Whether you’re diversifying your investment portfolio, hedging against inflation and a volatile stock market, or simply trying to establish a passive income stream, investing in real estate offers many key advantages over other investment strategies.
But as the cliche goes, you have to spend money to make money. Unless you’re sitting on a stockpile of cash, you’ll need to borrow capital to get a foothold in the market and start building your real estate portfolio. Fortunately, there are several types of investment property loans available and a seasoned real estate investor will take advantage of all of them as needed, depending on the situation.
So what are your options for finding financing and which one makes the most sense for you? Here are five possible routes you should understand before making a decision.
1. Conventional Financing
Taking out a conventional mortgage is the most common way real estate investors buy new investment properties. That being said, you should be ready to place around a 20% down payment, which can be hard for people who are new to real estate investments. You will also need a solid credit score (preferably 740 or more) to qualify for affordable interest rates that won’t eat into your profits. Finally, be prepared to prove that you have enough liquid assets to make around 6 months’ worth of payments.
It may surprise you to learn that a standard mortgage is frequently the most cost-effective option – even compared to saving up and purchasing real estate outright. But the sooner you own a rental property, the sooner you can earn passive income – and that extra cash flow will often more than pay for the interest on your loan.
Of course, you’ll need to shop around for a good interest rate and pay attention to the fine print. There are often hidden fees that kick in once you have multiple mortgages, and you want to avoid as many surprises as possible when you’re getting started as a real estate investor.
2. Hard Money Loan
A hard money loan is typically issued by private investors and uses your assets as collateral. Because they aren’t coming from a bank, these loans aren’t as restrictive as mortgages. They’re much easier to qualify for than other kinds of property loans, and they have the advantage of quick approval. The process from start to finish can be done in a day, so they are a great way to beat the competition to the punch in areas with a lot of buyers. If you can provide a 25-30% down payment, you can usually qualify for the loan.
However, these are short-term loans, requiring repayment within 1-5 years, and they can be very expensive. Most people use hard money lending for property investments they plan to fix and flip as quickly as possible. Landlords generally can’t afford to pay off a hard money loan in the timeframe they are meant for. You can still use this option for purchasing rental properties, but you’d need to refinance it as soon as possible.
3. Private Money Lender
A private money lender is, in general, not a professional. Often they are a friend, relative, or business associate willing to take a risk to help you out because they trust you to make good on the loan. It may be a handshake deal, or there may be paperwork in case things go wrong, but there will never be as many formalities as there would be when financing through a bank loan or private lender.
The main disadvantage here is the consequences it could have on your relationship if there are any misconceptions about their return, or if you wind up losing their money on the deal. But if everything works out, a private loan can be the perfect way to enter the world of real estate investing when all the other doors are closed to you.
The major advantage of using private money lenders is the flexibility you can get with repayment. Your lender may be perfectly willing to wait until you have rental income before you start paying them back, and some of them may not care about interest rates, as long as they get their investment back.
Occasionally, you may be able to find a seller willing to privately finance the purchase of the property. But even the most generous of sellers aren’t usually willing to offer long-term financing like a bank would (e.g. a 15- or 30-year mortgage), so you should expect high monthly payments in the rare instances this option is available. But because you aren’t constricted by banking regulations that set interest rates, this option can help you get far more value for your money.
4. Federal Housing Authority (FSA) Loan
If you’re unable to qualify for conventional financing, either because your credit score isn’t good enough or you can’t make the down payment, you may still be able to get a loan backed by the FHA to finance your purchase. FHA loans can be a perfect entry point for first-time real estate investors. These loans are insured by the US government and require much smaller down payments – sometimes as low as 3.5%. The drawback here is that you’ll have to pay for mortgage insurance as long as you have less than 20% equity in your home.
There are two main disadvantages with this approach. First, you can only use FHA loans to purchase a property you will reside in for at least 12 months. This may not be an issue if you’re buying a duplex or a multi-family unit, meaning you can reside in one part of the property and have tenants living in the rest. Once you start making payments, your credit score will improve dramatically, and you can start saving money for a down payment using conventional financing for your next investment property.
