The Ultimate Guide to Using Conventional Mortgages to Expand Your Portfolio

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Perhaps I'm being overly ambitious by taking a leaf out of @Brandon Turner 's book and throwing "The Ultimate Guide" in the title, but my goal is to create a comprehensive point of reference for investors looking to utilize Conventional loans to grow their real estate portfolio. There have been many great articles written about using either an FHA or VA loan for the purchase of a small multi-family (2-4 units) as your first Primary Residence, and I wholeheartedly agree. If you're eligible for a VA loan I would highly recommend taking advantage of that program. If not, FHA is a great second choice for financing a 2-4 unit.

But let's talk about purchasing properties that will be exclusively used for investment purposes. Government loans (FHA, VA, and USDA) can only be used to purchase a primary residence, so you will need to look elsewhere. Unless you're sitting on a pile of cash, your options will be a Portfolio loan, a Private loan, Hard Money, or a Conventional loan.

Portfolio Loans

A Portfolio loan is a note that will be held on the balance sheet of the lender. For example, a credit union or small bank will take a certain portion of deposits held and use those funds to write loans, in order to generate a return on assets. These can be auto loans, lines of credit, business or commercial loans, or residential mortgages. Because the loan will stay on the books, the Portfolio Lender will set its own Underwriting criteria. Finding the right Portfolio Lender can add tremendous value to your business, especially if you’ve already hit the limit of financed properties that a Conventional loan will allow.

Like every option, Portfolio loans have pros and cons. The main benefit is that some Portfolio Lenders will not care how many financed properties you already own – however, most will place a limit on how many loans they will write for you, or how frequently they will lend to you. For example, a certain Portfolio Lender might not care if you already have 20 financed properties, but they might only be willing to offer you 5 loans (they want to diversify their note holdings across different borrowers to manage their risk). It is also common for a Portfolio Lender to wait a certain number of months each time before offering you another mortgage, to make sure that you are establishing a good track record with them.

Portfolio loans typically do not offer terms as favorable as Conventional mortgages; whether it is a higher interest rate, an ARM (Adjustable Rate Mortgage) instead of a Fixed-rate, a balloon, or a shorter amortization (the number of years over which the loan is paid off). However, Portfolio terms are virtually guaranteed to be better than Hard Money.

 

 

Private Loans

A Private loan is a note provided by an individual who is not actually in the business of lending money. This can be a family member, a friend, a co-worker, or a seller who is willing to carry a note for you in order to dispose of a property. Private Lenders can be hard to come by, and depending on their resources may only be able to offer you one or two loans at a time.

While interest rates with Private money will generally only be slightly higher than Conventional rates, it is very rare that the Private lender will be willing to tie up their capital with you on a long-term, fixed-rate note. Most Private loans will involve a balloon in 5 to 10 years, at which time you’ll need to refinance at the current market rate, and may have difficulty finding a new lender depending on how the landscape has shifted.

 

 

Hard Money

Hard Money loans are written based on the underlying real estate asset which will stand as collateral for the note, and not necessarily based on the borrower’s creditworthiness. This is why Hard Money is very expensive (12-15% is common, perhaps even with some upfront points and fees). A Hard Money Lender can be a great resource for short-term needs, like financing a flip – but with this post, I’m specifically focusing on how to use financing to grow a portfolio of longer-term buy-and-hold properties.

Hard Money can be a good tool for purchasing and rehabbing a home that will not qualify for other types of financing in its current condition, with the goal of refinancing into a longer-term mortgage with a lower interest rate once the property has been fixed up. This can be a great strategy, but it is important to have your exit financing lined up ahead of time. And keep in mind that this can be very risky, because a lot can change in the time it takes you to rehab and refinance. For example, underwriting guidelines could change, or the Lender you had planned on using to refinance could decide that they want to reduce their exposure to real estate – In this case, you’d be left making those incredibly expensive Hard Money payments, and you might be in a negative cash flow situation.

 

 

Conventional Financing

We've looked at Portfolio, Private, and Hard Money loans - each of which can play a role in your overall strategy at some point – but what about Conventional? A Conventional loan is a mortgage that is underwritten in accordance with either Fannie Mae or Freddie Mac guidelines, so that the lender will have the option to sell the mortgage on the secondary market to one of these Government-Sponsored Enterprises. Fannie Mae (FNMA) and Freddie Mac (FHLMC) are institutional investors who purchases mortgages from originating lenders, and bundle them into instruments called Mortgage-Backed Securities which are sold on the open market to various parties (Mutual Funds, Pension Funds, and even regular investors like you and me who might want to allocate a certain portion of our IRA or 401(k) money toward fixed-income investments). The role of FNMA and FHLMC is to provide liquidity, so that mortgages will be readily available to homebuyers.

