As a beginner investor, understanding how to finance a real estate deal is just as important as finding one. A lack of real estate financing continues to hinder the majority of new investors in today’s market, simply because they are not aware of the different financing avenues. Whether you have access to working capital or not, there are always ways to acquire capital.
Investing in real estate is never a bad idea. It offers potential investors a slew of financial and personal benefits, such as increased cash flow, home appreciation, and tax benefits. In fact, real estate investment continues to be one of the most popular vehicles in producing financial wealth. According to the IRS, approximately 71 percent of Americans that declared more than a million dollars on their income tax returns in the last 50 years were in real estate. Ironically, beginner investors face the challenge of learning how to obtain real estate investment financing before they can start creating wealth. Read on to learn about some of the most common types of real estate financing options out there, as well as prominent loans for real estate investing.
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What Is Real Estate Financing?
Real estate financing is generally used to describe an investor’s method of securing funds for an impending deal. As its name suggests, this method will have investors secure capital from an outside source to buy and renovate a property. Not unlike traditional financing, however, real estate finance comes complete with terms and underwriting, not the least of which need to be fully understood before entering into a contract.
How To Obtain Real Estate Investment Financing
One of the biggest misconceptions of real estate investing is that you need to have a lot of money to get started, which isn’t true. However, the secret that many professionals don’t understand is that many different real estate financing options are available to fund every investment. Understanding the financing aspect is imperative because the method in which a specific deal is funded can greatly impact its outcome.
As an investor, there are a few different ways to go about financing real estate investments. Each one will have its own set of pros and cons, and your financing approach will depend on the property and the situation. Beginner investors need to remember that not all real estate investment financing options are created equal. What works for someone else may not necessarily work for you, but the trick is understanding which real estate financing option will compliment your business strategy. By taking the time to research the various real estate financing options out there, new investors are sure to realize how accessible investing can be. Broadening one’s toolkit of real estate investment financing options is simply a matter of being knowledgeable about what strategies exist, as well as proper ways to leverage them. Keep in mind that all investors have faced the financing hurdle at some point in their career; when in doubt, there is nothing wrong with tapping into your investor network and ask for advice.
Real Estate Financing Options
Investors with a deal lined up have already accomplished one of the most important steps in home flipping. However, finding a viable deal is only one piece of the puzzle. Once you find a good property to invest in, you need to finance the impending transaction then.
Financing a real estate deal tends to send new investors into a fit of anxiety or is even enough to compel them to pack up their dreams and retreat to their nine-to-five job. However, if an investor commits to doing his or her due diligence, the fear of a lack of funds is irrational.
If you have a great deal on the table, there is no limit when it comes to ways to fund it. A great example would be leveraging a self directed IRA, which would require some careful consideration beforehand; however, it goes to show that there are many available options for real estate investment financing. Experts at Loan Advisor suggest “Financing not only provides flexibility but also improves cash flow. There is fluidity in repayment and it provides options for collateral. I would suggest new real investor financing through hard money loans, hybrid loans, asset-based mortgages, and an FHA loan”. For investors wondering how to finance an investment property, I’ll explain some of your real estate finance options:
Cash Financing: Great for investors who have access to a significant amount of capital, either personally or through their network, and wish to purchase properties free and clear.
Hard Money Lenders: Accessible to investors who have less-than-perfect credit or financial history, and are in need of a short-term loan.
Private Money Lenders: Investors who are well-connected can often tap into capital from personal connections, borrowing money at a specified interest rate and payback period.
Self Directed IRA Accounts: Individuals who have elected to create savings through a self-directed IRA may make the decision to tap into their account as a way to access capital.
Seller Financing: Buyers and sellers can sometimes strike up a mutually beneficial agreement, allowing the investor and seller to avoid having to go through a private lender altogether.
Peer-To-Peer Lending: This is a great option for investors trying to raise the last portion of funding for a project. Peer-to-peer lending can offer high flexibility and low interest rates.
As an investor, cash is a monumental tool to getting what you want. Along with getting more offers accepted, cash financing enables investors to save on interest, increase their cash flow, and receive instant equity in their investment. It also has the ability to save investors on the purchase amount.
In the first quarter of 2016, all-cash homebuyers for single-family homes and condos paid, on average, 23 percent less per square foot than all homebuyers nationwide, according to RealtyTrac.
Also, it’s important to remember there will be times when paying cash for property makes sense and other times when other financing options should be considered. However, if you have your own capital, you should always consider using it in the best possible scenarios.
Hard Money Lenders
Funded by private businesses and individuals, hard money lenders provide short-term, high-rate loans for real estate investors. This financing option, which doesn’t conform to bank standards of creditworthiness, is typically used by rehabbers looking to renovate a property.
Hard money financing is generally determined by the value of the investment property itself, with lenders analyzing the “After Repair Value” (ARV) to determine the size of the loan. Hard money lenders generally won’t fund an entire deal but rather a percentage of the purchase price or the after repair value, ranging from 50 to 70 percent.
