How To Finance a Real Estate Investment
Loading...Loading...Loading...Loading...Note: This is chapter 5 of an entire series on How To Buy Your First Investment Property
By this point, you have a deal under contract and have gone through due diligence. Now it is time to make sure that you have the capital in order to actually purchase and close on the home.
But here's the thing: most people don't have $200,000 lying around in their bank account to invest in an investment property. The best part is that you don't need to.
To reiterate on previous blogs, leverage is one of the best advantages to real estate. Here's a refresher if you need it:
💡 Definition
Leverage is one of the few tools not normally available for stocks and bonds. In simple terms, leverage is the ability to use borrowed money (e.g. your mortgage loan) to expand a person's asset base. This typically increases the potential return of the investment and amplifies returns.
Borrowing money is typically a long process. You'll need to talk to lenders, get together paperwork, and apply for loans.
This chapter focuses on the different options you can use to purchase your investment home. As a heads-up, the world of mortgages involves a lot of jargon. I'll be adding definitions throughout to help familiarize you with it all!
30-Year Mortgage (Traditional)
This is the standard mortgage you get on a personal property. This is typically a fixed rate mortgage where the interest and principal payments are the same for the lifetime of the loan.
The advantage of this loan is the ability to pay it off slowly over time which increases the amount of cash flow a property will have. It also allows you to pay off the loan quicker if that is your desired outcome without penalty.
However, the disadvantage is the interest. Over a 30-year span, you will pay more in interest than if you were to use a shorter loan option. For example, on a $100,000 loan financed at a 3% interest rate over 30 years, you pay $51,912.01 in interest. On the same loan but financed over 15 years, you pay $24,332.09 in interest.
15-Year Mortgage
This is very similar to the 30-year above. This is typically a fixed rate where interest and principal remain the same for the lifetime of the loan. Note: 15 years is the standard other option, but the below information also applies to other less common lengths like 10, 12, and 20 year mortgages.
The advantage of this loan is the ability to pay off the loan while paying less interest. It also has the ability to pay off the loan quicker without penalty.
However, unlike the 30-year mortgage, properties will typically not cash flow properly on these loans since they have a higher monthly payment. Also, you typically need to have more income before a lender will offer this type of loan to you because of the higher monthly payment rate.
There are two primary government agencies and programs that aid Americans in purchasing a home: the Federal Housing Administration (FHA) and the Department of Veteran Affairs (VA). However, note that these loans will only cover personal properties. However, many first-time investors use these loan options to rent out their personal properties initially to build up capital, so I thought I would include them here.
The main advantage to both is that they help lower and moderate income families afford homes by guaranteeing the mortgages to banks, and therefore lowering the cost of default and risk to the bank.
Federal Housing Administration (FHA) Loans
The FHA loan insures against losses (i.e. when a person defaults on their loan) to the lender. This means that lenders will often offer you lower interest rate and downpayment requirements because they are guaranteed by the FHA.
However, this loan is not limitless. There are stringent requirements to apply for one. Moreover, the maximum loan amount may not be enough to actually purchase a large home (i.e. one large enough for a small family).
Department of Veterans Affairs (VA) Loans
This is a loan that veterans or dependents of veterans are able to take. This loan requires no downpayment and lower interest rates.
Similar to the FHA loan, the loans have other requirements that borrowers must have in order to be approved and the loan amounts are not extremely high.
The last option that is typically not done is a private party loan. This means that you borrow from private individuals or groups (i.e. friends, family, private investors, or more).
This offers a number of advantages:
However, this becomes more risky if you are not familiar with the legal procedures. You'll need to hire a lawyer to ensure the contract is actually legal, and that all of your personal interests are covered and addressed in contract.
Mortgage lenders go through a process called underwriting.
💡 Definition
Underwriting is a process that a lender uses to determine if you are qualified for a loan by determining the your risk profile and the risk you pose for the lender.
Many lenders have stringent premium requirements that will limit their ability to give you a lower rate. But by nailing down on the next 3 criteria, you have a higher chance of getting the best rate.
Income
You'll need to provide a lender with a financial statement. This financial statement will be used to determine if you fit the income criteria for the amount you are borrowing.
Having a high enough income means that you have money left over for monthly payments, emergency reserves, and other living expenses. This means your monthly payment of $1,000 cannot be equal to your income of $1,000.
But how much income is actually enough? The golden role is 28%. Your mortgage payment including interest, principal, tax, and insurance should be lower than 28% of your monthly income.
Also, another ratio many lenders also stick by is the 36% rule. This means that all outstanding debts in your name cannot exceed 36% of your income monthly. For example, if you have a car loan that represents 10% of your monthly income and want to qualify for a mortgage loan, the monthly mortgage loan must be 26% (36% - 10%) or less of your monthly income.
Credit
A credit history plays a massive part in your interest rate. Good credit leads to lower interest. This is because a high credit score represents and shows a lender that you have good money management skills, and thus, are lower risk to lend to than other borrowers.
At this point, a lender may ask for employment history, occupation, level of education, and more to determine if you have the credit to actually purchase and own the property with a low chance of defaulting on your loan.
You can actually receive a free credit report before talking to a lender via annualcreditreport.com. You'll want to get this credit report before to fix any errors you may find (as this will generally increase your credit score leading to a better rate).
Collateral and Security
Collateral is the asset that a lender will use against your loan in the case of default.
Typically, for mortgages, the collateral a lender will use is the property they are lending you money for in the first place. In the case of you defaulting on a loan, the lender will take the home, sell it, and pay off the remaining balance on their loan (and you lose the home in most cases).
This also brings up another point: appraisals.
💡 Definition
Appraisals are reports of the market value of a property at a specific point in time. Typically, these are done by a third-party contracting company or an appraisal agent of the lender.
These determine the Fair Market Value (FMV) of the property. If your appraisal comes back too low compared to the contracted price, the lender will often not agree to the mortgage amount.
Typically, most real estate investors opt for a 30-year fixed rate mortgage. These are good for investments due to the low monthly cost, consistent payment amount, and gives ample time for the investor to pay back the loan even with emergency situations.
However, this article focused on bringing forward other financing options in real estate.
And lastly, we covered the 3 criteria looked for in every mortgage: income, credit, and collateral.
Next article in this series will focus on closing on the actual property (so that it is 100% yours)!