30 Tips for Financing Your First Investment Property
Renters Warehouse Blog
30 Tips for Financing Your First Investment Property
Most people know that real estate can be an ideal investment.
In fact, property has long been the alternative investment of choice for many investors -thanks to the fact that it provides an excellent hedge against inflation, and offers the valuable long-term rewards of equity growth and appreciation. With rental property investments, there's the added benefit of immediate cash flow in the form of rental income each month. Not to mention, income property provides the opportunity for some decent tax breaks as well.
But for many first-time investors -getting started with real estate investments can be tricky. Not only is it overwhelming; navigating the ins and outs of real estate investing, it can also be difficult to secure traditional financing -especially when it comes to the 20 percent -or higher, down payment that banks often require for investment property.
If you're finding it difficult to meet the bank's strict lending standards -don't feel discouraged. The good news is that there are options available that can make it easier for you to get your foot on the property ladder. Familiarizing yourself with the myriad of different financing methods that are available for first-time investors will give you a considerable advantage -and help you to find a financing option that will work for you -one that will give you the best returns possible.
If you're interested in making your first real estate investment -but not sure where to begin, here are some tips that will help you to get started. Read on to see how you can secure a favorable loan, discover different financing options that are available to you as a first-time investor, and find out how you can choose a property that will provide you with a good rate of return.
Obtaining a Favorable Loan
1. Try to Make a Substantial Down Payment
If you're going to try to obtain a conventional loan, you'll want to start by ensuring that you have enough for a down payment -since a sizable down payment is something that will help you to secure the best interest rates possible.
If you're getting started as an investor, the bank will usually want you to come up with at a down payment that's at least 20 percent of the property's value. However, if that number sounds woefully out of reach to you, don't worry -there are other options available, including buying as an owner occupant -something that can help you to secure a more favorable loan.
Ready to start saving? Check out this list of advice from the experts on saving for a down payment. Ideas include budgeting for it, looking to create an additional stream of income, and seeking to slash expenses as much as possible.
2. Consider Paying Down Debt First
Next, you'll want to take a look at your debt-to-income ratio (DTI). This is one way that the bank will assess your ability to manage monthly payments. To calculate your DTI, divide your recurring monthly debt by your gross monthly income, the resulting percentage will show you -and the bank what your current DTI is.
A high DTI could signal that you have too much debt for your income level, and could negatively impact your ability to secure a favorable interest rate from the bank. It could even make it harder to obtain funding from alternative sources. In most cases, 43 percent is the highest DTI that you can have in order to qualify for a mortgage, although 36 percent -or lower, is preferable.
3. Maintain Good Credit
Before you start, you'll also want to check your credit score. If you're going through a bank, your credit score will have the greatest impact on the loan's terms -and you'll want to ensure that yours is high enough to qualify you for a low-interest rate. In most cases, a score that's below 740 can result in a loan with a higher interest rate, or -a requirement that you to pay a fee to keep the interest rate down.
You'll want to be diligent when it comes to your credit score. To maintain good credit, regularly monitor your credit score, always make your payments on time, and try to handle any errors or discrepancies as soon as possible. You'll also want to avoid over-utilizing your credit to keep your score high -try to maintain credit card balances that are lower than 30 percent of your credit limit.
4. Consider a Fixed-Rate Mortgage
When going through the bank, you'll usually have to option of choosing between a fixed or an adjustable-rate mortgage (ARM). With a fixed-rate mortgage, you'll be able to lock into an interest rate for the duration of your loan -but with an adjustable-rate mortgage, the interest rate will fluctuate.
ARMs usually offer lower introductory rates, making them attractive to many homebuyers -however, you'll want to keep in mind that while interest rates may currently be low, they could go up at some point in the future. Locking into a low-interest rate will protect you from seeing your monthly mortgage payment increase, should interest rates go back up. If you're thinking of choosing an ARM, make sure you understand the terms -and how this could affect your monthly payments.
5. Prepare Your Paperwork
Any lender is going to require proof of your financial situation -and will ask you to prepare some important documents. Be prepared to produce at least two months of banks statements -and if you're self-employed, you'll need to obtain a certified letter from your CPA that proves two years of self-employment. You'll also need statements for your investment and retirement accounts, at least two recent pay stubs, your driver's license, Social Security card; as well as any bankruptcy, divorce, or separation papers, if applicable.
