Real Estate Investing Financing Strategies
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Real estate purchases, whether as a residence or an investment, is one of the biggest purchases most people will make in a lifetime. It follows then that understanding the ins and outs of the process is vital in ensuring you get the best property for your money. This article will seek to clearly illustrate the process, define key terms, and provide excellent financial strategies that can bring you the best results.
What is a mortgage?
A mortgage is a legally-binding document you sign at the time of purchase. A mortgage allows the lender to claim the property if you fail to pay the loan. Signing a mortgage can be intimidating - especially for first time buyers - as you are committing to paying 10s to 100s of thousands of dollars over a time frame of typically 15-30 years.
Your standard mortgage is comprised of the principal, interest, taxes, and insurance payments.
Principal payment: this is the actual amount of money you borrowed. Your monthly mortgage payment covers a portion of your principal.
Interest: this is the money you pay in order to have the loan. Interest rates vary based on your credit score, the purchase price, your down payment, and the amount, term, and type of loan.
Taxes: property taxes are typically included in your mortgage payment; your lender keeps this money in an escrow account and pays it on your behalf when your tax bill is due.
Insurance: Private mortgage insurance (PMI) is required when your down payment is less than 20% of the purchase price. Lenders will allow you to remove the PMI once you’ve paid 20% of your loan. There are options to essentially drop your PMI through home refinancing or appraisal.
There are many types of loan options that will appeal to different buyers - those for military veterans, and others who live in rural areas. Whatever your personal situation and preference, there is a loan for you!
Fixed-rate loans: this is the most common type of home loan, as the interest rate remains locked in for the duration of the loan. Most fixed-rate loans are offered with 15 or 30 year options.
Pros of 30 year:
Lower monthly payment, higher cash flow
Ability to afford a more expensive home
Free up funds to invest in other lucrative options (potential to offset savings you’d have with a 15 year option)
Cons to 30 year:
Higher PMI
Higher interest rate
Pay more interest in the long run
Takes twice as long to pay off your property
Ultimately, there is no objectively “better” option. Whether you decide on a 15 or 30 year mortgage will depend entirely on your personal and financial goals, and your desired property. When just starting your investment portfolio, it may be in your best interest to go with 30 year mortgages, as this will allow you to build cash flow and scale faster. In later years as you approach retirement, you may consider switching to 15 year mortgages as you seek to pay off your properties.
Adjustable-rate loans: an adjustable-rate loan (ARM) changes over time. The most common types are 3/1, 5/1, and 7/1 - meaning your interest rate is set for 3, 5, or 7 years and adjusts annually for the remaining portion of the loan. The benefit is the low rate on the front end; but you don’t have this rate locked in for long.
Government -backed loans: this loan is subsidized by the government, which provides protection for lenders against default on payments. These loans can have higher closing rates and lower interest rates, and include: veterans administration (VA), federal housing administration (FHA), and U.S. Dept. of Agriculture’s Rural Development (USDA).
FHA loan program: this is a popular option for many first time home buyers, as it offers such benefits as: minimum down payment of 3.5%; gifted down payment from an approved source; minimum credit score of 580; lower interest rates than many conventional loans, etc.
Talk to your bank or lender about what loans you may qualify for, and what options make the most sense for you.
How much mortgage can you afford?
There are several factors that lenders use to determine your loan amount, including:
Your debt-to-income (DTI) ratio: i.e. total assets less your debts (loans, credit cards, etc.)
Your loan-to-value (LTV) ratio: this quantifies the size of the loan taken out against the value of the property securing the loan.
Your credit score: there is a range of ideal required credit scores depending on the type of loan you are seeking. An FHA loan will require 580+, while most conventional loans require 620+. If you need to boost your credit score you can try paying off debt (including high interest credit cards); pay bills on time; increasing your income with a second job or “side hustle;” etc. Remember there is no quick fix to improving a credit score - it takes time and diligence.
Your down payment
Your down payment is the money you give to the seller to finalize your purchase. Conventional loans require a 20% down payment, but there are several ways to obtain a lower payment, including the 3.5% FHA loan. A conventional loan may offer a lower payment depending on the size and the borrower’s credentials.
How much should you put down will be determined by several factors, including your savings, the loan amount, your credit score, marital status, age, etc. While putting more money down will lower your monthly payments, it’s important to consider your overall financial situation and goals. If your goal is to scale your investment portfolio more quickly, you can achieve this by wisely using borrowed money. If your goal is to pay off debt you might consider putting more money down or even purchasing a property using cash or private money. Know that not all debt is bad debt, especially when you can leverage favorable interest rates to purchase cash flowing assets, like a rental property.
