General advice on a financing plan for first deal/Interest rates

11 Replies

I am a complete REI newbie looking to gain some knowledge on the financing side of a potential first deal. I was looking for some advice on the following financing plan, plus have what I am sure will turn out to be a very simple answer to an interest rate question on loans.

Plan: Borrow the complete purchase price of a SFR or MFR (under 200k) from family and friends. Structure the family loan with an attractive interest rate (family special, hopefully around 6%) and a repayment period of 13 months. After the property has shown a positive rental cash flow and a great new ARV, refinance at 12 months with a conventional lender on a 30-year loan for 70% to 80% of the new ARV, paying back family and friends and pulling out whatever profits are left for the down payment on the second investment property. The BRRR strategy I have read so much about.

Questions/Concerns:

  • If 200k is borrowed from family how would the hypothetical 6% interest be calculated?  For example, could the 200k be divided by 360 payments (30 years x 12 months = 360 payments / around $550 a month) plus 12k divided by 360 (6% of 200K / around $30 a month) for a monthly payment of around $580 be the structure of the loan? Again, I am sure this a really basic question and I am also sure that these are really attractive lending options that aren't really realistic, but I am just looking to better understand the process.
  • Any suggestions or templates on how to write out a lending contract with family and friends?  I know that borrowing from family can be extremely tumultuous if the things go wrong and want to cross my t's and dot my i's.  Any great lessons learned from family and friends lending?
  • Will a conventional lender refinance on numbers that look roughly like this? I know this is pretty general and fully depends on the new ARV, but what are some potential hiccups with this plan? Our current family DTI is around 28%, solely from the current mortgage on our primary residence. We have no other debt, but I am worried that a lender will think we are over leveraged and we won't be able to refinance.

This is my general plan with lots of future knowledge to be gained before the deal.  I truly appreciate any advice, knowledge or harsh criticism on the plan.  Thank you for your time and I look forward to the discussion.  

Best Regards,

Andrew

@Andrew Lapham - I assume your plan is to borrow $200,000 at 6% from family/friends as an interest only loan, and then once you have refinanced, pay back the full $200,000 to the family/friends. If that was the case, your monthly interest only payment to them would be $1,000. 

You can play around with the numbers for an interest only loan with this calculator:  https://financialmentor.com/calculator/interest-only-loan-calculator

Richard -

I guess the fact that I didn't know about an interest only loan shows how "green" I am to REI. Thank you for the advice and the link to the calculator.

Any further comments on interest only loans? What would be a great rate? Any pitfalls? Have any experience with friends or family loans?

 Thanks!

Andrew

@Andrew Lapham - I have no experience with private money lending. I would also like to use the BRRR strategy for my next property doing something similar to your plan so I have done research and read a lot about private money lending on the forums. If you can borrow money at 6% from friends and family, that's a great rate - Hard Money lenders typically charge 10 to 15% (and also charge points up front).

I would guess the biggest pitfall of borrowing from family and friends is if the deal went poorly and you weren't able to pay them back, as it could damage relationships. So if the deal doesn't work out as planned, make sure that you pay your private lenders what you promised to pay, even if it means money out of your own pocket and losing money on the deal. 

@Richard Jahnle

All great advice.  I have read a few stories of private lending from family and friends going really bad.  My plan to mitigate this risk, from the minimal knowledge I have is to:

  1. Fully understand the ARV's in the areas. If you're pretty confident in your calculated/ estimated ARV after repairs, you should also be pretty confident that once your refinance you will be able to repay friends and family.
  2. Line up the refinance before borrowing from friends and family.  I plan on talking to some local banks and lenders to see how viable a refinance will be after the rental property seasoning period with my families current financial situation.
  3. Check and Re-check the numbers on the deal analysis.  If I am super confident on the cash flow after expenditures (loan repayment, cap-ex, vacancy, maintenance), I don't think that the refinance will be too difficult to obtain.

Good luck with the BRRR strategy and thanks again for the advice.

-Andrew

@Andrew Lapham You technically only need to season for 6 months before you pull cash out although a common overlay that many lenders have is that they want to see 12 months of payments on a private mortgage.

If you're going to be forcing a lot of equity through renovations, it would be a good idea to hang on to all of your receipts and invoices for a couple of reasons.

