Before you can start generating rental income from your latest property acquisition, you’ve got to go through the process of buying the rental property. That process can be a challenge all on its own – particularly when there are so many financing strategies to consider!
Financing Principles Investors Should Follow
Principle #1 – Make a Strong Down Payment
When utilizing leverage (debt) to buy real estate, a balance must be struck. While you don’t want to use too much of your own money to make the acquisition, a robust down payment (between 25-30% for investors) can make your life a lot easier. It will lower your monthly mortgage payment as well as your interest rate. Lenders see you are more trustworthy when you have a larger stake in the property.
For real estate investors, saving for larger down payments for future acquisitions can take time. Passive income earned through your rental property helps, but understand that this is a long-term investment strategy that demands time and planning to generate impactful wealth.
Principle #2 – Guard Your Borrowing Power
The single most influential factor in your ability to secure financing – and financing with favorable terms – is your credit score. You can hurt your credit score by making late payments, having a high debt-to-credit utilization ratio, applying for a high volume of credit all at once (either in amount or number of accounts), closing credit card accounts, or failing to utilize credit. Be diligent in making your payments on time and keeping track of all your lines of credit. Having an exemplary credit score is one of your best assets! And, as a real estate investor, it will make your life much easier.
Principle #3 – Choose the Right Lender
When it comes to mortgages, banks are not one-size-fits-all. Investors must be diligent in choosing their lending partners. One aspect to consider is the experience your lending has in dealing with investors. Some less experienced lenders may shy away from a larger volume of mortgages that can come with investor clients. At the same time, a national bank may not always be your best bet!
Local and regional banks – smaller lenders – may be more flexible with terms and rates. Sometimes that room for some negotiation makes all the difference in the world!
Financing Challenges for Investors
Challenge #1 – Rising Interest Rates
In a bid to ease inflation, interest rates are up. In the long view of historic interest rates, topping 6% isn’t all that shocking. After all, mortgage interest rates hit an all-time high of 18.4% in late 1981. By comparison, today’s rates don’t seem all that bad. The problem, however, is that high home costs make every fraction of a percentage that much more impactful on one’s monthly payment.
Because of this, investors should take advantage of every opportunity they have to secure a lower interest rate through the diligent stewardship of their financial circumstances. Keep interest rates in the forefront of your mind as you consider the prices you’ll pay for real estate.
National 30-Year Fixed Mortgage Interest Rates VS Median Home Price
Challenge #2 – Lack of Liquidity
Real estate is not a particularly liquid asset. In general, it’s considered illiquid because there are long transaction times, various holdover periods, and significant transaction fees. If you want to turn a real estate asset into pure cash, it’s going to take some time. Real estate should not be your first financial line of defense in an emergency because of these timelines. Focus on bolstering your savings, leverage, and other means to cover the unexpected and scale your portfolio.
Challenge #3 – Overleveraging
Utilizing leverage is one of the best strategies available to real estate investors. This means we acquire properties through debt (the mortgage) and equity (the value of the property minus debts). An over-leveraged property means that the LTV (loan-to-value) ratio is high. Investors may have suffered loss in property value or made too small a down payment. It can result in the inability to make payments or handle operating expenses due to the burden of debt.
Your Options: Loan-Based Financing
Conventional Bank Loan
How It Works: The most common form of financing for real estate. You approach a financial institution, and they offer to lend you money based on factors like income, credit history, down payment, and your overall ability to handle and pay off the loan on time. Your interest rate is impacted by things like credit score and the percentage of the total loan you’re willing to put down. The more you’re able to put down, the more trustworthy the institution’s perception of you.
Pros: The greatest advantage to traditional bank lending is leverage. You’re buying real estate without having to pay for it in full upfront. Some savvy financing combined with smart number crunching can maximize your rental property profits. Investment properties tend to come at higher interest rates than primary residences…but still lower than some of the other financing options you’ll see on this list.
Cons: Because you’re taking on a debt, you’re automatically taking on risk. If you encounter a property vacancy for any length of time, you’re going to be on the hook for the mortgage payment yourself (versus utilizing rent payments to meet your monthly debt obligations).
And, if you’ve ever bought a home, you know that acquiring bank financing can be a long process. If you’re considering investing in real estate, get preapproved ASAP!
Private Money Loan
How It Works: Investors approach private individuals willing to give them a loan. They profit by charging interest and by investing in reputable owners who will increase the value of the property in question. Investors typically don’t need to utilize private money loans unless they have a reason not to pursue a conventional bank loan, but it is an option if you’re in a tight spot!
Pros: The big advantage of private money loans is flexibility. Because you’re not dealing with a financial institution that is governed by a long list of rules, regulations, and lengthy processes, there’s considerable room for negotiation. You can really hammer out a deal that suits your individual needs. The timeline is shorter, and you have more room to get what you want from your lender.
Plus, private lenders are often willing to work with people the bank won’t touch – those with bad credit or “too many” existing mortgages.
