Financing The Deal - Options
On your first deal, you don’t want to get into anything too creative. You can go to workshops that focus specifically on creative financing, however there are reasons banks and other lending institutions won’t touch these deals. Creative financing increases the risk exponentially. Once you’ve got a deal or two under your belt, your ability to absorb more risk and play around with financing is much greater. By this point, you will be a savvier investor therefore, your increased risk on the financing side will be offset with your increased knowledge on the investing side.
It is important to begin with the financing side of things once you’ve committed to investing in real estate. Simply put, what are you approved for? Better question, what are you comfortable with?
Building relationships with banks/lenders as well as private lenders will become a very important job. If you are serious about starting a life in real estate investing, it will be a crucial task. Eventually, you want to be able to call your bank or private lender and get a quick ‘okay’. It is a great feeling when someone on the other phone line trusts you and your ability enough to invest their capital with you.
Today, we will focus on the financing options most banks will offer. We will also look at a couple simple "creative" financing options as well.
The 30 and 15-Year Fixed Mortgage
Prior to the 1930’s, homeowners would take a mortgage out on the purchase of their home and be required to pay it back within 5 years. When the Great Depression hit, lenders were cautious. To help lending spur the growth of the economy, the Federal Housing Authority (FHA) was created. The FHA began to insure loans with lower down payments and longer payback periods of 15-30 years.
These 15- and 30-year loans are amortized over the respectful time periods. Meaning that a portion of the principal balance along with accrued interest is paid each month to eventually decrease the balance to $0, at the end of the specific time period.
The best part of old faithful is the ‘fixed’ portion. Rather than being adjustable or a floating rate, the interest rate is constant over the entire length of loan. So long as you don't refinance, you have locked in your interest rate for the life of your loan.
Taxes and insurance will make up the variable portion of your mortgage payments. These expenses will more than likely, be included in your monthly payments. When you make these payments, your lending institution will escrow these funds and disburse them when they are due. Each year, they will be adjusted, more than likely, they will increase. Your principal and interest portions of your payments will remain constant while your taxes and insurance fluctuate over the next 30 years.
The advantage of this financing tool as an investor is it allows you to lock in a significant amount of your monthly costs. These costs will stay constant over the next 15 to 30 years. The biggest benefit of this being that the investor has flat costs, while your rents should appreciate over time. With flat costs in your principal and interest payments and appreciating rents, your net cash flow should increase over time.
The 15- and 30-year fixed loans are the most widely used tools to finance real estate.
The Adjustable Rate Mortgage
Banks are just like any investor; they want a return on their investment. Adjustable Rate Mortgages are the carrots that these institutions dangle in front of customers. Unlike the 30-Year Fixed Mortgage, the Adjustable Rate Mortgage, can do just that, adjust.
There are many types of ARMs, but the most common are 5/1, 7/1 and 10/1. These numbers correlate to the number of years the interest rate of the loan will be fixed; 5, 7 and 10 years respectively. At that time, the interest rate will increase OR decrease depending on the index it is tied to. It will be able to increase once (1) per year. Many of these ARMs are still amortized over 30 years which makes the payments very affordable.
These types of mortgages will typically have a maximum increase or decrease allowed, “5/2” for example. This means the interest rate on the loan can only increase or decrease by a maximum of 2% per year and 5% in total overall.
When the interest rate DOES adjust, it will adjust based off of the current principal balance outstanding.
Lets look at this in hard
Purchase Price: $300,000
Loan amount with a down payment of (25%): $225,000
Monthly Loan Payments: 7/1 ARM with an initial Fixed Rate of 5% = $1,207.85 *
*NOT INCLUDING Property Taxes and Insurance*
YEAR 8. The index in which the interest rate is tied to increases by 1/4 of a percent. Therefore, your interest rate and monthly payments will increase. The remaining principal balance of the loan is at $197,492.81.
Monthly Loan Payments in Year 8: New Interest rate of 5.25% = $1,233.85 - a 2.2% monthly increase in your principal and interest payments or $312 per year.
YEAR 9. The index in which the interest rate is tied to increases by one (1) full percent. Therefore, your interest rate and monthly payments will increase. The remaining principal balance of the loan is now at $192,946.52.
Monthly Loan Payments in Year 9: New Interest rate of 6.25% = $1,346.63 a 9.1% monthly increase from the prior year’s payments and 11.49% increase from the initial monthly payments.
