The purpose of this post is to inform new investors of their options. Financing is an obstacle for new investors, and I want to enlighten investors with new options. When it comes to options, I believe the more you have, the less desperate you are. Here is an example. Imagine you have an ice cream store with 3 types of ice creams. Now, imagine another ice cream store with 20 different types of ice creams. I mean sure, you might get overwhelmed with so many options, but chances are, you’ll eventually narrow your options and find the perfect selection.
Same can be said for financing. New investors believe there are only 2-3 options when starting out. Truth is, there are more than enough to fit most situations. Whether it’s a motivated seller, or buyers low on cash, there are multiple real estate financing methods to help out. But the problem is, new investors don’t know about these investments. And one of the main reasons is through fear. Thinking of paying a 20% down payment on a $700,000 house is daunting. But if they change their thinking from “I can’t do it”, to “how can I do it?”, this article will prove useful. Finding creative solutions is possible with these financing methods. But don’t stick to just one real estate financing method, mix and match to see what works if you ever invest. All it takes is some learning and creativity. So read the article carefully, so down the line you can apply it to your future investments.
1. All Cash
The most common method for newbie investors is using all cash. It’s probably what scares people off the most who want to start investing. Even when I thought about investing, a barrier to entry is accumulating enough capital just to start. Who wants to do that? Saving enough money to make an investment in which you have no experience is risky. Add the fact that it takes a lot of time to save enough money and it’s no wonder people shy away from real estate. Technically, when a investment deal happens, the transfer of funds isn’t “all cash”. Either a bank cashier’s check transfers to a title company, and the title company transfers the fund to the seller, other times funds are transferred via a wire transfer.
An advantage with the “all cash” method is there are no complications. You market yourself as an “attractive” option because you don’t have to apply for a mortgage. Sellers and brokers like “all cash” because they know applicants don’t always get the mortgage. As a buyer, going with “all cash” gives you more bargaining power. Especially if you’re in a market with low inventory, having “all cash” gives you more leverage to really find the best investment. But there is one big disadvantage. Returns. If you put all your cash in one property, you’re losing opportunity to invest in other properties. Your cash-on-cash return would be much smaller compared to an investment that is leveraged (debt). Even though “all cash” is one of the more common methods, it doesn’t means it’s the most effective.
2. Delayed Financing
Delayed financing is a real estate financing method that I’ am not too familiar with. A simple explanation for delayed financing is it lets investors take out cash without waiting for a specific amount of time. Unlike waiting 6 months to do a cash-out refinance, a delayed finance lets investors take out money against the home.
There are multiple advantages that happen when going with delayed financing. The first is lower fees. Just like “all cash”, delayed financing doesn’t have as much fees. Another advantage is a lower purchasing price. Buying a home for cheaper is always welcome in my book. But to truly compound investment growth, you need to reinvest. Having the ability to take out cash early gives you more flexibility in investing. With the extra cash, you can make renovations to your current rental property, or you can put another down payment on a property.
As a real estate financing method, delayed financing comes in handy during certain times. For instance, when purchasing a property, and looking for another one to invest in, delayed financing gives investors the option to receive the mortgage only when it’s time to rent out a property. This is huge! Not only is there less pressure to find a tenant, but you can finance a new property right after finishing up another one. If there’s a problem with the economy or unexpected debt accumulates, delayed financing will help. It affords you a liquidation of assets when real estate is known as an illiquid asset.
However, before going into delayed financing, make sure you’re eligible. Some requirements include making sure the loan amount isn’t higher than purchase price. Another requirement is to make sure you’re at an arm’s length distance, meaning you don’t have a personal relationship with the seller. This provides integrity in the financing process and provides people who need delayed financing a better chance of attaining it. Also, remember to provide documents relating to your financing. If you financed an investment property with a personal loan, or a home equity line of credit (HELOC), then be sure to provide official documents.
3. Hard Money
Hard money is a loan coming from a small group of lenders or private individuals. Typically, hard money loans cost more than conventional loans percentage-wise. Starter rates for hard money is 7-10% with 10% being more common. If you’re asking why rates are higher, let me explain. Lenders are taking more risk by handing out hard money loans. Risks like a shorter duration, and interest rate changes make default likelier. That’s why lender want higher rates. They want to compensate for higher risks.
Lenders will usually accept investors who have more experience. Determining factors such as the market, neighborhood, and street are also taken into consideration. Also, lenders check loan-to-value to see how much leverage the property has. The more leverage equals higher risk.
It’s also important to understand what is collateral for the note. If the investor happens to default, understand what the lender gets for compensation. In some instances, lenders get the property, or equity. It all depends on the terms of contract. Covenants are important details to know on the contract. Potential limitations like not borrowing over a certain amount can also limit risk. That’s why lenders want to know an investor’s investment history. You get to see if they’re leveraging other properties, or have defaulted on any obligations.