Before I get into any specifics, it's important to note that underwriting guidelines and federal rules and regulations change frequently. What I write here today (March 26, 2015) may not be correct a few months from now, so it is important to form a relationship with a Loan Officer who can keep you informed as the landscape shifts. Please note that the guidelines I'm going to cover are those that apply specifically to the purchase of an investment property, and not a primary residence or a second home. Also, I'm going to focus on FNMA guidelines as opposed to FHLMC – there are subtle differences, and in some circumstances a FHLMC loan might fit your situation better, so be sure to consult your Loan Officer.

FNMA has 2 distinct sets of guidelines. The standard set of guidelines, commonly referred to as DU Pure (DU stands for Desktop Underwriter, which is the Automated Underwriting System that lenders run each file through to determine if the loan will be eligible for sale to FNMA) allows for up to 4 financed properties. Even though most mortgage lenders will add their own overlays (additional underwriting requirements on top of the minimum guidelines established by FNMA), many do allow for up to 4 financed properties. However, FNMA has a separate program called Multiple Financed Properties which allows for up to 10 total financed properties. These underwriting guidelines apply to properties 5 through 10. Even though FNMA provides this program, very few lenders actually participate in it.

Before I go more in-depth, it’s important to define what is considered a “financed property” per FNMA guidelines. Many people incorrectly assume that the limit is based on how many properties you own, or the number of mortgages that you have. As is almost always the case with FNMA, it’s just not that simple!

Let’s take a look at several scenarios:

  • Ownership of residential property (consisting of 4 or fewer dwelling units), which is financed (individual total ownership in one’s personal name, or joint ownership in two or more personal names, regardless of who is liable on the note) – YES, this is considered a “financed property.”
  • Ownership of residential property (individual total ownership in one’s personal name, or joint ownership in two or more personal names), which was purchased subject-to the existing financing, and the previous owner is the only party liable on the mortgage – YES, this is considered a “financed property.”
  • Ownership of a residential property, which is owned free and clear – NO, this is not considered a “financed property.”
  • Joint or total ownership of a residential property that is held in the name of a Corporation or S-Corporation, even if the borrower is the owner of the Corporation, and the financing is in the name of the Corporation or S-Corporation – NO, this is not considered a “financed property.”
  • Joint or total ownership of a residential property that is held in the name of a Corporation or S-Corporation, even if the borrower is the owner of the Corporation; however, the financing is in the name of the borrower – YES, this is considered a “financed property.”
  • Ownership of a residential property that is held in the name of a Limited Liability Company (LLC) or Partnership where the borrower(s) have an individual or combined ownership in the LLC or Partnership of 25% or more, regardless of the entity (or borrower) that is the obligor on the mortgage – YES, this is considered a “financed property.”
  • Ownership of a residential property that is held in the name of a Limited Liability Company (LLC) or Partnership where the borrower(s) have an individual or combined ownership in the LLC or Partnership of less than 25%, and the financing is in the name of the LLC or Partnership – NO, this is not considered a “financed property.”
  • Ownership of a residential property that is held in the name of a Limited Liability Company (LLC) or Partnership where the borrower(s) have an individual or combined ownership in the LLC or Partnership of less than 25%, and the financing is in the name of the borrower – YES, this is considered a “financed property.”
  • Residential property held in a REVOCABLE trust – YES, this is considered a “financed property.”
  • Residential property held in an IRREVOCABLE trust and the borrower has NOT personally guaranteed the debt – NO, this is not considered a “financed property.”
  • Residential property held in an IRREVOCABLE trust and the borrower HAS personally guaranteed the debt – YES, this is considered a “financed property.”
  • Obligation on a mortgage debt for a residential property, regardless of whether or not the borrower has an ownership interest in the property – YES, this is considered a “financed property.”
  • Ownership of a vacant residential lot, even if it is financed – NO, this is not considered a “financed property.”
  • Ownership of commercial real estate (office building, retail space, warehouse space, etc.) – NO, this is not considered a “financed property.”
  • Ownership of a multifamily property (consisting of more than 4 dwelling units) – NO, this is not considered a “financed property.”
  • Ownership in a time share – NO, this is not considered a “financed property.”
  • Ownership of a manufactured home and the land on which it is situated that is titled as real property – YES, this is considered a “financed property.”
  • Ownership of a manufactured home on a leasehold estate not titles as real property (chattel lien on the home) – NO, this is not considered a “financed property.”