Hard money lenders also charge fees apart from the interest on the loan. These fees are generally delineated in points (three to five), representing additional percentage fees based on the loan amount. In general, hard money lenders charge much higher interest rates – sometimes double the amount of a traditional mortgage, plus fees. In the end, all hard money lenders will have different requirements, and real estate investors need to be fully aware of what they’re getting themselves into.
Private Money Lenders
Private money lenders are integral to the growth of every new investor. They have the means and intent to invest capital into your business, and they are just as interested in working with you as you are with them.
Generally speaking, private money lenders will provide investors with cash to purchase real estate properties in exchange for a specific interest rate. These terms will generally be established upfront and with a specified payback period – anywhere from six months to a year. These loans are most common when investors believe they can raise the value of a particular property over a short period of time, typically through renovations. It’s also important to understand that private money should only be used when you have a clearly defined exit strategy like hard money.
Self-Directed IRA Accounts
A self-directed IRA (Individual Retirement Account) is, at its most basic level, a savings account that allows for compounded, tax-free growth over time. Self-directed IRAs are unique from other savings accounts, such as a 401K, as the owner can control various investment options, including real estate.
Owners of self-directed IRA account enjoy the unique benefit of purchasing, rehab, and selling properties while still being able to defer taxes. However, it is important to note that owners under 60 are typically subject to a penalty for withdrawing funds early.
There are some scenarios when both an investor and a seller can strike up a mutually beneficial seller financing deal. In seller financing, the property buyer will make payments directly to the seller of the property rather than going through a bank. This can help a motivated seller sell the property more quickly. The investor can avoid jumping over traditional mortgage lending hurdles, such as financial and credit score minimums.
Together, the buyer and seller can often enjoy a faster transaction process and avoid many costs and fees associated with the closing process. Furthermore, the owner can sell the promissory note if they no longer want to manage their own owner financing.
Peer-to-peer lending allows investors to borrow money from other investors or groups of investors (hence the name). The basic process can be thought of similarly to hard or private money lending, though the specifics are actually quite different. Like these methods, investors can bypass traditional funding requirements and allow their portfolios to do the talking.
This form of real estate financing typically involves a lower loan-to-value ratio than other funding types. This often prevents investors from borrowing the entire loan amount needed to purchase a property; however, don’t be afraid to seek out the financing you need. Peer-to-peer financing, as a whole, offers a high degree of flexibility overall.
Best Loans For Real Estate Investing
When examining the large umbrella of different real estate financing options, one should also consider loans offered by the government, traditional lenders, and methods of leveraging personal equity. Read on to find out some of the most popular loan options that are used creatively by investors, including real estate investment loans on bad credit:
203K Loan: A special type of loan backed by the Federal Housing Administration, 203K loans support the purchase of older or damaged properties in need of rehabilitation.
Home Equity Loan: Homeowners who have built up equity in their property can take out a loan in the form of a line of credit, allowing them the flexibility to expand their portfolios by using their equity as collateral.
FHA Loan: Consumers with less-than-perfect credit or those who do not have access to capital to satisfy a large down payment can achieve homeownership by taking out a mortgage backed by the Federal Housing Administration. According to finance experts at Finance Jar, “FHA loans are government-backed loans that encourage people to buy homes by requiring only a 3.5 percent down payment.The FHA does not guarantee the line of credit; instead, it acts as an assurance for the loan company”.
Traditional Mortgage Loan: Conventional home loans financed by banks still remain one of the most popular methods of financing real estate deals.
Conforming Loan: As its name suggests, a conforming loan is a mortgage that is equal to or less than the amount established by the conforming loan limit set by the FHFA. Perhaps even more importantly, conforming loans comply with Freddie Mac and Fannie Mae.
Portfolio Loan: Portfolio loans are serviced by the initial lenders that first issued the funds. Instead of selling the loan to the secondary market, the servicer will keep the loan in its own portfolio.
VA Loan: A VA loan is a mortgage that is guaranteed by the United States Department of Veterans Affairs.
Commercial Loans: Certain financing is available for commercial real estate, though it does often come with higher interest costs.
203K loans are a special type of loan backed by the Federal Housing Administration and are designed specifically for those who plan to rehabilitate older or damaged properties. The loan includes the price of the property’s purchase, plus the estimated costs to make renovations. 203K rehab loans are attractive to some because of the low down payment requirement of 3.5 percent and allows the funding of cosmetic or major repairs as needed. Also, the borrower can include 6 months’ worth of mortgage payments in the loan.
This policy is designed to help homeowners make mortgage payments when they cannot live in the property during its rehabilitation phase. However, investors should be aware of some potential downsides to this particular loan. First, 203K borrowers must hire a licensed contractor and construction consultant, meaning that DIY projects are not allowed. Also, fix and flip investment properties are not eligible. Those would be able to take an owner-occupied approach by purchasing a property with 1 to 4 units.