Your lending institution will tell you what documentation you'll need to provide, but being prepared can help you to start the process of compiling the required documents early.
1. Buy As an Owner Occupant
As we touched on above, one of the most feasible ways to begin your foray into real estate investing -is by purchasing your first property as a primary residence, and living in it as an owner occupant.
Banks generally require a much lower down payment for an owner-occupant loan than they do for investor loans -think 5 percent down or even 3.5 percent if you qualify for an FHA loan, rather than the typical 20 percent, or higher-down payment that's usually required for an investment property. In most cases, as an owner-occupant, you will be able to qualify for a lower interest rate as well.
Just keep in mind that you'll want to check the rules surrounding owner-occupied property. Most banks will require you to reside in the home for a specific period of time, usually one year, before you will be able to sell it, or rent it out as an income property. Once the year is up, though, you'll be free to find another property -and will be able to purchase it as an owner-occupant, while keeping the first house as a rental, or selling it.
2. Obtain a Home Equity Line of Credit
If you already own your own home -and have equity, you may want to consider tapping into the equity and using it to finance your investment. A home equity line of credit, or HELOC, is relatively easy to get, and will save you from the hassle of having to finance the investment property itself. In many cases, you'll be able to borrow up to 80-90 percent of the home's total equity.
In many ways, the process of qualifying for a line of credit is similar to being approved for a regular mortgage. The bank will check your credit score, and verify that your income is sufficient to pay back the loan.
Keep in mind, though, that by using your home's equity, your home will become the security for the new loan, which means if you default on your payments, you could stand to lose the property. Be sure to talk to a home mortgage consultant for more details regarding this type of loan.
3. Use the Proceeds From a Cash-Out Refinance
Another option for homeowners is refinancing and using the money to buy an investment property. Of course, the feasibility of this option will depend largely on how low-interest rates are, as well as how much equity you have in the home -but with rising home values, you could have more than you might think. Once you've purchased an investment property, you can then refinance that property after a year as well.
4. Consider Exchanging Property
If you already own your own home, exchanging it for another property is another option. Consider exchanging it with a buyer for a property that will help you to reach your investment goals -such as one that will perform better as a rental, or, combine the property with cash to purchase the property that you want.
5. Look for "Subject-To" Financing
With subject-to financing, the existing financing will stay in place when you buy. This means that the title will transfer, but the loan will remain in the seller's name, while you will take over the payments and pay down the mortgage. Of course, if you don't make the payments -you'll lose the property, and the seller's credit will be damaged.
With subject-to financing, you won't have to come up with a down payment, making it ideal for many first-time investors. This option is sometimes available for pre-foreclosure properties since it allows the buyer to get in easily and quickly and take over payments immediately.
Keep in mind that this type of financing can be a bit tricky -most bank mortgages are not assumable, which means that when a homeowner sells a house, they'll be required to pay the loan off in full. If the bank finds out the home has been sold, there's always a chance that they will require the loan to be paid off immediately.
6. Assume the Seller's Mortgage
Assuming a seller's mortgage is similar to subject-to financing, but the key difference is that the buyer assumes liability for the deed of trust. If you were to default on payments, the seller would no longer have any responsibility.
This form of financing is an option that is sometimes available for foreclosure properties -in these cases, the homeowner is anxious to sell and more willing to be flexible. The buyer benefits since they'll be able to get the interest rate of the seller.
This was a popular option when interest rates are higher, but in recent years, with interest rates having been at near-record lows, assuming a mortgage isn't nearly as common. Still, it's an option that's worth bearing in mind -especially if you're having difficulties obtaining a low-interest rate.
7. Look for Seller Financing
If a seller owns a property free and clear, you can offer to buy it with owner financing. With this form of financing, the seller acts as the bank -they give you the title of the house but holding a note and security deed to the house. In exchange, you will make monthly payments to them. Should you stop making payments, the owner could foreclose on you.
Finding an owner who's willing to seller finance can be difficult -most sellers would rather receive the full amount for their property, and aren't interested in financing loans. Still, there are some sellers out there who are willing to go this route. Just be prepared to pay a higher interest rate than you would for a conventional loan.