 

The main take-away here is that if you are personally liable on the note for a 1-4 unit residential property, it WILL count against you (whether it is your primary residence, a second home, or an investment). If you are not personally liable on the note, it MAY not count depending on how ownership of that asset is structured. And other types of property, like multifamily (anything 5 units or more) or commercial, will NOT count against you even if you are personally liable on the note. So for example, an investor who owns a handful of 5-plexes, a 10-plex, and an office building, all with mortgages… This individual would still be able to obtain 10 Conventional FNMA loans to purchase 1-4 unit properties, even if he or she is personally liable on all of the existing notes!

 

 

DU Pure (1-4 Financed Properties)

If you are purchasing an investment and you currently have 3 or fewer financed properties as defined above, or if you are refinancing and currently have 4 or fewer, you will be able to take advantage of these guidelines. FNMA currently requires that you have at least a 620 credit score, and the following minimum down payment from your own funds (no gifts):

  • 15% down for the purchase of a 1 unit property (or 25% down with an ARM)
  • 25% down for the purchase of a 2-4 unit property (or 35% down with an ARM)

 

  • 75% maximum LTV (loan-to-value) for a rate/term refinance of a 1-4 unit property (or 65% with an ARM)
  • 75% maximum LTV for a cash-out refinance of a 1 unit property (or 65% with an ARM)
  • 70% maximum LTV for a cash-out refinance of a 2-4 unit property (or 60% with an ARM)

You must also meet the following minimum reserve requirements:

  • 6 months PITIA (Principal, Interest, Taxes, Insurance, Association Fees) for the Subject Property.
  • 2 months PITIA for each second home or investment property currently owned and financed.

 

Reserves are funds that will remain available after closing, but they do not necessarily have to be liquid. For example, a DISCOUNTED portion of the value of a non-liquid financial asset such as stocks, bonds, mutual funds, certificates of deposit, trust accounts, vested portion of retirement accounts, and cash value of a vested life insurance policy. For non-liquid financial assets, 70% of the current balance less any early withdrawal penalty (for example, 60% of the balance would be used for an IRA if the borrower is not at retirement age, since there would be a 10% penalty) can be used to satisfy reserve requirements.

 

 

Multiple Financed Properties (5-10 Financed Properties)

If you are purchasing an investment and you currently have 9 or fewer financed properties as defined above, or if you are refinancing and currently have 10 or fewer, you will need to follow these guidelines. FNMA currently requires that you have at least a 720 credit score, and the following minimum down payment from your own funds (no gifts):

  • 25% down for the purchase of a 1 unit property (or 35% down with an ARM)
  • 30% down for the purchase of a 2-4 unit property (or 40% down with an ARM)

 

  • 75% maximum LTV for a rate/term refinance of a 1 unit property (or 65% with an ARM)
  • 70% maximum LTV for a rate/term refinance of a 2-4 unit property (or 60% with an ARM)

 

  • 70% maximum LTV for a cash-out refinance of a 1 unit property (or 60% with an ARM) – Only with the Delayed Financing Exception, see below.
  • 65% maximum LTV for a cash-out refinance of a 2-4 unit property (or 60% with an ARM) – Only with the Delayed Financing Exception, see below.

 

You must also meet the following minimum reserve requirements:

  • 6 months PITIA for the Subject Property.
  • 6 months PITIA for each second home or investment property currently owned and financed.

 

 

Delayed Financing Exception

With 1-4 financed properties, you can’t do a cash-out refinance until after the deed has seasoned for 6 months, UNLESS you utilize the Delayed Financing Exception. With 5-10 financed properties, you can ONLY do a cash-out refinance within the first 6 months using the Delayed Financing Exception.

