the limit, pay it back, and then borrow again.

They pay interest only on the amount currently borrowed, so they could leave the balance at $0 until they need it. These lines of credit generally have lower interest rates than home equity loans, but those rates are generally variable, so they can rise or fall.

9. Investment accounts

Another way to receive a line of credit is by borrowing against any stock investment accounts. These are nonretirement accounts, and there are rules about how much has to be in the account to open a line of credit. The investment account is used as collateral against the loan.

Since this asset is pretty liquid, the line of credit tends to have a good interest rate. As the investment account balance increases or decreases, the limit available on the line of credit can also fluctuate, which is something to watch out for.

Besides nonretirement investments, investors might have an IRA or a 401(k). An IRA can be set up as a self-directed IRA. Instead of investing IRA funds into the stock market, those funds can be used to invest in real estate. There are strict rules and guidelines for a self-directed IRA. Some companies provide the setup and management of self-directed IRAs.

A 401(k) plan usually offers a loan that can be taken from a 401(k). In this case, borrowers are withdrawing money from their 401(k) and must pay it back. There is no tax or penalty since it’s a loan and the borrower isn’t taking the money as income. Payments are taken out of the borrower’s paycheck and applied to their 401(k).

Depending on the plan, there could be interest paid or none at all. The interest is paid to the 401(k), so the borrower is paying themself interest. If an investor isn’t making a great return on their 401(k), taking a loan may be a good option. The 401(k) plan sets the terms and payments; while options may be unavailable, they’re not negotiable.

10. Cash-out refinance

On the surface, a cash-out refinance seems similar to a home equity loan, but these creative investment strategies differ. With a cash-out refinance, you aren’t actually taking out a second mortgage. Instead, you borrow more money than your previous mortgage left, using some of the money to pay off the old mortgage. You can use the additional funds you take in any way you like. This means you can take that money to invest in another real estate deal that will earn you income.

You won’t gain an extra bill with a cash-out refinance as you do with a home equity line of credit since you’re basically just exchanging one mortgage for another. Lenders may be willing to give you up to 80% of the value of your home.

Here’s an example to demonstrate:

If your home is appraised at $200,000 and you owe $120,000 on your mortgage, you have $80,000 worth of equity. A bank could potentially loan you up to $160,000 — 80% of its value. You’ll pay off the previous mortgage of $120,000 and still have $40,000 left to put toward your investment deal. 

This could be a great boon to help you get started in real estate investing.

11. Personal loan

Getting a personal loan through a bank can be much less arduous than securing a mortgage, making it a viable option when looking into creative financing strategies. Although you can’t secure as much money as you can with a traditional mortgage, they’ll often loan up to $50,000. While this isn’t usually enough to buy a house, it could make for a decent down payment or give you the funds you need to rehab a property.

The qualification terms and interest rates can also be much less for personal loans. You’ll have to make sure that you meet the requirements, and there will be a box to check that wants to know how you’ll use the money. But checking off “home improvement” or “paying down debt” can technically qualify.

12. Hard money

Hard money lending is another creative financing tool. Hard money loans, or asset-backed loans, are an alternative to traditional bank financing. And while the cost is generally higher than normal, the availability and speed of funds make them very helpful to many investors. You’ll definitely want to look at your numbers to make sure this funding source will be worthwhile, but a hard money loan can be much quicker to get. This means you won’t miss out on a deal while you wait for your funding to come through.

13. FHA loans

An FHA loan is backed by the federal government, so banks don’t mind giving out these types of loans. In fact, they’ll even give these loans to those with low credit scores and bankruptcies. So if you can’t get a conventional loan through a bank, it’s worth looking into the FHA route. Of course, there are limitations to FHA loans and you must meet the requirements to qualify. The property you’re buying must be a primary residence, not an investment property.

This might mean you have to purchase the property and live in it for a while before you can sell it for a profit or rent it out. However, the guidelines are pretty loose, and you may be able to unload the property after just 90 days. You won’t be able to use an FHA loan often, as another limitation is that it’s intended for first-time homebuyers. So you can’t have purchased a home using this source recently.

14. Lease option

If your credit won’t let you qualify for a loan, you can look for a rental unit with a lease option to buy. This means you rent a property with an agreement to buy it at a later date at the current market value. The owner usually charges a premium on top of the normal rent to make up for a potential loss when they sell you the property later for the price it’s valued at when you rent it. You may want to use this creative financing real estate option if you have bad credit or can’t currently afford a down payment.

Multiple Exit Strategies With Options

Going back to the example from above with Chris, the entrepreneur, and Jane, the burnt-out landlord, here’s a list of  three profitable exit strategies that Chris can consider:

  • First, Chris could patiently save a down payment and look for permanent financing and/or partners. This would allow him to buy and keep the building as a long-term hold investment. Because he has five years to accomplish this, he could shop around until he finds the best terms.
  • Second, Chris could use this as the replacement property in a 1031 exchange. This would allow him to sell another rental property he owns, exchange for this property, and defer his taxes on the gain of the sale. Many investors don’t have the perfect property picked out when they execute a 1031 exchange, so this could be a big benefit.
  • Third, Chris could sell his option to another investor. Let’s say he finds a landlord investor who is willing to buy this property for $160,000. He could simply assign his option contract to him (yes, contracts can be sold), and his fee for the assignment would be the difference between $160,000 and his strike price of $120,000 — or $40,000.

So, in addition to the $36,000, Chris earns from operating the rental over five years, he also receives a profit of $35,000. Or $40,000 minus the $5,000 initial investment from assigning his contract. That’s a total of $71,000! Not a bad payday considering he invested only $5,000, some hard work, and a little creativity.

And perhaps even more exciting than the $71,000 profit, the lease option allowed Chris to use enormous leverage without the typically enormous risk of traditional bank financing.

If things go badly with Chris’s lease option, he has only risked his $5,000 initial investment, his time and energy, and any potential negative cash flow during the five years of his lease. After that, he could legally just walk away.

Creative Financing in Real Estate — Is It Possible To Buy a House With Bad Credit and No Money Down?

Many of the creative financing tools we’ve discussed can be used even if you have bad credit, and several of them you can use to get money for a down payment. So there’s no reason you can’t get into the real estate investing business, no matter your financial situation. When you get creative with your financing options, you can leverage other people’s money to start building your wealth. And the best part is that it can be lucrative for everyone involved.

Buy Real Estate Without A Loan Using Creative Financing Techniques

So, can you use any of these tools to build wealth and income for yourself? Of course, you can, but our advice is not to use too many creative financing tools simultaneously. It’ll just weigh you down unnecessarily. And don’t give up your old tools, especially if they’re working for you.

Instead, decide on one or two of these tools that you’d like to add to your toolbox. Then commit to mastering that tool. Learn about it. Practice it. Ask questions. Then, start using the creative financing tool in your real estate investing strategy as quickly as possible. You’ll become a better and wealthier real estate investor as a result. Best of luck!

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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.