Seller financing deals can be structured a number of different ways. In some cases, the seller can even take out a second mortgage on the property -in full or in part, for the buyer to pay down each month, with interest. An attorney will be able to draft up a contract with terms that both parties agree to.
To find home sales with seller financing, have a look at MLS listings. Check the property descriptions -and look for properties that say seller financing is available.
8. Find a Lease With an Option to Buy Property
A rent-to-own or lease-to-buy arrangement is a popular form of seller financing and a good way for first-time buyers to get started with real estate investing. With this option, you'll be able to rent the property for a period of time, usually two or three years, before obtaining a mortgage.
One of the benefits of a rent-to-own property is that it gives you some time to secure financing -or, to improve your credit score before attempting to buy. In some cases, you may even be able to apply all or part of the rent payments toward the balance of the home. Before entering into a rent-to-own agreement, you'll want to have an attorney draft up an agreement, to ensure that both you and the seller are on the same page.
9. Obtain a 203K Loan
If you're thinking about buying a fixer-upper or a property that's in need of repairs, you'll want to consider an FHA 203K loan. A 203K loan will allow you to secure financing to cover the price of the home, as well as the cost of repairs, for a low down payment -currently, 3.5 percent. Keep in mind, that just like with an FHA loan, you'll need to occupy the property as an owner-occupant, and reside in the property for a specific period of time before you will be able to rent it out.
10. Use Your Self-Directed IRA
If you have a self-directed IRA, you may be able to use the money for an investment property -without facing the stiff penalties that are usually involved when taking funds out. When structured properly, your rental expenses can be paid through your IRA, and the revenue will go back into the account, making your income tax-deferred -at least, until you take the money out. With a ROTH IRA, though, most of the income will have already been taxed, which means that in most cases, the income and appreciation on the property will be tax-free.
If you're considering using your retirement account, you'll want to consult a financial adviser to ensure that you don't lose out with taxes and penalties.
11. Use Your Self-Directed 401k
An IRA isn't the only option; a self-directed 401k can be used to invest in real estate as well. Much like using an IRA, with a 401k, you should be able to use the money to buy income property without having to pay penalties for taking the money out early. Just make sure you check with your financial advisor to ensure that you'll be clear of potential fees.
12. Consider a Hard Money Loan
A hard money loan is a short-term loan that's obtained from a professional private lender. This form of financing is often used by house flippers, who are usually after fast money, but they can also be used to purchase rental property -as long as the property is a good investment that has positive cash flow and a high chance of appreciation.
While the interest is generally higher on hard money loans, the benefit of this type of financing is that the loans are based more on equity in the property, rather than the strength of a borrower. They're also generally faster to obtain than conventional mortgage financing -and many hard money lenders will allow a buyer to borrow up to 100 percent of the purchase price -and in some cases, will even allow them to finance repairs as well. Hard money loans are usually structured to include both an interest rate -and a number of points (one point is equal to 1 percent of the loan) that are added to the loan or paid at closing. Interest rates for hard money loans are typically between 10-18 percent, with points that fall somewhere between 1-10.
If you're interested in hard money loans, be sure have a look at Bigger Pockets' helpful directory of private lenders to find hard money lenders in your state. Start by making a list, and then start reaching out to different lenders to see what options are available to you. In many cases, private funding can be used for a short-term solution, until conventional financing becomes available.
13. Consider Private Funding
Private funding is similar to hard money loans -but the difference is that usually private money lending is considered more relationship based. In most cases, you will obtain the funds from a family member, friend, or acquaintance that's willing to back your investment property -be it a house flip or a rental property.
Private funding works in a similar way to hard money loans, but there will typically be less formality than going through a professional lender. There will also usually be lower interest rates, somewhere between 6-12 percent is common. In most cases, there will also be fewer -or no points than there would be with hard money loan.
14. Find an Investment Partner
Another way to fund your real estate investment is by teaming up with an equity, or investment partner. While a private lender will receive interest for the use of their money, an equity partner will share in the proceeds of the rental property.
An equity partnership can be structured as 50:50 -or, however you choose to divide it up. If you sell the property, you can split the resale profits -or, if you keep the property as a rental, you can divide the income and share the responsibilities associated with the rental -such as property management, repairs, and maintenance. Just make sure you have an attorney draft up an agreement for you. Having terms that are in writing will ensure that both you and the other party are clear about what's expected of you, helping to prevent potentially costly misunderstandings.