The 6 month window is measured from the date of purchase to the disbursement date on the new mortgage loan. To be eligible for this exception, the following conditions must be met:

  • The original purchase was an arms-length transaction (buyer had no previous relationship with seller)
  • The original purchase was an all-cash transaction
  • There are no existing liens on the property
  • The source of funds used for the purchase transaction are documented (from bank account, HELOC, etc.)
  • The new loan amount can be no more than the actual documented amount of the borrower's initial investment in purchasing the property, plus the financing of closing costs, prepaid fees, and points – even if the current appraised value shows more than the minimum amount of equity needed per LTV guidelines

 

 

Using Net Rental Income to Qualify

Depending on your situation, growing your rental portfolio quickly could be a lot easier than you might think. For example, the income you show from your existing rental properties can be used to help you qualify for your next purchase.

For a property that appears on the Schedule E of at least your most recent tax return, the lender will use the following formula: Start with the Net Rental Income/Loss (Line 21 on the Schedule E), and then add back Depreciation (Line 18), Insurance (Line 9), Mortgage Interest (Line 12), and Taxes (Line 16). Make sure to combine the figures from your 2 most recent tax returns if available. Next, divide this total by either 12 or 24, depending on if the property was listed on Schedule E for 1 or 2 of the most recent years. And finally, subtract the current verified PITI. Essentially what this does is takes whatever income or loss you claimed on your taxes, adds back depreciation, makes sure you are being hit for the CURRENT tax and insurance figures, and also accounts for the principal portion of your mortgage payments which is not reflected on the tax returns. Here is an algebraic depiction of the formula used:

For a property that was acquired after your most recent tax filing, so you have NOT had a chance to claim it on your most recent tax return, you can still use Net Rental Income from this property to help qualify as long as it is currently tenant-occupied (Note that many lenders have an overlay requiring documentation of at least 3 months of rent checks received). In this situation, the lender will use the following formula: Start with the Gross Monthly Rent (From lease agreement), multiply by 75%, and then subtract the current verified PITIA. Here is an algebraic depiction of the formula used:

But I’ve saved the best for last. Whether you fit within DU Pure guidelines or Multiple Financed Properties guidelines, you can actually use the Net Rental Income from the Subject Property that you are purchasing to help you qualify! Surprisingly enough, this can be done even if the Subject Property is currently vacant, with NO tenant and NO lease in place. The lender will use the following formula per FNMA guidelines: Start with the Gross Monthly Rent (As determined by the Appraisal), multiple by 75%, and then subtract the PITIA of the new mortgage being written. This is the exact same formula as above, but the gross rental income is taken from the appraisal instead of a current lease. Note that if the property IS currently occupied and there is a lease that will be transferred to the borrower, the lender must verify that the lease does not contain any provisions that would affect FNMA’s first lien position on the property. Also, most lenders have an overlay requiring that the Gross Monthly Rent from the Subject Property being used in this calculation can’t exceed a certain percentage of other qualifying income being used. For example, many lenders would use 50% of the borrower’s other qualifying income as the Gross Monthly Rent in this equation if that 50% would be less than the Gross Monthly Rent suggested by the appraiser (Let’s say a property would rent for $1,000 a month but the borrower’s only other qualifying income being used is an employment salary of $1,800 per month – with this overlay, the lender would assume $900 for Gross Monthly Rent instead of $1,000 when calculating the Net Rental Income on the Subject Property).

 

 

How Does NRI Affect DTI?

So how exactly does Net Rental Income, whether from the Subject Property or from other real estate owned, fit into the DTI (debt-to-income) ratio? If it is a positive number, it is simply used as additional income. If it is a negative number, it is used as negative income as opposed to a liability – This is a very important distinction. For example, let’s say that a borrower has salary income of $1,800 per month, a Net Renal Loss (from the subject and other properties combined) of $100 per month, and existing non-mortgage liabilities of $750 per month.

By taking the Net Rental Loss and reducing the income instead of increasing the liabilities, the DTI is more favorable.

Structuring Ownership

With a Conventional loan, the deed must be recorded in either the personal name of the borrower(s), or in an Inter Vivos REVOCABLE trust, assuming the following conditions are met:

  • The trust must be established by one or more natural persons, solely or jointly
  • The primary beneficiary of the trust must be the individual(s) establishing the trust
  • The trustee(s) must include either:

o The individual establishing the trust

o An institutional trustee that customarily performs trust functions and is authorized to act as trustee under the laws of the applicable state

  • The trustee(s) must have the power to mortgage the security property for the purpose of securing a loan to the party (or parties) who are the borrower(s) under the mortgage or deed of trust note

Please note that FNMA does NOT allow you to close in an LLC or other type of business entity. Many investors will use a Conventional loan to close in their own name and then transfer ownership to an LLC; however this will trigger a due-on-sale clause, allowing your lender to call the note due in full within 30 days if they so choose. Note that transferring ownership after closing is not an illegal act; it just activates a clause in the contract that gives the lender the option to call the note. There has been much written on this topic, so feel free to search for the term "due-on-sale" here on BiggerPockets and you'll find a wealth of content.