#1 It might be helpful to have those invoices to justify a steep climb in appraised value from purchase to when you refinance over a relatively short time period. Having those invoices proves the renovations were done that justify the new appraised value.

#2 Without getting too into the woods, it can help with your tax planning and mortgage qualification down the road. If you're going to deduct large repair expenses on your taxes, you can create a separate line item for those renovations and match up the numbers with your invoices. A lender should be able to add those back into your income as one-time expenses.

It helps to be as organized as possible.

@Jared Bouzek  

All around awesome advice.  

It is great insight that providing receipts for all renovation costs could potentially have a factor into the ARV for the refinance. I just assumed they utilized comps sold within six months to determine a fair market value.

I will also dive deeper into the tax benefits of rehabs and the mortgage qualification factors that rehab costs can have on your DTI. It is something that I have been a little worried about in qualifying for a refinance after a year of seasoning a future investment property. Our family DTI right now is 28%, based solely on the mortgage payment on our primary residence. I feel like we might be creeping up on the 43% if we were to refinance.

I had another question that I have been researching in terms of a calculated DTI that a lender like yourself might be able to answer. What is the norm for factoring in the cash flow to your overall income of the rented property that you are attempting to refinance on? I have read that some lenders will take 70%-80% of that cash flow amount, some will not factor it in at all and some will factor the entire amount into your income. Is this lender specific or is there a standard across the industry that I am missing?

Again, I appreciate all the advice and it is invaluable to hear from a lender on the specifics of a potential refinance.

Andrew

Hey Andrew.. I just wanted to throw this out there as well. Since this will be your first deal and you might not want to go all in with your family and friends for around $200k. My suggestion is to borrow from them, enough for the down payment on a fix and flip loan from a HML. That way you wouldn't have to owe them the entire amount of the home, only a smaller amount if the deal goes sour. Whatever HML lend you use would hold the majority of the debt and if it falls through then so be it. The majority of HML's out there will charge you a 14-15% interest rate at being new, BUT, those are almost always interest only payments with no pre-payment penalties. That way, you could do a cash-out refi in the 6 months, pay the HML back, pay them back a lot less money but still keep their interest in mind, and move forward with your new investment property.

Overall I'm just saying that this would be less risk from the ones close to you in case something doesn't work out the way you want it to. Hope this helps some.

@Andrew Lapham When you refinance an investment property, there are two primary ways of calculating your income from that property. 

1. If you have owned the property for less than a year and it does not appear on your tax return, you take 75% of the gross monthly rents and then subtract your monthly PITIA (Principle, Interest, Taxes, Insurance, & Association Dues). If the resulting number is positive, it adds to your monthly income. If it is negative, it is included in your monthly liabilities.

Example: 

$1,800 Monthly Rent * 75% = $1,350
$1,500 PITIA Payment
$1,350 - $1,500 = ($150)

So you would carry $150 to your monthly liability payments.

2. If you have owned the property longer and are declaring it on your tax returns, there is a slightly more complicated way of calculating your income. A loan officer should use your Schedule E of your tax return and take your Net Income or Loss and add back to this number the following deductions: Mortgage Interest, Insurance, Taxes, HOA payments, Depreciation, and any major one-time event expenses. Note that you need to be able to justify adding back the one-time expenses (documentation, separate line items, etc.). Once the deductions have been added back in, divide this number by the months the rental was in service to get your monthly income and then subtract your PITIA payment back out. Once again, if the resulting number is positive, add to your monthly income. If negative, include in monthly liabilities.

If you want to see this laid out in a spreadsheet format, google: Fannie Mae form 1037

What I just spelled out is the exact Fannie Mae guideline. Yes, lenders can add their own overlays on top of those guidelines, but the key is finding a lender who doesn't have overlays and a loan officer who knows what they're doing.

And yes, you're correct that valuation will be done based on comparable sales, but let's say you're refinancing 6 months after your purchased a property. You purchased for $250,000 and did extensive repairs and now your appraised value six months later is $325,000. Within that time frame, the appraiser is likely to note your purchase price from six months earlier. Some underwriters may question this steep valuation climb. It just helps your case to be prepared to show invoices for the work you did to increase the value that much in a short time period. We try to make underwriters feel warm and fuzzy about what they're doing.

I also think instead of borrowing $200k now, borrow enough for your down payment and repairs on your 1st.  Rehab and refi.  Pay back borrowed cash, and repeat as many times as possible.