15. Consider Going Through a Turnkey Provider
A turnkey provider is a relatively new concept, but it's an option that's quickly growing in popularity with many investors today. By going through a turnkey rental property provider, you'll be able to invest in a rental property that's already been purchased and rented and is being managed by a property manager. This type of investment makes it easy for you to buy rentals that are out of state -allowing you to take advantage of potentially better housing markets. Some turnkey providers will offer properties for down payments that are as low as 5 percent but keep in mind that lower down payments usually entail higher interest rates.
16. Opt for a Local Bank
By all means, shop around -but if you're having trouble meeting the bank's lending requirements -or making the full down payment, you may want to consider going to a neighborhood bank. A smaller bank will usually have more flexibility and may be willing to work with you to help you secure financing. You may also want to consider checking with mortgage brokers in your area. They'll have access to a wider range of loan products -and you may be able to find one that's a better fit for you. Just make sure you do your research -and see what options are available before making your decision.
17. Get Creative With Financing
If you have a property in mind, and you're confident that it will provide excellent returns -you may want to consider securing a down payment through creative financing. This could include paying for part of the sale with credit cards -or loans. You may also want to look into obtaining funding through peer-to-peer lending sites like Prosper.com and LendingClub.com -that match investors with individual lenders. Just keep in mind, that you may have a lower chance of successfully obtaining funding from lenders without a history of successful real estate investments. In some cases, peer-to-peer groups will also require you to have a high credit rating.
Additionally, while creative financing could make it possible for you to purchase a property without having to meet the bank's strict lending criteria, you'll want to make sure you research your investment thoroughly before turning to high-interest forms of cash. If you do turn to credit cards for a down payment or repairs and find that you can't pay it off right away, try to get another card that will allow a balance transfer. This will help to give you more time to pay off the balance, saving you from having to pay interest rates that could be as high as 17 percent. You'll also want to look into using a rewards card to finance repairs -just make sure you pay the balance off every month.
Securing the Best Deal Possible
1. Look Into Distressed Sales
According to recent reports from the National Association of Realtors, while home price growth has cooled recently, home sales are still on the rise in most markets. However, there are still bargains to be found in many areas. Most of these deals will come in the form of distressed sales -or, foreclosures. With foreclosures, you may be able to negotiate better deals since the bank will usually be in a hurry to get the property off of the books. You'll also want to look at pre-foreclosure properties -to see what you can find. Buying a distressed home or a pre-foreclosure property allows you to get started for less than market value -something that can have a significant impact on your returns.
2. Check Into Off-Market Properties
Off-market properties, or pocket listings, are homes that are for sale, but aren't listed on the multiple listing services (MLS) -these properties are purchased through word-of-mouth or direct marketing. An off-market property doesn't always guarantee a better deal, but sometimes you can come across owners with more flexible terms -they may be willing to seller finance, for example. In some cases, you can find properties that you can purchase with no down payment. Housing inventory is still limited in many markets across the states -and off-market listings can help you to find potentially better deals. Here's how you can start finding off-market properties.
3. Negotiate the Closing Costs
You'll also want to ensure that you have a clear understanding of what closing costs you'll face. These costs include appraisals, credit check fees, title transfer fees, title insurance, underwriting fees, and more. Tax escrow is one of the biggest costs that you'll face when closing -while not technically considered a closing cost, it's a significant expense nonetheless, and could easily end up costing you thousands of dollars. It's a good idea to check with your lender to obtain an estimate of closing costs so that you can know what to expect.
If you can, try to have the seller pick up some of the closing costs as part of the negotiation. Often, this will prove to be more valuable for you than a reduction in the asking price would have been. Any savings in the purchase price will be spread out over the length of the loan, and in most cases, won't amount to much more than a few dollars extra each month. But fewer closing costs can help you to save you from having to pay out -often thousands of dollars, at the time of the sale.
4. Start an Emergency Fund
Whether you go through a traditional lending institution or opt for a private loan, you'll want to ensure that you have enough cash stashed away for unexpected emergencies. Most banks and hard money lenders will want to make sure that you have six months of cash reserves available per property -enough to cover mortgage payments for your primary residence, if you own a home -and your future investment property. Even if you go through a lender that's more lenient in their requirements, it's still important to have adequate reserves to cover expenses should unforeseen circumstances arise.
