Financing a real estate transaction on an all-cash basis is unrealistic for most people and often not the best use of available cash, even if it is feasible. Fortunately, investors have ample options when choosing a financing strategy for their investments.
Here are some to consider for your transactions:
A mortgage is the most common option for investment property financing. The process for getting a mortgage loan varies, but many lenders require investors to put down a percentage of the property’s purchase price as a down payment. In fact, one drawback to investment property mortgages is that lenders typically require a larger down payment and higher rates than for a primary residence. Lenders may believe that there is a higher chance that an investor will default on a commercial loan so that the terms will be stricter.
Your credit score and debt-to-income ratio will determine whether you will be approved for a mortgage loan. Your mortgage lender wants to see a history of on-time payments, a low debt-to-income ratio, stable income, and proof of your ability to pay back the loan.
One advantage of using a mortgage to finance the investment property purchase is that the interest you pay on the loan is deductible as a business expense. You will likely also have the ability to finance multiple properties and carry large mortgage balances with good credit.
Consider a home equity line of credit by tapping into the equity on your primary residence to purchase a property or fund improvements. One clear advantage of a HELOC is flexibility. If you have gained equity in your primary residence, you can use that money through a HELOC to finance investment purchases. Then, when you repay the funds to the line of credit, you once again have it available as a cushion for future needs.
The potential danger in using your home to finance investment property through the HELOC is that if you cannot pay the loan back, you are risking your residence, not just your investments. While you may be able to obtain a line of credit for an investment property, lenders typically set stricter terms for such loan products.
Hard Money Loans
Professional private lenders issue hard money loans, which are used for short-term, high-rate lending such as house flipping or real estate development. Lenders may not closely examine the borrower's creditworthiness but are more concerned about the property's potential value after improvement and repair. This approach may allow the investor to borrow against the property's prospective "improved value," providing you with the capital needed to fund the work.
Two significant drawbacks to hard money lending are the cost and repayment period. Interest rates are higher for hard money loans due to the level of risk taken by the lender and the repayment period is much shorter.
Private Money Loans
Although similar to hard money, private money loans are offered by lenders not generally involved in lending. Usually, there is an established relationship between the lender (either an organization or an individual) and the borrower, allowing more room for personalization and negotiation. The lender finances the purchase with an agreed-on interest rate and specified payback period. The terms must comply with state and federal usury laws. Private lenders will look at the investor's credit, pricing strategy, and exit strategy before offering a loan.
For the borrower, a potential advantage may be the relative ease of obtaining a loan from a private lender who is supportive of their efforts for personal or value-based reasons. On the other hand, if a borrower is not diligent about researching the lender, there is a risk that the loan could fall through, leaving the investor without financing.
A non-recourse loan is a consumer or commercial debt secured by the collateral with no personal liability. The lender is entitled to repayment from the profits of what the loan is funding. Borrowers often need good credit to qualify, and there are higher fees and interest rates due to the higher potential risk. In most cases, borrowers begin repaying immediately in an installment plan.
Private lenders may offer non-recourse loans in some cases.
Peer-to-peer (P2P) lending allows investors to borrow from another investor or group of investors. There are P2P online platforms that connect lenders with borrowers. Each platform sets its rates and terms, but most offer a range of interest rates depending on the borrower's creditworthiness.
The advantage for the borrower is that while interest rates may be higher than what you could get for a mortgage loan, they should be lower than credit card financing. Also, for an investor trying to improve their credit score, a P2P loan can help reduce the overall interest that you pay.
The financing method you choose depends upon the property, how much leverage you want to use, your creditworthiness, and your plan for the property. Make sure you compare different loans and look at the terms, fees, and interest rates and use the help of a trusted advisor to guide you through the process.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. All real estate investments have the potential to lose value during the life of the investment. All financed real estate investments have the potential for foreclosure.