As you can see, this type of loan carries the possibility to dramatically change your monthly payments. However, there is a possibility the interest rates decrease and positively effect your monthly payments.
YEAR 10. The index in which the interest rate is tied to decreases by 1/2 of a percent. The remaining principal balance of the loan is now at $188,726.60
Monthly Loan Payment in Year 10: New Interest rate of 5.75% = $1,291.52 a 4% monthly decrease in your principal and interest payments or $661.32 savings from the prior year.
The Adjustable Rate Mortgage is a tool for investors to get into properties initially with a lower rate. The potential risk of interest rates increasing and making your investment no longer viable is present. Negative cash flow on a rental property is an unsustainable model. The best course of action would be, if you finance your investment with an ARM initially, to refinance out of the ARM as soon as possible. If not as soon as possible, definitely before it adjusts.
As mentioned above, one of your jobs as an investor will be to create relationships with banks and other private lenders/investors. The reason, besides "your net worth is your network", is that these relationships can bring deals to you. These banks and lenders will be on the lookout for deals for you, and who knows, maybe they are looking to offload a property of their own. If the latter occurs, there may be significant or 100% equity in the property by the investor. Enter, seller carry financing.
Seller carry financing has come under close regulation from the Dodd Frank Act. Real estate agents are no longer permitted to negotiate or get involved with negotiating the terms of seller carry financing. The buyer and seller will work together exclusively to come up with the financial terms and obligations.
The property will close with title transferring to the buyer while the seller will have a deed of trust recorded in their name with a supporting promissory note.
Seller carry financing in hot real estate markets can be hard to come by. It takes the right opportunity and right seller.
This type of lending is great for a buyer who makes a lot of their income in cash and tips. These individuals tend not to claim all of these tips and monies on their taxes. Thus, may not be able to qualify for a traditional bank offered loan. They may have a bunch of money saved up and can show a seller (lender) that they have the ability to pay.
These loans, as with anything carry more risk. Therefore, you can expect the interest rate and terms to be a bit more favorable to the lender.
If the seller is not interested in carrying the full loan, they could potentially carry a portion of the total loan needed. You’ll need to discuss with the bank if they will allow you to purchase the property with the seller taking a second position behind the lending institution.
Most banks will want to see that you are the one who is in fact, bringing the 25% down payment to the table. As discussed, there are many reasons for the 25% down payment portion, but the one significant theory is that there is more skin in the game coming from the buyer. That the buyer, you, would be less likely to walk away from the property if you have a significant sum of money put into the property.
If the lending institution does allow you to take a second loan on the property in the form of seller financing, the seller could cover any and all of the remaining 25% of the purchase price. The risk to the lender is higher, being in second position, so expect more stringent terms. A higher interest rate, specifically.
In reality though, there are many ways that you, the buyer, and the seller could structure the carry back note. You could have it being a fully amortized loan such as the 30-year fixed. Other options include interest only loans with a balloon payment. A balloon payment is one large lump sum due at the expiration of the loan. Another option would be a partial amortization with a balloon payment at the end of the term.
These properties and opportunities are most appetizing for owners who may want to avoid a big capital gains tax bill. They can do this by locking in their profit in the form of the sale, and take payments in the form of mortgage payments over many years. Investors may also be looking for alternative cash flow options without the headache of managing properties, and being the bank is one way.
Seller carries are a great way to get started in investing, but they are hard to find. Not many people are willing to explore and look for these seller carry possibilities. Finding these deals may be how you get your start. Getting a mortgage broker or attorney involved would be a great idea. This would be to make sure you are protected and not being taken advantage of in a usury way. Offering a premium in hopes of obtaining the seller carry financing may be worth the opportunity, but you’ll need to run the numbers.
Private Loan/Hard Money
There are individuals out there who may have money ready to lend. These investors may have access to funds with the intention of financing real estate. These individuals typically have a strong knowledge of real estate. They are now making money from lending funds to hungry, go getter real estate investors.
As with seller carry financing, which is a form of a private lending, these loans will carry substantially higher fees. Depending on the length of the loan, the asset (which will act as collateral) and the amount requested may all dictate the terms of the loan.
Here is what I expect when I am closing on a property with a traditional loan and 25% down payment. Without “paying down the interest rate”, I expect to pay about 2% of the loan amount in closing fees. So, for example, if I bought a property for $300,000 and put 25% down, the loan amount is $225,000. At closing, I am required to pay closing costs of the transaction. The title fees and lender fees along with prepaid expenses. What I estimate to be about 2% of $225,000 or $4,500 in closing costs.