Cons: Of course, there must be some cons. Private money loans tend to be shorter-term and saddled with higher interest rates. You might get out from under the debt more quickly than in a conventional loan, but your monthly payment will be considerably higher in the meantime. Finding a private lender, too, isn’t nearly as easy and convenient as contacting your local bank. It takes some time to build the right connections to find willing lenders.
How It Works: Hard-money loans are a variant of private money loans that are best suited for flippers, not buy-and-hold investors, but it’s worth mentioning. Hard-money loans involve the property itself as the hard asset: essentially holding it as collateral. In this short-term structure, the lender provides funding until the property is sold for a profit or if the investor can secure traditional funding down the line.
Pros: The big draw here is speed. With a hard money loan, you could have funds within days. The lender is most concerned with your property – the hard asset and collateral – more than your credit score or other financial details.
Cons: You’ll get hammered by high interest rates. In 2020, the average interest rate for these types of loans was 11.25% – compared to the then record-low 30-year-fixed rate of around 3%. Investopedia calls hard money loans the “last resort.” The terms here are short, with most borrowers planning to resell the collateral property within a year. Most of these loans have terms up to three years. If for whatever reason the borrower must default, the lender would own the property and benefit from its resale in full.
Home Equity Loan
How It Works: Commonly referred to as a second mortgage, these types of loans allow you to borrow against your existing home equity. They’re based on the difference between your property’s current market value and the remaining mortgage balance. For example, if you have a $100,000 mortgage balance remaining on a property worth $250,000, you will use your equity ($150,000) as collateral for the lender.
Typically, you would be able to borrow 80-90% of the CLTV ratio (combined loan-to-value) based on the latest appraised home value. Like a traditional loan, your borrowing limits and interest rates are also based on your credit score and financial report card.
Pros: If you’re a responsible borrower, a home equity loan could be a great option. Though you’ll be looking at a higher interest rate on a second mortgage than on a first, it will be lower than the rates on credit cards or unconventional loans. If you have a clear idea of how much money you need and precisely what you want to use it for, a home equity loan could serve you well.
This type of financing isn’t used exclusively for obtaining more real estate, either: it’s often used in the pursuit of other financial goals like remodels, debt consolidation, and other “big” financial goals that demand a large lump sum.
Cons: Home equity loans are fairly easy to secure, which can result in a cycle of debt difficult to climb out of! It’s common for borrowers to fall into a habit of reloading: which is a “rob Peter to pay Paul” approach wherein loans are taken out to pay existing debts and gain more lines of credit, which the borrower then uses to fall further into debt.
This can result in loans that aren’t fully secured and interest payments that are no longer tax-deductible.
How It Works: Portfolio loans aren’t too different from conventional bank loans. The real difference is that the portfolio lender (the bank or financial institution) does not have its loans resold on the secondary market to the likes of Fannie Mae and Freddie Mac. Because of this, the lenders can set their own terms versus sticking to the strict guidelines dictated by secondary buyers.
Pros: Without the imposition of additional guidelines from the secondary market, lenders are allowed to set more favorable terms – terms that make it easier for borrowers (investors and self-employed individuals in particular) to secure financing.
Cons: Typically, lenders who offer portfolio loans don’t advertise it. If you’re after this type of financing, you’ll need to build up a network or contact lenders and ask them point-blank. Additionally, you may be charged a prepayment fee along with high interest rates considering the extra risk they may be taking on.
How It Works: A 203K loan, otherwise known as an FHA 203(k) loan, is issued by the government for one of two purposes: purchasing a property and funding property renovations. The idea is that the mortgage is essentially a construction loan that focuses on rehabbing and repairing the borrower’s primary residence. It’s good to know what this financing method is, but it’s not for investors. It targets low- to moderate-income borrowers.
Pros: This financing method aims to address the issue of languishing older neighborhoods, incentivizing homebuying and rehabbing to revitalize the area. It’s most advantageous to lower-income households that may have a low credit score.
Cons: Not for investors. Additionally, borrowers will pay in terms of a monthly insurance premium, additional costs, and long timelines for approval in the program. Investors looking for something similar should investigate construction loans outside of the FHA program.
A Breakdown of Loan-Based Financing
Your Options: Other Types of Financing
All Cash Offer
How It Works: Perhaps obvious, this is when you buy a property outright with your own money. There’s no lender financing involved. While that technically makes this not a type of financing at all, it is a common investment strategy worth mentioning.
Pros: All-cash offers are extremely attractive to motivated sellers that don’t want to fool with the longer timelines and contingencies that can come with traditional financing. If you’re facing multiple bids on a property, it’s likely to give you an edge over other (sometimes higher) offers. It also means you won’t have to pay a mortgage each month – freeing up a significant portion of rental income to be pure profit. Plus, you’re not dealing with interest!