Home Equity Loan
When an investor has built up equity in their personal residence, they have the opportunity to take out a loan against that equity. A home equity loan, more formally known as a Home Equity Line of Credit (HELOC), allows homeowners to leverage their home equity as collateral to take out a loan. Common uses for a home equity loan include home repairs, education, or resolving debt.
A major benefit of a home equity loan is the low rates typically based on the prime rate, currently at a low. Also, borrowers enjoy the flexibility to use the loan to manage their own repayment structure. This flexibility creates an avenue for homeowners to expand their portfolios on their own terms.
The FHA loan is one of several home loan options offered by the federal government. The Federal Housing Administration (FHA) established the loan to help broaden access to homeownership for consumers with less-than-perfect credit profiles and those who do not have the financial means to save up for a large down payment. When a new homebuyer shops for mortgage loan options, they can search for lenders that offer mortgage loan products backed by the FHA. These loans offer a down payment requirement of as low as 3.5 percent while still allowing a low interest rate.
However, it should be noted that putting down less than 20 percent on a home loan will result in a required private mortgage insurance payment. Besides, the FHA loan only allows owner-occupied properties but does allow for purchasing a property with more than one unit. According to The Lenders Network, the current loan limit for a single-unit property ranges between $294,515 to $679,650, depending on whether the market is a low-cost or high-cost area.
Traditional Mortgage Loan
One of the more popular financing methods in real estate is through traditional lenders, which includes conventional and FHA loans. Many investors are pursuing traditional lender financing options in today’s market because interest rates are at historic lows.
However, traditional lenders follow strict guidelines with many demands that other financing options don’t require. The hurdles with traditional loans, such as a conventional mortgage loan, include a sufficient down payment (anywhere from 15 to 25 percent), an adequate credit score (a minimum of 680) and documentation of income. Also, the money used must be called “sourced and seasoned” for at least 60 days and cannot be a gift. In many cases, this could limit many investors.
As their names suggest, Conforming loans conform to standardized rules set forth by Fannie Mae and Freddie Mac. However, the “conforming” part of these loans refers to the amount loaned out. Conforming loans must be less than the conforming loan limit set by the Federal Housing Finance Agency. The 2019 limit for conforming loans is set at $484,350, or $31,250 more than the previous year’s conforming loan limit. However, it is worth noting that the conforming loan limit isn’t universal across every market. The limit is higher in higher-priced areas like New York or San Diego.
Outside of the size of the loan itself, conforming loans are also characterized by the following:
Credit Score & History
The loan originator finances portfolio loans, but instead of being sold to a secondary market—like most traditional lenders tend to do—the lender will retain the loan for their own portfolio. As a result, borrowers won’t have to establish a relationship with another lender and can instead maintain the connection with their current lender. In other words, it’ll be much easier to maintain an open line of communication.
VA loans are intended to service United States Veterans, Service Members, and their spouses. VA Loans are issued by qualified lenders and guaranteed by the U.S. Department of Veterans Affairs (VA). Specifically, the VA will guarantee a maximum of 25 percent of a home loan amount up to $113,275, which limits the maximum loan amount to $453,100. Meanwhile, “the reasonable value of the property or the purchase price, whichever is less, plus the funding fee may be borrowed,” according to VAloans.com.
Using lender financing is a great option for beginner investors, but it’s important to be patient and prepared. Make sure you understand the process and what is required to get approved.
Commercial loans are associated with short loan terms and higher interest overall. However, they can be used to fund large-scale projects. These loans rely heavily on the projected returns of the commercial property. Investors will need to provide the lender with projected income from the deal. This requires a solid deal analyzer and accurate revenue predictions. These numbers will then be carefully reviewed before the loan is approved and underwriting begins. In the end, commercial loans are a great way to secure large amounts of financing and can be quite attractive overall.
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Which Real Estate Financing Option Should You Choose?
There is no right answer when looking at which financing option you should choose. Instead, it’s helpful to focus on your long-term goals and preferred investment strategy. For example, if you plan on using real estate as a way to bolster your retirement savings it may be smart to turn towards an IRA to invest in real estate. On the other hand, if your long-term goal is to have your own real estate investing business then options like a hard money lender may be a better fit.
Another key component to look at when choosing a financing option is what type of real estate investing you want to do. Again — the right strategy is up to you but certain financing options may be better suited towards different investments. Many investors find that a home equity loan can help finance a rental property, while private money lenders may be what you need for a rehab property. Think through why you are investing in real estate and weigh the pros and cons of each option before deciding how to finance.
When it comes down to it, real estate is a commodity that must be paid for. As an investor, it’s up to you to determine which real estate financing will work best for each deal. Ultimately, understanding the importance of real estate financing, including the different financing methods used by real estate investors, will help get started. Now that you have been equipped with some of the most popular financing strategies, there is no need to hesitate to take on your next venture.
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The information presented is not intended to be used as the sole basis of any investment decisions, nor should it be construed as advice designed to meet the investment needs of any particular investor. Nothing provided shall constitute financial, tax, legal, or accounting advice or individually tailored investment advice. This information is for educational purposes only.