5. Consider Investing in Other Housing Markets
You're not limited to housing that's in your own hometown, often; there are great deals to be found in housing markets across the country. While places like San Francisco or New York may be booming it's often unrealistic for first-time investors to get their foot on the ladder in these hot markets. Instead, try to look for up-and-coming areas in your search. Often, overlooked markets can have more opportunities for investment property. Make sure you do your research, check out the home value index to see how much home values have increased over the years, to gain an idea of what type of appreciation, if any, you can expect with the property. While some areas appreciate more quickly, in other locations, homes may not increase in value much at all, and you'll want to determine how important appreciation is to your investment strategy.
6. Be Realistic When Calculating Your Projected Profit and Loss
If you're looking for an investment property, you'll want to ensure that the property that you buy is one that will perform well, and give you the returns that you're after.
If you're planning to house flip, you'll want to take care that you realistically add up your expenses -as well as your projected profit. Don't base your estimates on pure appreciation -that strategy has left many an investor with an underwater mortgage.
If you're looking for an investment to use as a rental property, you'll want to calculate your projected income and expenses to determine your cash flow. You'll want to ensure that you're going to be generating the type of returns that you were hoping for. Be realistic when estimating your monthly rent -as well as expenses. Remember to include the mortgage, property taxes, insurance, maintenance, repairs, utilities -if you're paying them, and professional fees -such as accounting, attorney costs, and property management, if you're going to use a property management company. You'll want to factor in vacancies -since your property is unlikely to be occupied 100 percent of the time which means that you'll have to cover the monthly expenses during the months that the property is vacant.
You'll also want to survey the local rental market to get an idea of what you can expect in terms of rental income from your property. Start by looking at websites like Zillow and Trulia. Seeing what other, similar properties are going for show you what you can expect with your own property.
7. Assemble Your Team
In addition to obtaining financing, you'll also want to ensure that you have a great team by your side -especially if it's your first time investing in property. Financing your first investment property can be difficult -and confusing, and it's important to realize that you don't have to do it alone. Having a qualified real estate agent, insurance agent, and attorney by your side will help the process to go much more smoothly. If you're planning to rent the property, you'll also want to consider enlisting the services of a property manager -especially if you lack time to oversee the property yourself, or if you're thinking of investing in a property that's out of town. It's also a good idea to ensure that you have an experienced accountant who understands investment property strategies. Finding an attorney who is experienced in asset protection will also help you to form the right structure for holding your investment property -often, this will be a limited liability company -something that will help to save you from potential losses should something go wrong. According to Rich Dad Advisor, Garrett Sutton, holding investment property in your own name exposes your real estate and personal assets if a lawsuit arises.
Finally, you've done your research -you know what your options are and where you stand. Now it's time to take action. You won't want to be in such a rush that you end up buying an overpriced property, or purchase something that's not going to deliver the financial returns that you're after. But once you've done your homework, and everything checks out, at some point you're going to want to take the leap.
"The biggest deadly deal disaster of all is hiding behind analysis because you are afraid to pull the trigger on the deal," says Peter Conti, author of The Real Estate Fast Track: How to Build a $5,000 to $50,000 per Month Real Estate Cash Flow. "At a certain point as an investor, you will need to step forward in the deal and commit."
Consider getting involved with a real estate investment club, or finding a good financial advisor who will be able to answer your questions and guide you through the process. This will make it easier to determine whether a prospective property is a good deal; which can give you confidence that you need to make the final call.
Finally, as with any investment, you'll want to ensure that you purchase property that you can afford. The last thing that you'd want to do is to overextend your finances to the point of being unable to keep up with your payments. For this reason, it's a good idea to consult with a certified public accountant before making any decisions, to determine a course of action that's best for your financial situation, and to see how investing in property will impact you from a tax point of view.
As you can see -purchasing investment property cash-in-hand isn't the only option. Neither is obtaining a traditional bank loan. By taking into account all of the variables -and carefully assessing your financial situation, as well as exploring all available financing options prior to securing a loan will help you to gather the information that you need to make an informed decision -allowing you to confidently choose a financing strategy that will help you to get the best returns possible.
Are you interested in starting your own real estate investment venture? Which investment options sound the most promising to you?