 

 

Conclusion

Hopefully this has been helpful! There was no way to cover everything here, but I believe it’s a good overview of several key points that us investors need to understand when putting together our long-term strategy. If anyone has any feedback or questions, jump in and let’s discuss!

Updated over 1 year ago

***Update: Fannie and Freddie no longer allow a Net Rental Loss to be deducted from income instead of treated as a liability for purposes of calculating DTI.

@Michael Smith

Wow, you're not messing around ;).  Good stuff!

Bookmarking this, thank you for your hard work this was great.

Thanks @Brandon Turner !

One of my images in the post didn't show up very well... Any way to fix that?

Also, the bullets disppeared from all of my lists

That's very clear and comprehensive, thanks a lot! 

Originally posted by @Michael Smith :

But I’ve saved the best for last. Whether you fit within DU Pure guidelines or Multiple Financed Properties guidelines, you can actually use the Net Rental Income from the Subject Property that you are purchasing to help you qualify! Surprisingly enough, this can be done even if the Subject Property is currently vacant, with NO tenant and NO lease in place. The lender will use the following formula per FNMA guidelines: Start with the Gross Monthly Rent (As determined by the Appraisal), multiple by 75%, and then subtract the PITIA of the new mortgage being written.

This is great @Michael Smith! Is this typical or would a borrower have to call various lenders to find one that will take Net Rental from the Subject Property into account? 

@Micheal Smith great job! This is the reason I love bigger pockets, people helping people.

That answered many of the questions I've asked various lenders over the years and never been provided a clear answer. Thank you!

Question: How do we best stay current on the frequent changes that are implemented with this program?

@Lee Miles

I'm pretty sure that most lenders that will finance up to 10 properties will also use the NRI from the subject.

@Randy Beadles

Your best bet is to pick a good Loan Officer who will stay in touch with you, and you could also subscribe to some mortgage industry blogs.

Awesome information Michael! Thanks for the hard work.

Michael,

In your post, you included examples of what is considered a financed property for FNMA guidline purpoes. You note that "...total ownership of a residential property that is held in the name of a Corporation or S-Corporation, even if the borrower is the owner of the Corporation, and the financing is in the name of the Corporation or S-Corporation – NO, this is not considered a “financed property.”

Question: If the property is held in the name of an S-Corporation, and the loan is in the name of the S-Corporation, but I give the bank a personal guarantee, would this S-Corp owned property be considered a "financed property" under FNMA guidelines?

@Jim Breedlove

That loan held in the s corp is part of the corporation, a living entity other than you. So I should not be counted against you. I had a dozen loans refinanced out of my personal name into a commercial loan held by my LLC. So that cleared some of my lending plate.

Frank

@Michael Smith

How do seller financed properties, which aren't on your credit report, affect your # of loans? I've had some lenders say they do and some say they don't count....

Frank

@Jim Breedlove

 If you are personally liable then it counts as a financed property.

@Frank Romine

It doesn't matter if the loan is on your credit report or not. If there is a lien on the property it is counted as a financed property. To not disclose this debt would be mortgage fraud. The lender would see mortgage interest on your most recent tax return, or if it was acquired since your last return the lender would need proof of it being free and clear (like an insurance binder with no mortgagee) to calculate NRI without a mortgage debt.

@Michael Smith

I don't think that is true if you have a personal guarantee then the loan counts against you.  Where is a good source for the answer? The scenario I'm thinking of is If you have a entity with 30 mortgages all in the name of the entity and the P&L flows to your personal tax statement.  

Thanks,

Frank

@Frank Romine for some reason I never saw your most recent comment, sorry that it took so long for me to look at this again! I am 100% sure that Fannie and Freddie will count a loan in the number of financed properties if you are personally liable on the note, even if the home is owned by an entity. If you signed the note as a borrower, it counts. I read this directly in Fannie and Freddie selling guides when I was working in the mortgage business (I am now a Realtor, I was a Lender when I wrote this post originally)