Are you thinking about buying a property? Whether it’s a home or an investment property, one of the first most important things you can do is ensure that you are obtaining the correct type of financing. Not only will knowing your options, allow you to close the deal, but it will also save you thousands of dollars.
Brandon Turner is always mentioning the metaphor of having tools in the toolbox. The more tools you have, the easier and more successful the project (or deal) will be. Imagine that you are trying to build a house and you only have a hammer. How do you think that house is going to look?
However, what if you added a circular saw, a drill, a staple gun, a drywall lifter, and other tools to your tool box? Do you think that house would turn out better?
Think of each financing option as a tool in your toolbox. The more options you have and know how to use, the higher the probability that you will be able to close on a deal and make the numbers work.
If you’re a frequent visitor of BiggerPockets, you know that there are all types of financing terms that get thrown around when it comes to loans: conventional, FHA, USDA, hard money, private money, etc. It can get confusing!
If you are getting overwhelmed by all of these terms, look no further. The purpose of this article is to succinctly lay out a few of the most popular financing options, briefly explain what they are, and also explain the pros, cons, and strategies each loan is mostly used for. If either of these piques your interest, I highly recommend digging a little bit deeper before diving right in.
Note that there are thousands of ways to finance deals when you start to get creative. Because I only have a couple thousand words to spare in this article, I am going to briefly go over the most common. Brandon Turner wrote a book called The Book on Investing with No (or Low) Money Down, which goes into much more detail. If you are interested, I highly suggest you pick up a copy here on BiggerPockets.
10 Ways to Finance Your Next Property
The conventional loan is the most popular (perhaps why it is called conventional). Many times, conventional loans get sold to Fannie Mae or Freddie Mac, two government-sponsored organizations created to purchase mortgages. As of July 2018, you can put down as low as 3 percent of the purchase price, but be careful—any down payment lower than 20 percent will likely mean you will be required to live there for one year and will have to pay a monthly premium called private mortgage insurance (PMI).
- Easy to Understand.
- They typically have the lowest interest rates and yield.
- In many cases, the PMI automatically burns off as you make loan payments and gain equity in the property.
- Fannie and Freddie are only willing to purchase the loans if the borrower meets these very strict standards, which involve the borrower’s debt to income ratio, credit score, job history, etc.
- There is little flexibility with conventional loans, and there is a limit to how many you can have out at once.
- Conventional mortgages take a long time to underwrite. It will take your average lender 3–4 weeks to get through the underwriting process.
Conventional loans are great for any type of buy-and-hold strategy, including house hacking. While these can be used to flip houses, the lenders do not particularly like having a loan outstanding for such a short period.
2. Federal Housing Authority (FHA) Loans
FHA loans are government-sponsored loans (also sold to Fannie and Freddie) that incentivize people to purchase a home by offering a product where the buyer only needs to put down 3.5 percent. The FHA loan is owner-occupied, meaning that the buyer needs to live on the property for at least one year.
- Low down payment.
- Lower interest rate.
- You’re required to live in the property for one year.
- You’ll need to pay private mortgage insurance that does NOT burn off as you gain equity. You’ll need to refinance.
- You can only have one FHA loan out at a time.
- There is more paperwork at closing.
3. 203K Loan
The 203K loan is the cousin to the FHA loan. It is an owner-occupied, 3.5-percent-down loan that allows you to lump the rehab costs into the mortgage. For example, what if you wanted to purchase a property for $100,000, but it needed $50,000 of work? You could take out a $150,000 203K loan.
- You can finance the whole project with one lender.
- You can use this to increase value of the home in excess of the loan.
- You do not need to use cash for rehab costs.
- Any work you do yourself will not be covered under the 203K loan. You’ll need to have licensed contractors fill out the necessary paperwork.
- Contractors must be vetted by the lender.
- It’s not open to investors. Must be an owner-occupant.
- More paperwork can be involved.
House hacking, which encompasses buy and hold, live and flip, and live as you BRRRR.
4. Veteran Affairs (VA) Loan
The VA loan is one of the great advantages of being in the military. This loan offers no down payment to veterans, service members, and select military spouses. Similar to the FHA loan, you’ll be required to live in the property for at least one year.
- No down payment. You can get into a property with almost no money down (you will likely still need to pay some closing costs).
- Lower interest rate.
- No required PMI for VA loans.
- Higher allowable debt-to-income ratio.
- Not everyone has access to this type of loan.
- There’s a VA funding fee that gets lumped into your loan that the VA charges to keep the program running.
- You’ll be required to live in the property for one year
- More paperwork at close
- House hacking, which encompasses buy and hold, live and flip, and live as you BRRRR.
5. United States Department of Agriculture (USDA) Loan
Sponsored by the USDA, this type of loan allows the buyer in a rural area to purchase a property with 0 percent down. You must meet the criteria, which includes purchasing in a rural zip code, a monthly payment of less than 29 percent of your income, and an acceptable credit history.
- No down payment. You can get into a property with almost no money down (you likely still need to pay some closing costs).
- It can only be used for rural properties.
- There are strict requirements for taking out the loan.
- It can only be used for single-family homes.
Because you are required to live in the property for a year, the USDA loan is perfect for house hacking, which encompasses, buy and hold, live and flip, and the BRRRR strategy.
6. Adjustable-Rate Mortgage (ARM)
An adjustable-rate mortgage is exactly what it sounds like. A mortgage in which the interest rate fluctuates with the overall market interest rate. As of 2018, interest rates are low, so the creditors tempt you with a lower rate on an ARM than they would a fixed-rate mortgage.