The other disadvantage to FHA loans is that the property must be in a good, livable condition before the loan is approved. If an inspector finds any issues, they must be resolved by the owner. This can prolong negotiations if any surprises come up, and the owner may prefer to sell to another investor who isn’t restricted by FHA requirements. You’ll be limited to one FHA loan at a time, but as soon as you have built equity in your property, your purchasing power for future real estate will increase.
5. Home Equity Loan or Home Equity Line of Credit
There are two ways you can use the equity you have on any of your properties to acquire financing. Both are essentially second mortgages, which lets you draw on the equity you’ve built by paying down your home loan. Generally speaking, you can take up to 80% of the value of your home, minus what you still owe on it. This is known as your loan-to-value ratio, and different lenders may determine it differently. Let’s break down these two options.
Home Equity Loan
A home equity loan is a loan that uses the equity of the borrower’s home as collateral in exchange for a loan. The value of the home is determined by an appraiser which sets the eligible loan amount. This does not mean that the collateral has to be on one of your new investment properties. A borrower can take out a home equity loan on the home he or she currently lives in or any other home that the borrower owns.
The interest rate is generally higher than conventional financing. Like a standard mortgage, you will need to start making a monthly payment right away. If you already have a renter in a property, that means you already have the cash flow paying off the initial mortgage on the house. And if you can quickly get another tenant established in the property you buy with a home equity loan, then the monthly payments are taken care of for you already, and the profit will increase your monthly income almost immediately.
You can even take out multiple home equity loans on the same property, and use them for down payments on new mortgages – so long as you are not double-dipping by borrowing more than your actual equity in your investment. The risk here is that if your home loses some of its value, you’ll owe more on it than it’s worth. But by buying a property in neighborhoods with signs of growth, you can minimize this possibility.
Home Equity Line of Credit
A home equity line of credit works more like a credit card. It allows you to withdraw money as needed by using your equity as your credit limit, up to around 80%. One advantage of this is that some lenders don’t immediately require you start making payments on the amount you borrow, so long as you pay down the interest each month. This can be a great option for properties you want to purchase that need more work before they can be rented out.
The disadvantage is that you don’t have a set interest rate. And while they usually start lower than home equity loans, they can rise at any point. This may increase your monthly payments dramatically, which can eat into your projected profit margins. Finding a line of credit that will allow you to convert it to a fixed-rate mortgage is the best way to offset this possibility.
Both of these options are generally cheaper than other kinds of loans, which are far too expensive to use for a down payment on a home when you factor in the additional interest on the mortgage. And if you’re using them to purchase more investment properties, the interest you pay is tax-deductible.
Although you can have up to 10 mortgages at once, many lenders won’t offer you another if you already have four. But a home equity line of credit bypasses these restrictions (so long as you don’t surpass your debt-to-income ratio) by allowing you to purchase properties outright.
Of course, you will need substantial equity to do this, which takes time to build. But once your equity is established, this approach is a great way to expand an already-profitable investment portfolio. Bear in mind – you are borrowing against the value of your home, and if you default on it, your lender will take your property to recoup their loss. So don’t overextend yourself, and don’t rush into any new deals.
The Bottom Line
There is no one perfect rental property loan that fits all, and different circumstances will call for different kinds of financing. That’s why it’s essential to take your time and do your research. The more experience you gain buying investment properties, the easier these decisions will become.
It’s also crucial to remember that rental properties require a lot of work to manage. From placing tenants and processing payments to inspections and daily maintenance calls, being a landlord is a full-time job. The more time you spend dealing with your tenants, the less time you will have to focus on growing your assets.
That’s where Great Jones comes in. Our team of experts can take the hassle of day-to-day property management off your plate – so you can focus on building your portfolio and enjoying your income. Learn more about what we do.