Financing Options
You can pay cash for your transactions if you want but unless you’ve got a few hundred thousand dollars in your sofa cushion it’s likely you’ll need financing. Even if you do have available cash in the bank it can be a better option to leverage. Borrow the funds needed to finance your transaction. Use “other people’s money.” And exactly where is that “other people’s money?”
That depends completely upon your transaction and the condition of the property. If you want to buy a rental property and hold it for long-term appreciation and monthly cash flow, as long as the property is in average-to-good condition you should head straight to a conventional mortgage lender.
If the property needs some serious work, so serious that a mortgage company won’t place a loan, you will need private funds. Here are the primary differences:
Conventional Loans
Forget FHA or VA loans or any other government-backed mortgage program, those are only available for a primary residence. For a rental purchase, you will need a conventional mortgage, one underwritten to either Fannie Mae or Freddie Mac guidelines. Most every mortgage company or bank has these two programs as their primary mortgage product. Why is conventional your best choice? Because you can finance the property up to 30 years with a fixed rate, the lowest rates available for rental homes.
Such loans require that you have at least 20 percent down although you can get a slightly better rate if you put down 25 percent. You will also need funds for closing costs that will include such items as lender fees, settlement charges, insurance and a host of others. Anticipate anywhere from 2 to 5 percent of the sales price for closing costs, although your lender will provide you with a complete list of potential charges.
With your first property you must qualify for the new mortgage without the benefit of the rental income the property provides. This is usually the biggest hurdle first-time real estate investors face but it also keeps most first-time purchases on the lower end of the investing scale. Once you file your first income tax return with a Schedule E attached, the form used to
calculate income and expenses on rental properties, a conventional lender will then allow rental income from your second investment to be applied toward your total gross monthly income. After the first, the rest is easy. However, when you reach 10 financed properties, most conventional lenders will stop there and another source of financing will be needed. Work with an experienced loan officer who can provide you with options.
But remember what we said earlier, the property must be habitable. It can’t be in such a condition that no one can live there.
Private Money
Private money is so-called because the loan is issued by an individual or a group of individuals who invest in real estate projects that don’t quite fit the box. A private lender can make a loan on mostly anything it wants but with regard to real estate it needs to understand the “story.”
The story is a financial narrative on what the existing property costs, how much it will take to rehabilitate the home and how much it will sell for. The private lender will issue enough funds to buy and rehab the property as long as you have decent, not necessarily pristine, credit and a down payment of at least 30% or more. Private loans are usually made only for as long as it will take to rehab the property and sell it.
You can expect higher rates and fees for such loans so it’s important that the math works out and then some, but a private lender has the ability to finance a property to get it in such a condition that any lender will place a loan on the property. For instance, a slab foundation shows cracks and the foundation must be repaired. A conventional lender will wait for the foundation to be repaired before considering any mortgage on it. A private lender just wants to make sure the numbers work out and there is a clear, reasonable exit strategy.
And if you’ve yet to make the connection, you can use a private lender to acquire and repair a home then use a conventional lender to finance the property and hold as a long-term rental. It’s completely your choice—fix and hold or fix and flip.
SUMMARY
- Using financing and other people’s money usually gives you a higher return
- Expect to fund 20% deposit and closing costs
- You need to qualify without the benefit of rental income from properties in year one until you’ve completed a tax return including their income
- You can finance up to 10 properties with conventional lenders