4. Private Money
The difference between a private money lender and a hard money lender is private money is generally more relationship-based. But the money can still come from non-institutional individuals or companies.
The first tier for private money comes from close ones. This can come from individuals like family members, friends, neighbors, and coworkers. Although some people don’t want to ask from people they know personally because there’s a chance that money can be lost. Another bad part of asking close ones is they might not know what differentiates between a good and bad deal. But the upside is they’re much more inclined to say yes to your offer. Make sure if you do go down this route, the people that lent you money can afford to lose it.
The second tier for raising private money is through associates of your close ones. You can consider this tier acquaintances, you might see them around on social networks. Although you have a solid chance of getting a “yes” when it comes to deals, you might need to spend more time courting these lenders. I’m talking about lunches, dinners, and dances. LOL, I’m just kidding about the dancing part.
For the last part, we have the professional lenders. People like accredited investors, banks, or people you meet from networking events make up this tier. If you consider financing with this group, it’s going to be a formal process. Credit checking, covenants, and lots of due diligence can be expected with this as you’re applying for a loan. Interest rates can differ when doing private money loans. But for more experienced investors like this, it’s more common to see hard money rates of 7-10%.
5. Portfolio Lenders
A portfolio lender is different from a conventional lender because they like to keep their money in the community. One of the great things with portfolio lenders is they can get more creative because they lend out their own money. They don’t have to abide by another institution’s criteria. Their criteria is based more off the person than numbers. They place more of an emphasis for qualitative factors than quantitative factors. To be clear, the type of people who commonly apply to portfolio lenders are people who have poor credit scores, self employment, or someone who was in a recent bankruptcy or foreclosure.
Moreover, portfolio loans come in handy when the property you’re trying to rent out doesn’t work for a conventional loan. Properties with water damage, no appliances, damaged flooring, or cracks in the foundation can’t use a conventional loan.
A disadvantage that comes with going with a portfolio lender is higher interest rates. They also come with high fees. Closing costs, origination fees, and a 10% downpayment is required. If you happen to default on a portfolio loan, prepare to give up some equity as a consequence.
If you’re prepared to meet these requirements then portfolio loans gives you another chance to build your investment portfolio.
6. Self-Directed IRA
Self-directed IRA’s differ from normal IRA’s because the beneficiary doesn’t directly control the funds. That jobs belongs to the custodian. A trustee you hire to who supervises the account. Your job in regards to the self-directed IRA is to act as the director. You tell the custodian or trustee to invest in whatever vehicle you want. You can invest in something normal like stocks or bonds, but you can also invest in an alternative asset like real estate. Since you can’t take advantage of tax breaks or other benefits with a self-directed IRA, there are loopholes you can use.
One trick is to set up an LLC. and appoint yourself as the manager where you can invest your funds yourself. With this, you can invest your funds yourself without a trustee, and benefit from tax breaks. Another thing to keep an eye out for is that you can only use non-recourse loans to invest in real estate. This means only the property can be used as collateral and funds in your IRA can’t be taken if default happens. Other limitations include not benefiting from your IRA until retiring, and your IRA absorbs all expenses related to investments
To prevent any “self-dealing”, the IRA doesn’t allow beneficiaries to purchase homes from relatives. And even if you purchase a home within the guidelines, you can’t do whatever you want with it. Which probably makes you think, why would I want to use an IRA as a real estate financing method? It comes down to taxes baby! A real estate investment made outside of a traditional IRA are subject to capital gains taxes which is around 20%. But if you invest through a regular IRA, taxes are subject to taxes around 40%.
7. Solo 401(k)
Solo 401(k)’s is another retirement account that can be used as a real estate financing method. Its known as a self employed 401(k) or individual 401(k) and it’s meant for employers who don’t have full-time employees. One advantage with the Solo 401(k) is any income or gain that happens is tax-deferred and profits are tax-free. Your contributions are not taxable until withdrawn, and business contributions are also tax-deductible. Since this 401(k) is for employers without full-time employees, beneficiaries can contribute any amount up until $54,000 which is the 2017 limit. Another cool perk is beneficiaries can do withdrawals whenever they want. Just consider the drawbacks of a Solo 401(k).
Some disadvantages include considering what happens to a self-employed person when their business grows and they need a full-time employees? Their Solo 401(k) turns into a regular 401(k) when full-time employees join the employer. Furthermore, if you have a Solo 401(k), it’s not subject to credit protection which means less administrative work, but in a downturn, could prove costly. However, just like the Self-Directed IRA, the Solo 401(k) requires a non-recourse loan for financing. A limited amount of $50,000 or 50% of account value (whichever is lesser) can be used for help with financing.
The Solo 401(k) does have its limitations. But when you study all of the different retirement accounts, you’re going to find out most, if not all have limitations. Consider the Solo 401(k) great for small business owners who don’t think their business will grow, or want it to grow. It provides great value by being tax-free while in the fund. This will allow the beneficiary to take funds out at the opportune moment. Later down the line, this can prove useful if you want to keep investing in real estate.