Cons: If you pay for a property in cash, you don’t get to benefit from leverage. Putting up 100% of the property price versus the 20, 25, or 30% down payment is a considerably bigger financial commitment. It’s just riskier and it slows down the frequency of further property acquisitions. It simply takes more resources to buy a property with cash, regardless of the discount you may score from the seller, and that means building up the resources for your next acquisition will take longer than if you were saving up for a more conservative down payment and partnering with a lender.
How It Works: SDIRA investing is rather complex – we’ve written about it extensively in the past – but this is a condensed explanation. This is a “self-directed” individual retirement account. The benefit here compared to a traditional IRA is that you can invest in assets that are usually prohibited by the traditional IRA structure: including real estate.
Your SDIRA is administered by another party – the custodian or trustee – but the account holder directly manages the account. SDIRAs can come in the form of a traditional IRA with tax-deductible contributions or a Roth IRA with tax-free contributions.
Pros: SDIRAs offer tax-free/tax-deferred account growth while also allowing the account holder to have agency in their investment decisions. The wider list of potential investments means higher diversification and opportunities for high returns. You’ll avoid capital gains on the sale of assets held by the SDIRA. All-in-all, SDIRAs are an attractive option for buy-and-hold investors looking to build long-term appreciation and portfolio diversification.
Cons: Because the account holder directs the account and what they invest in, your due diligence is paramount. The trustee isn’t allowed to give you their advice or input: you’ve got to do the research yourself. Additionally, this means that SDIRAs aren’t commonly offered, and you’ll often have to find companies and institutions that specialize in them.
SDIRAs must follow general IRA annual contribution limits. Your earnings cannot be withdrawn free of penalties until the account holder is 59.5 years old. While contributions can be withdrawn without fee or tax, your earnings are not the same. Be prepared to let your SDIRA do its thing without touching profits for quite a while.
There are also complicated fee structures and strict rules guiding SDIRAs that could result in hefty penalties. It’s also harder to exit an SDIRA investment. Regardless of the risks and complications, if you get a financial advisor on your side and know the SDIRA rules, it can be an enormously beneficial investing method.
A Brief IRA Breakdown
How It Works: This financing method turns home equity into cash. Essentially, you take out a new mortgage for a larger amount than your existing balance and get the difference paid to you in cold, hard cash. Your home or property is the collateral.
In a traditional refinancing structure, the borrower never sees cash – just a reduction in monthly payments. With a cash-out, you get to use funds in excess of the original mortgage payoff is yours to do with what you will.
Pros: Although a cash-out refinance means that you’ll extend the terms of your mortgage, it also could mean lower interest rates if you choose a strategic time to refinance. It’s also a good time to make any other changes to the terms of the mortgage agreement based on new and improved financial standing. Unlike a home equity loan, you’re not taking out a second mortgage here: you’re paying off the current mortgage and drawing up a new agreement.
Cons: Renegotiating your mortgage means that you may end up with a higher interest rate. It also means you’re left with less equity in your home. As it’s riskier for the lender, fees and costs associated with the transaction may be higher, too.
The real question is whether or not the cash you would get outweighs the risk of losing the property. If you are for some reason unable to pay the new mortgage or the value of your property goes down, you’ll wind up repossessed or underwater.
Home Equity Line of Credit (HELOC)
How It Works: A HELOC is a line of credit secured by your property as collateral. This credit is often issued as a credit card or checkbook. The amount is based on your home equity (the estimated value minus the balances of any mortgages, liens, etc.) While the amount may vary, well-qualified borrowers can expect to take out up to 85% of their equity in credit.
Pros: A HELOC can be a lot easier to secure than refinancing. This credit also has a “draw” and a “repayment” period. The former only demands smaller interest-only payments. The following repayment period, however, means you’ll be paying more.
Cons: Though HELOC interest rates will be lower than credit cards and personal or private loans, you’ll encounter higher rates than with your traditional mortgage. These rates are often variable, too, which means you won’t get to lock in a favorable interest rate. Again, too, your home is up for collateral: and you risk foreclosure if you’re unable to pay.
How It Works: The latest and most cavalier method of raising money for investing is crowdfunding. You’re much more likely to be part of crowdfunding efforts than hosting them – but the idea is that an owner or developer allows investors to contribute to the cost of the investment piecemeal. You’re basically investing in shares and receiving dividends in a real estate space.
When a project is fully funded, investors begin to receive dividends. It’s best suited for individuals that want to invest in real estate but may not have the resources or experience to take full ownership.
Pros: Crowdfunding has a very low barrier to entry. If you do basic due diligence, finding a partner is easy and the amount of financial commitment demanded is low. For the inexperienced investor, it might be a good way to dip your toes in.
Cons: Crowdfunding means that you’re a part of a whole. Not the sole owner and not in charge of the investment’s trajectory. You have considerably less agency – it doesn’t extend beyond the choice of the initial investment. You’re looking at smaller returns and no benefits from an exit strategy.
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