There are also hybrid ARMS, in which your rate is fixed for a certain amount of years and then it transitions to the adjustable rate. These are beyond the scope of this article. I would not recommend these types of mortgages because it makes forecasting your cash flow much more difficult, and you are gambling on something you cannot control: the market.
- Typically, ARMs have lower interest rates than fixed mortgages.
- There is a chance that your interest rate will decrease over time.
- Interest rate (and therefore cash flow) is unpredictable.
- ARMs are complex and hard to understand.
- There is a good chance that your interest rate will increase over time.
Adjustable-rate mortgages are good if you are looking to only use the loan for a short period of time before refinancing into a longer-term fixed rate. I advise against ARMs, but if you had to do it, the best strategy is a BRRRR or fix and flip.
7. Private Money
Private money is exactly what it sounds like. Financing sourced from non-institutional, private investors. Seeking financing from family, friends, co-workers, or people you’ve met at your local REIA (or on BiggerPockets) all count as private money potential. Typically, private money will be more expensive than a conventional mortgage, but terms can be very flexible.
- No qualifications are needed. You just need to find someone who is willing to invest with you.
- Extremely flexible with loan structure. Since these loans aren’t being sold to Fannie or Freddie, the terms of the loan can be whatever you want.
- Oftentimes, interest rates are higher than with a conventional mortgage.
- Terms are often shorter (3–5 years). This, coupled with the higher interest rates, makes for a much higher monthly payment.
- If things do not go right, it could create some bad blood between you and your partner
Private money can be used by investors of all kinds. Given that it tends to be more expensive and short term, I would recommend this type of loan to those pursuing either a fix and flip or BRRRR—a strategy where you can get the financing quickly, do a rehab to increase the value, and then either sell or refinance the private lender out as quickly as possible.
8. Hard Money
Hard money is private money’s twin. It is almost the same thing, but instead of being from an individual, it is usually from what is called a hard-money lender. Find a list of hard-money lenders here. It is called hard money because the lenders use the hard asset (the property) to secure the loan and not your ability to repay. If they are confident that the property is worth more than the loan, they will lend to you.
You would go to a hard money lender if you could not easily find private money investors. Hard money lenders typically charge exorbitant interest rates north of 10 percent, with points up front (fees that are a percentage of the purchase price).
- Very flexible loan structure.
- Little qualifications needed. Though, the riskier you seem, the more you will pay.
- They are easier to find and very quick to close.
- Hard-money loans can be very expensive. Especially if you are perceived as risky. In other words, if you don’t have a lot of experience, have bad credit, etc.
- There are shorter terms: Hard money loans are usually for a year or less.
Hard-money loans have exorbitant fees, shorter terms, but can close quickly. This type of loan is only suitable for the fix-and-flip and BRRRR investment strategies. You will want to use the hard money loan to obtain the property, make your improvements, and then quickly sell or refinance into a cheaper loan.
This strategy makes zero sense for the traditional buy-and-hold or house-hacking investor.
9. Home Equity Line of Credit (HELOC)
A home equity line of credit, popularly known as a HELOC, is what people can use if they have already purchased a home and have some equity tied up in it. For example, if someone purchases a home for $100,000 with an $80,000 loan and has paid down the loan to $60,000—all while the house has appreciated to $120,000, then the owner can take out a HELOC to tap into the $60,000 of equity they have on the property ($120,000 value minus the $60,000 loan outstanding). They can then use this for a down payment.
- It’s a cheap financing option in terms of interest rates and closing costs.
- You can pay it off whenever you like. You pay on the outstanding balance, not the entire HELOC.
- You are losing the equity in your original home and increasing the cost to retain it.
- Most HELOCs have adjustable rates. This does not allow you to easily predict your financing costs.
A HELOC is a great way to jump start your real estate investing if you’ve already purchased house and have significant equity in it. This is a great financing option for almost any strategy. You can use it as a down payment for buy and holds, for rehab costs on a fix and flip, or a combination of the two.
10. Seller Financing
Seller financing is when you totally remove the bank and any third party lender from the deal. Instead, the seller acts as the bank. Rather than wanting a lump sum payment all at once, the seller may want to receive monthly installments with interest over time.
- It’s super flexible: From a buyer’s perspective, this is an option if you have bad credit, high DTI, or other things that may disqualify you from getting a traditional loan.
- It can be cheap: In many cases, seller financing will be slightly more expensive than conventional, but likely much less than hard money.
- It’s faster and cheaper closing: The seller does not charge the same closing costs as a traditional lender would and does not need to go through the same underwriting process.
- You still need to gain seller approval, which can be less straightforward than with a bank.
- The due-on-sale clause: If the seller has a mortgage on a property and sells it, this will trigger the due-on-sale clause. The seller’s bank can require immediate repayment of the debt at risk of foreclosure. Avoid this by confirming that the seller owns the house out right.
This strategy is most commonly used for buy and holds, but can also be used for flips and/or BRRRR investments. For buy and holds, I suspect the loan would be a slightly longer term whereas fix & flips might be shorter term with a balloon payment at the end.
Either way, this is a great strategy for someone who may not be able to qualify for a conventional mortgage.
There is a plethora of ways to finance a home. While it would take forever for me to go through all of them, this post hopefully allows you to add more tools to your toolbox. If any of these ideas sound interesting to you, I highly suggest you do some further research.
A good start would be to read The Book on No (and Low) Money Down, which goes into much more detail than this blog post and describes some more sophisticated ways to purchase a home.
Otherwise, there are tons of internet resources out there that go into the advantages, drawbacks, and what to look out for in each loan type.
What types of loans have you used to score properties?
Share your experiences below!