Paying off your mortgage
You can pay off your mortgage more quickly to avoid exorbitant accrued interest through several means:
extra payments: A 30 year fixed rate loan for $200K with a 4% interest rates, and monthly payments of $955 would ultimately cost you $343,739 (of which $143,739 constitutes interest). But paying an additional $100 per month would save you more than $26,500 on interest, cutting your loan term by about 4.5 years!
bi-monthly payments: Because there are 52 weeks in a year, bi-weekly payments gives you a total of 26 payments/year, which is two more total payments than if you made two payments each month.
Example: Assuming a $100,000 30-year mortgage at a fixed interest rate of 6.5%, you'll pay $127,544 in interest, plus the $100,000 principal, for a total of $227,544. Paying one-half of your regular monthly mortgage payment every two weeks will result in interest of $97,215, a savings of $30,329! This truly is a fantastic method which can help you pay less interest over time, pay off your mortgage faster, and build equity faster.
Utilize a HELOC (Home Equity Line of Credit): this is a secondary mortgage loan based on the equity in the borrower’s home. Rather than receiving a lump sum from a lender, the loan essentially acts as a credit card in which the user can periodically take out sums during the drawing period.
Example: say you purchased a home for $400k, and you currently owe $300k on the loan. If your home appraised at $600k, you’d be eligible for a HELOC worth about $240k (80% of the equity: $600k - $300K).
While HELOC’s can be a valuable financing tool, it’s important to consider several potential downsides, including: variable interest rates; frozen credit lines if your property value drops; and your home being put up as collateral should you default on the loan.
Closing costs
Closing costs include the expenses of attorney’s fees, title insurance and search fees, taxes, lender costs, home owner’s insurance, etc. Some of these costs are fixed, while others are negotiable. A good real estate agent will know how to negotiate with the seller to cover some of the fees. You can typically count on budgeting 2-5% of the home purchase price for closing costs.
Most home buyers don’t realize they have the leverage to negotiate not only the purchase price, but potentially thousands of dollars in closing costs! It’s crucial to distinguish between pre-paid fees (i.e. property taxes that you’ll have to pay) , and recoupable fees (i.e. money you’ll pay to an appraiser for their service).
11 ways to reduce your closing costs:
Negotiate a lower escrow fee
Sign all escrow documents in person (will avoid mobile notary printing and mailing fees)
Ask the seller to pay all escrow fees
Ask the seller to pay title fees
Ask the seller to pay county and city transfer taxes
Avoid overpaying inspectors: shop around for multiple quotes from reputable professionals
Avoid unnecessary inspections: ask for an hourly rate or reduced price to match services required
Request repairs and credits from the seller
Get a mortgage that doesn’t cost you “points” (these points lower your interest rate but increase your upfront fees and may increase your total cost depending on the life of your loan).
Find a loan with lower fees: it never hurts to ask what fees can be waived
Negotiate your real estate agent’s commission fee
Always remember that everything is negotiable - most people simply fail to ask.
Financing strategies:
House Hacking: What is it? Buying an owner-occupied multifamily property, in which you live in one unit and have renter(s) live in the other unit(s), essentially having your renters pay your mortgage.
5 best house hacking strategies:
Traditional house hack: purchase a multifamily property with a 3.5% down FHA loan. The cash flow from your renters should cover your mortgage.
Living room: just like it sounds, you rent out the rooms and make the living room your bedroom
Single family home: rent by the room.
Trailer: purchase a trailer and live in your driveway while renting out the rooms in your house.
Luxurious house hack: purchase a property with an additional dwelling unit, and rent this unit.
Seller financing: an arrangement between a homebuyer and seller where the buyer purchases the property in installments - usually including principal and interest - until the property is paid off in full.
Example: You want to purchase a property selling for $100k, but you’re unable to get traditionalfinancing. The owner of the property offers to carry the contract, or finance the property Themselves. They ask you for $5,000 down with a 7% interest rate on the balance, amortized over 30 years for a monthly payment of $632.03.
While seller financing can be a win-win for both parties, one major caveat is the “due on sale clause,” in which the bank holding the preexisting mortgage can approach the seller and demand that the entire balance is paid in full immediately, or foreclose on you. So the goal in using seller financing is to find sellers who don’t have a mortgage.
These are just two of the many different financing approaches you can take when purchasing real estate properties. It’s in the best interest of all prospective home-buyers to be educated on this process, to have all their financials in a row before house-hunting, and to be willing to go out and find great deals!
Sources: https://www.biggerpockets.com/guides/ultimate-home-loans-guide/down-payment-on-a-house // https://www.biggerpockets.com/member-blogs/7392/46906-11-easy-ways-to-drastically-reduce-your-closing-costs
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