After a big increase in housing prices over the past year, it appears that the market is beginning to slow. Nevertheless, price changes remain positive. The good news is that interest rates are still low, presenting an opportunity for prospective real estate investors who aren’t sitting on piles of cash.
While selecting a great investment property is difficult enough on its own, once you’ve found that perfect house or apartment, how do you go about financing it? A little creativity and preparation can bring financing within reach for many real estate investors.
Here are five tips to finance investment property:
- Make a sizable down payment
- Be a “strong borrower”
- Turn to a local bank
- Ask for owner financing
- Tap your home equity
If you’re ready to borrow for a residential investment property, these tips can help improve your chances of success.
1. Make a sizable down payment
Since mortgage insurance won’t cover investment properties, you’ll generally need to put at least 20 percent down to secure traditional financing from a lender. If you can put down 25 percent, you may qualify for an even better interest rate, according to mortgage broker Todd Huettner, president of Huettner Capital in Denver.
A larger down payment gives you “more skin in the game” and therefore more to lose if the investment doesn’t work out. That can be a powerful incentive, and a larger down payment also provides the bank greater security against losing its investment. If the investment goes poorly, you’ll lose your whole stake before the bank begins to lose any money in the property.
If you don’t have the down payment money, you can try to get a second mortgage on the property, but it’s likely to be an uphill struggle.
2. Be a “strong borrower”
Although many factors — among them the loan-to-value ratio and the policies of the lender you’re dealing with — can influence the terms of a loan on an investment property, you’ll want to check your credit score before attempting a deal.
“Below [a score of] 740, it can start to cost you additional money for the same interest rate,” Huettner says. “Below 740, you will have to pay a fee to have the interest rate stay the same. That can range from one-quarter of a point to 2 points to keep the same rate.”
A point is equal to one percent of the mortgage loan. So a point on a $100,000 loan would equal $1,000. (Here’s when it’s worthwhile to buy points.)
The alternative to paying points if your score is below 740 is to accept a higher interest rate.
In addition, having reserves in the bank to pay all your expenses — personal and investment-related — for at least six months has become part of the lending equation.
“If you have multiple rental properties, (lenders) now want reserves for each property,” Huettner says. “That way, if you have vacancies, you’re not dead.”
3. Turn to a local bank or broker
If your down payment isn’t quite as big as it should be or if you have other extenuating circumstances, consider going to a neighborhood bank for financing rather than a large national financial institution.
“They’re going to have a little more flexibility,” Huettner says. They also may know the local market better and have more interest in investing locally.
Mortgage brokers are another good option because they have access to a wide range of loan products — but do some research before settling on one.
“What is their background?” Huettner asks. “Do they have a college degree? Do they belong to any professional organizations? You have to do a little bit of due diligence.”
4. Ask for owner financing
In the days when almost anyone could qualify for a bank loan, a request for owner financing used to make sellers suspicious of potential buyers. But now it’s more acceptable because credit has tightened and standards for borrowers have increased.
However, you should have a game plan if you decide to go this route.
“You have to say, ‘I would like to do owner financing with this amount of money and these terms,’” Huettner says. “You have to sell the seller on owner financing, and on you.”
This game plan shows the seller that you’re serious about the transaction and that you’re ready to make a real deal based on the practical assumptions that you’ve presented.
5. Tap your home equity
If you have a significant amount of equity in your primary residence or other investment property, you can use it as a form of financing. If you want to tap your home equity, there are a few ways to go about it.
Home equity loan
One option for leveraging your home equity is a home equity loan. The advantage of these loans is they are secured by the equity in your home. This allows the interest rates to be relatively low with repayment terms up to 30 years. For those with good credit, interest rates can be even lower.
A home equity line of credit (HELOC) is another way to tap your home equity. These loans are also secured by your home equity, but in this case, you draw the funds as needed instead of as a lump sum. HELOCs can have interest rates lower than home equity loans, but the interest rates are variable. Thus, you could find yourself paying a higher interest rate on your HELOC in the future.
A cash-out refinance cashes out your existing mortgage and replaces it with a new, larger one. It then gives you access to the difference between the old mortgage and the new one in the form of cash. You can then use that cash to finance your investment properties. The new loan often has a lower interest rate or shorter repayment term as well.
Other creative financing options
If all else fails, sometimes you have to get creative. Fortunately, there are several other available options to finance your investment property.
Peer-to-peer lending has become popular in recent years with several lending platforms popping up online. This is a way for investors to connect with borrowers who need financing for various purposes. Investors like them as a form of alternative investment, but, of course, there is also someone on the other side. Fees and interest rates are generally low, depending on creditworthiness.
Fix-and-flip loans, as their name implies, are generally short-term loans intended for house flippers. These are hard money loans with interest rates typically in the range of 12 to 18 percent, plus two to five points. If you come across a property you would like to fix up and sell in the next 12 to 18 months, a fix-and-flip loan might be worth a look.
Life insurance policies
Life insurance may be considered a liquid asset (depending on the type), which is preferable for lenders. In particular, a permanent life insurance policy gives you easy access to cash. You can borrow against that money which can help when purchasing a new home. This makes you more attractive to lenders and could make it easier to secure financing.
Credit cards and personal loans
Credit cards and personal loans can be an easy way to finance part of your home purchase. Some credit cards have zero percent introductory offers and personal loans may let you borrow up to about $100,000.
While both are a convenient form of financing, personal loans often have high interest rates, as do credit cards after any introductory offers. Thus, this shouldn’t be your first option, but it can provide some additional financing in a pinch.
Margin loans are a line of credit that can be used to finance a property and are backed by a borrower’s investments. They’re typically used as a short-term funding tool and come with a number of risks such as margin call and amplified losses if your investment portfolio declines in value.
Use real estate to create retirement income
Real estate is a popular way for individuals to generate retirement income. In fact, it’s now Americans’ favorite long-term investment, according to a recent Bankrate study.
That popularity partially relies on real estate producing a steady stream of income, as investors collect a regular monthly rent from their tenants. For retirees, a steady income is exactly the kind of security that they’re looking for when not fully employed.
And retirees have upside on that income. Over time, a well-managed property can increase its rents, putting more money into investors’ pockets each month. The property can also increase in value, so when it comes time to sell or even invest in another property, there’s equity that can be tapped. Of course, investment property has other advantages, especially around taxes.
If you don’t want to get into managing property directly, you can buy it via real estate investment trusts (REITs) in the stock market and let a professional manager deal with all the problems. REITs are tremendously popular with retirees because of their steady dividends.
Real estate is usually a long-term game where the gains tend to come over time. But however you invest in real estate, you can make money if you follow smart principles of investing.
When financing property, make sure you can afford the payments when you take out the loan. Then as you pay down the loan over time, consider how you might be able to reduce the interest expenses even further based on your solid borrowing history and lower outstanding loan balance.
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Note: Jennifer Acosta Scott wrote the original version of this story. Bob Haegele also contributed to a recent update.