I personally would need to know the other person well enough to recommend a partnership. But obviously, people are different. Getting into a partnership is a compelling idea if you want to invest in a property that you can’t necessarily get into yourself.
If you’re fine splitting everything from profits, appreciation, depreciation, and cash flow, then fumble around with the idea of doing a partnership. Benefits include sharing the responsibility with someone, or putting less of your capital into the pot. Different partnerships have different relationships. That’s why terms need to be agreed upon on whether one partner will be active or passive, or if both partners will play an active role. In fact, a partnership with both parties being active can increase the likelihood of success for an investment. And, the partner doesn’t need collateral. If the investment doesn’t pan out, both of you are liable. This motivates either party to do their best.
9. 203K Loan
If you see potential in a property but it needs some repairs, a 203k loan can help finance those repairs and build it in the mortgage. As long as the property is part of the FHA, lenders will go ahead and give the green light. Similar to other loans, the 203k has requirements and limitations.
To be eligible for the program, you need to be looking at a 1-4 unit property. Anything similar to a condo or townhouse is ruled out. As for down payments, you can pay as little as 3.5%, but beware that you’ll also need to pay for private mortgage insurance. This insurance kicks in when you make a down payment under 20%. As for requirements, you need to use licensed contractors. Using a 203k loan takes away freedoms you usually have as an investor.
The 203k loan provides affordability for properties which need repairs. Understanding the details more in-depth will help you get a better feel to decide whether or not this is the right investment for you. Click here to get more details.
10. Conventional Mortgage
Another beginner-friendly real estate financing method is the conventional mortgage. Down payments on conventional loans usually range from 20-30% and lenders consist of banks, credit unions, and other formal institutions. As the down payment is higher than a FHA loan, monthly payments are lower due to lower interest rates. This happens because lower interest rates mean lower risk which results in lower monthly mortgage payments.
Conventional mortgages range from 15, 20, to 30 years. The more time on a loan means lower monthly payments, but it also means equity is not built up faster. That can come back and bite an investor who wants to do a cash-out refinance in the near future. To qualify, an applicant needs to have a good credit score. 620 is the minimum credit score to receive a conventional loan while a 740 score lands you better rates.
If you have the down payment and credit score, a conventional loan might be right for your first investment. It provides more flexibility when it comes to loan amounts and it has less provisions than other loans like FHA loans.
For a first time investor, weigh your options. If you plan on being an owner who also lives in the rental property, an FHA loan might suit you best. It’s all about what you plan on doing for the future. Paying a higher down payment will limit you from making another investment in the near future.
11. Seller/Owner Financing
An uncommon real estate financing method is definitely seller financing. This doesn’t happen often because when sellers are selling, they usually need the money now. Whether it’s to make a new investment, or purchase their actual home, sellers need the money. When sellers provide money to a buyer, that’s seller financing.
A motivated seller is more akin to use this method. Problems that can make a seller do this kind of financing varies. If a seller wants to really sell the property, advertising it as seller financing will get it sold quicker. Another scenario is when the seller wants to use the money for another down payment. There are other investors who will do this when they see a more attractive investment option. Other sellers will do this to minimize carrying costs which come while waiting for the best buyer.
For buyers, advantages include lower closing costs, and a faster closing process. Some disadvantages include higher interest rates, and the seller’s lender might foreclose the property if the seller doesn’t own the property free and clear, or the seller’s lender agrees to conditions. Analyzing how motivated a seller is will tell the buyer a lot. It could work in your advantage, but make sure the lending companies are okay with the circumstances.
12. Commercial Loans
If you’re looking into into investments beyond 1-4 units, commercial loans are for you. Requirements and standards are different with commercial loans. One standout factor on deciding whether you can get the loan is analyzing how much revenue the property generates. Because even if you’re making $500,000 a year, can you really pay off a $15 million dollar apartment complex? Lenders think of commercial real estate criteria like this:
How much revenue property generates > income and credit score
I don’t want to get into all of the details when it comes to real estate commercial loans, but there are 5 types of loans. Most commercial loans last 20-30 years with loan-to-value ranging from 80-90%. So if you find the right deal, “small-time” investors can get in the commercial game for 10% down. Also, it comes down to the types of tenants you have, and what type of commitment they’re willing to provide. The more commitment means less risk because there’s more long-term income. Lenders wouldn’t have to worry about where you’re going to generate income.
All in all, different financing techniques require different standards and requirements. All of this is part of the game which comes with varying degrees of risk. To make it easier, think of financing as an art. You can use different paint brushes for each property. Nothing is the same. For example, if a property has value, but there are repairs that need attention, a 203k loan could be the right choice. But what if you wan’t tax-free profits for the short-term? Do a Solo 401k. It’s fun thinking of financing strategies because it requires creativity to achieve maximum profitability. All we have to do is learn these strategies and apply it.