So you’ve decided to try your hand at real estate, but you’re confused about where you will get financing for your project. Maybe you’re nervous that without a portfolio, lenders might find investing in you a bit risky.
Or worse yet, you are nervous that you or your deal will be turned down for lending entirely.
These are all very valid concerns if you are a newbie investor getting into the real estate game. But you still have opportunities. Let’s break down your options for lending and set you up for investing success.
What Lenders Want
If you are just starting out, know that lending can come from a variety of sources, including banks, mortgage companies, hard money lenders, commercial lenders, private lenders, and even peer lending platforms and crowdfunding. There are many options out there, and most likely there is an option that will work for you.
No matter where my lending comes from, I view my lender as my investment partner. Like you, they are looking for a solid asset in a great market and a stable sub-market.
Depending on your investment strategy, the lender is looking for:
- Good equity position
- Potential for good cash flow
- Multiple exit strategies to protect their investment
- A creditworthy, capable person to execute the business plan (you!)
Let’s tackle the different types of lenders and what they are looking for.
Traditional Mortgage Companies
If you have ever purchased a primary home, you are probably familiar with the traditional mortgage company. This is often the lending source most new investors think to go to first when investing.
Traditional mortgage companies are government-sponsored entities (think Fannie Mae and Freddie Mac). This means that these programs buy half of the share in all mortgage loans from lending companies. This way, lenders can give out more mortgages to borrowers on certain conditions.
The basic qualifying criteria for securing a traditional mortgage are:
- Minimum credit score of 640 (620 permissible in certain cases)
- Debt to income ratio from 36% to 43% (credit and down payment dependent)
- Downpayment of 3% (with mortgage insurance) to 20% (without mortgage insurance)
- Housing debt to income ratio under $35,000
- No recent bankruptcies, repossessions, foreclosures, or short sales
- Verifiable income through two years of W-2 and tax returns
- Cash reserves
- Loan limits of $424,100 to $625,500 (exceptions may be allowed for expensive areas)
Programs vary from the 30-year fixed-rate mortgage to adjustable-rate mortgages, FHA first-time homebuyer programs, or 203K construction loans (this combines the FHA loan with a rehab loan).
The drawback is you can only qualify for 10 loans under your personal name and the qualifications change the more properties you get. So once you hit 10, you need a new game plan (a great problem to have if you want to scale).
Another drawback is the home has to be in habitable condition (unless you are using a 203K loan, which will roll in purchase and construction for an FHA borrower). This means that traditional lending doesn’t work very well for the initial purchase of a BRRRR property, but can be a great option when you are in the refinance stage of a BRRRR.
Unless you are working with FHA lending, you will want to find a lender who is investor-savvy and will use up to 75% of the rental income from the property to help you qualify for the loan. Don’t assume the lender that you used to purchase your primary home wants to or even knows how to do this.
Hard Money Lenders
What if your credit score is less than 620? Or what if you are purchasing a property that won’t qualify for a traditional mortgage? Maybe it needs lots of love (new HVAC, new roof, carpet, etc.)?
What happens then?
Well, you won’t be qualified for a loan from traditional lenders, but might be for hard money!
Hard money is a short-term loan with real estate as collateral. This type of lending is best used if you need fast and flexible financing.
Hard money loans for real estate have very few requirements when compared to traditional lenders. These loans are generally asset-based, meaning the lender is primarily concerned with the value of the property and the borrower’s equity in the property. The more equity that you as the borrower have in the property, the safer the loan will be for the lender.
Here are the basic requirements for hard money lending:
- Down payment/equity of 25-30% for residential properties and 30-40% for commercial properties (this is lender, deal, and experience-dependent).
- Strong cash reserves that show you can cover the holding costs (loan payments, insurance, taxes, HOA, etc.) for three to 12 months. The stronger your financial position, the better terms you can expect to see.
- Track record of performance. If you don’t have a track record (yet!), then you can partner with someone who does have the track record on your first couple of deals (consider it part of the cost of getting into the game).
- At least one exit strategy (ideally more) in the deal. This could be a sale, refinance, rent, lease-option, etc. The more exit strategies you have, the better protected your and the lender’s capital is.
Private Money Lenders
Private money is very similar to hard money and can be used for short-term or long-term financing. Private money could be a “rich uncle,” family member, friend, or a seasoned investor who lends money on real estate deals.
These types of loans can be very flexible as there are no bank rules really to govern the underwriting or the terms (though many professional private money lenders will underwrite as stringently as a hard money loan). And you can get as many loans as you can qualify for since these loans do not report on your credit report.
Commercial and Portfolio Lenders
Commercial and portfolio lenders are either national or local banks that look to put long-term debt on a property. This type of lending is great for original buy-hold purchases and refinances. It’s not really that great for flips or short-term projects, as the closing costs are higher and there usually are prepayment penalties involved.
Relationships go a long way in commercial financing, especially with a bank that holds their own notes and does not sell them on the secondary market. I just closed on a property where the lender would have dropped my loan as it didn’t meet Freddie Mac guidelines. But because we knew each other, they were able to bring the loan in-house and service it directly—at the end of the day saving the deal!
Commercial lenders look at three basic requirements to qualify you for a loan:
- Business finances – How is your current portfolio performing to date with a DSCR of 1.25+?
- Your business credit (do you have any?).
- Your entity organization and standing with the state. This will clue the lender in on how likely you are to succeed at your proposed business plan for the asset in question.
- Personal finances – Lenders will also look at your personal credit score to see if you have had any past financial problems (think foreclosures, liens, judgments).
- Property characteristics – Since the property being financed is collateral, the lender will attach a lien to the property and seize it if you don’t pay on time. The lender will look for:
- Loan to value (LTV) of 65-75%
- Strong cash reserves that show you can cover the holding costs (loan payments, insurance, taxes, HOA) for three to 12 months. The stronger your financial position, the better terms you can expect to see.
- At least one (or multiple) exit strategies to the deal. This could be a sale, refinance, rent, lease-option, or something else. The more strategies you have, the better.
While commercial and portfolio lending (think one loan with many properties) can be more flexible, there are some disadvantages.
- The lending rate will be higher than a traditional mortgage.
- The closing costs may be higher.
- There are usually prepayment fees (although the federal law restricts the amount a lender can charge).
So if it costs more to do a commercial or portfolio loan, why the heck would you do it?
For starters, the property (not you) is generally qualifying for a loan, meaning it can be easier to qualify if you have a great deal. Also, if you keep your debt service coverage ratio (DSCR) above 1.25, entity in great standing, and reserves high, you can continue to qualify for lending.
Partnering to Amplify
In these trying times of COVID-19, people are afraid to invest in the market. Investors know that the market is unstable, and an inexperienced option is not the best bet. To overcome this problem of experience, look to partner with an experienced investor for your first few deals to start building your track record.
Partnering with the right person can open so many avenues for you. You can benefit not only from the investor’s experience but also from their credit score and/or assets if yours are not high enough. Having a seasoned investor on your side can help open doors faster that you didn’t know were possible.
Finding Your Lender
Knowing where you are going to secure your first few loans for your investments can seem a bit daunting at first, but figuring out this piece of the puzzle pays off royally. And not having a portfolio already shouldn’t keep you from getting started.
But where can you find these lenders?
Here are just a few ideas on how to find great lenders to work with.
- Ask other active investors.
- Research lenders on the web.
- Research the network list right here on BiggerPockets.
So what are you waiting for? Get to work!
What’s your favorite type of loan and why?
Let us know in the comments.