I can purchase a home, put 25% down, pay 2% in closing costs and obtain a 30-year fixed mortgage at 4.5% interest. If I wanted to do that same transaction with a private lender it may look a little different. A hard money lender may charge 4 Points and 14% interest on a 6-month loan. A point, when discussing lending is a percentage point of the loan. $100,000, 1 point = $1,000.
2.5 Points and 7% interest amortized over 30 years, with a balloon payment in 7 years.
As you can see, lenders will charge more for a shorter loan. It costs them more and it is riskier. You will pay a premium to a private lender. Private lenders typically can't spread their risk over hundreds and thousands of borrowers and therefore charge you for that risk. If they are going to make you a loan, their return has to match their risk.
Business is simple. Pricing always comes down to supply and demand. If you want a loan bad enough and there isn’t anyone or any institution that is willing to loan you the money, you are going to pay for it in points and interest rates from a private lender.
What if you come across a deal that is a “can’t miss, home-run”? First, be careful when you find these deals and make sure to do your due diligence. Have a trusted advisor double check your work. If everything checks out, maybe paying the premium to get the hard money loan is worth the return. An example of a hard money loan:
Lets look at this in hard numbers:
Purchase Price of Opportunity Property: $210,000.
Estimated repairs to property: $40,000
Time from purchase, rehab to resale: 4 Months
Estimated “After Repair Value”: $310,000
Loan Details: $230,000 (you will put $20,000 of your own money into the rehab) at 14% with 4 points due at first closing.
Closing costs: $9,400
Projected interest over 4 months: $10,733
Resale Price: $310,000
Closing Costs in the sale side: 8% or $24,800.
All in costs (initial closing costs, rehab costs, holding cost or interest, and closing costs in the sale): $84,933
Even with $100,000 of buffer going into the deal, if all goes perfect and you sell for 100% of original list price, your profits are slim and your risks are huge. That is why these deals should not be taken lightly.
Using hard money is a great opportunity if you have a great opportunity. Hopefully you can build a relationship with the lender and be able to get better financing terms for future deals if you perform.
Closing Costs and Discount Points
As discussed above, most loans will come with closing costs. The lending institution will want to run credit checks, have the property appraised, make you prepay insurance, taxes, and other expenses. Here is a sample closing document from the buyer’s side, detailing all of the additional costs:
On a $280,000 purchase, we were responsible for paying an additional $7,742 in closing costs. Some of those costs are prepaid and we are the direct beneficiaries. Others, are purely fees paid to both the title company and lender to be able to finance and close the deal. 3% in fees to close this deal.
A lender may offer you the opportunity to "buy down the interest rate". They will offer you a decreased interest rate in exchange for discount points. A point is 1% of the loan amount. Different lenders will offer different rates for different prices. It could be worth shopping around to find the best deal in regards to buying down the interest rate.
The biggest discussion to be had here, is are paying points worth it while investing? To understand that, let’s look at some examples:
Purchase Price $300,000 - putting down 25%
Loan Amount: $225,000
Interest Rate: 4.5%
Monthly Principal and Interest Payments: $1,140.04
Option: Pay one point to lower your interest rate to 4.375% - Cost $2,250
New Monthly Principal and Interest Payments: $1,123.39 = Monthly savings of $16.65 or $199.80/year. This scenario will take an 11.25 years to pay back the initial $2,250 it cost to get a lower interest rate. If you decide to sell the property prior to the 11 years, the bank wins. If you keep the property longer than 11 years, you win.
Purchase Price $600,000 and putting 25% down
Loan Amount: $450,000
Interest Rate: 5%
Monthly Principal and Interest Payments: $2,415.70
Option: Pay one point to lower your interest rate to 4.75% - Cost $4,500
New Monthly Principal and Interest Payments: $2,381.44 = Monthly savings of $34.26 or $411.12/year. It will take 10.9 years to make up for the original cost of $4,500 to buy down your interest rate.
These numbers and scenarios are just to get you an introduction into the different ways to finance a property and how they generally work. I am not a licensed mortgage broker and do not offer advice on lending. I do however have experience in each and every one of the mentioned ways of financing real estate. There are plenty more ways to creatively finance a real estate deal, these are just the basics.
You know have an idea of the different financing options to pursue your real estate investments. Go and introduce yourself to 2 lenders. A mortgage broker and the mortgage specialist at your bank.