What are the Different Types of Real Estate Investment Loans?
Investing in real estate offers numerous advantages and opportunities that make it a compelling choice for savvy investors. It serves as a valuable safeguard during times of market instability when stocks experience downturns, and it provides various perks for those who own investment properties.
The possibilities in real estate investment are diverse and cater to different goals. One option is to acquire and hold land for future development, capitalizing on its potential appreciation over time. Another strategy involves property flipping, wherein investors purchase a property, renovate or improve it, and then sell it for a profit. Some individuals may choose to invest in a property for their elderly relatives to live in, benefiting from its appreciation when eventually sold. Additionally, real estate investment presents an opportunity to generate passive income by renting out properties, creating a steady stream of cash flow. These different approaches to investing in real estate allow for portfolio diversification, providing a level of security and potential for growth.
Contrasting with stock market investments, which often require minimal funds, real estate investments typically involve a higher initial cost. Once you have determined that real estate investment aligns with your goals, conducted thorough research, and identified a promising opportunity, the next step is to secure financing for your investment property. This aspect is crucial and warrants careful consideration to ensure a successful investment venture.
There are a multitude of options available when it comes to financing an investment property, each with its own set of requirements that borrowers must satisfy. It is crucial to carefully consider and understand the specific criteria associated with different types of loans, as selecting the wrong one can significantly affect the overall success of your investment. Prior to approaching a lender, it is imperative to familiarize yourself with the workings of various loan alternatives and their respective prerequisites. This knowledge will empower you to make informed decisions and increase the likelihood of securing financing that aligns with your investment goals.
Notably, future rental income is generally not factored into the debt-to-income (DTI) calculations, and most lenders expect borrowers to have a reserve of at least six months' worth of cash to cover both mortgage obligations.
Conventional Bank Loans
If you currently possess a primary residence, you are likely acquainted with the concept of conventional financing.
Conventional mortgages adhere to the standards established by Fannie Mae or Freddie Mac. In contrast to loans supported by the federal government such as those offered by the Federal Home Administration (FHA), U.S. Department of Veterans Affairs (VA), or U.S. Department of Agriculture (USDA), conventional loans lack federal backing.
In the realm of conventional financing, the customary norm for a down payment is typically set at 20% of the purchase price for a home. However, when it comes to an investment property, lenders may impose a higher requirement, necessitating a 30% down payment.
When applying for a conventional loan, your personal credit score and credit history play a pivotal role in determining your eligibility as well as the interest rate applicable to your mortgage. Lenders also scrutinize your income and assets. It is crucial for borrowers to demonstrate their ability to afford both their existing mortgage and the monthly loan payments associated with an investment property.
Hard Money Loans
A hard money loan serves as a short-term financing option primarily suited for flipping an investment property rather than purchasing and holding, renting, or developing it.
While it is feasible to utilize a hard money loan to acquire a property and subsequently repay it with a conventional loan, private money loan, or home equity loan, opting for one of the alternative options from the outset proves more convenient and cost-effective if your intention is not to flip the property.
One advantage of utilizing a hard money loan for financing a house flip is the potential for an easier qualification process compared to a conventional loan. While factors like credit and income are still taken into account, the primary focus lies on the property's profitability.
The estimated after-repair value (ARV) of the property is used to assess whether you will be able to repay the loan. Furthermore, securing loan funding can be expedited, often taking only a matter of days, in contrast to the weeks or months typically required for a conventional mortgage closing.
However, it is important to note that utilizing a fix-and-flip hard money loan comes with its drawbacks. Interest rates for this type of loan can soar as high as 18%, depending on the lender, and the repayment time frame may be relatively short. It is not uncommon for hard money loans to have terms lasting less than a year. Additionally, origination fees and closing costs may be higher compared to conventional financing, potentially impacting your overall returns.
Private Money Loans
Private money loans involve borrowing from an individual rather than a traditional financial institution. Typically, these loans originate from friends and family members of the investor. If you do not have access to friends or family who can provide funds for your investment property purchase, attending local real estate investment networking events can be a fruitful way to connect with potential private money lenders. Notably, popular real estate investment platforms like BiggerPockets maintain directories of local real estate investment clubs where networking opportunities abound.
The terms and interest rates of private money loans can vary significantly, ranging from highly favorable to potentially predatory, depending on the relationship between the borrower and the lender. These loans are typically secured through legal contracts that allow the lender to foreclose on the property in the event of default. For those new to real estate investing, it is essential to carefully consider the potential impact on personal relationships if default occurs before signing any agreement with a loved one.
On the other hand, a cash-out refinance would offer a fixed rate but may extend the duration of your existing mortgage. A longer loan term could potentially result in higher interest payments for your primary residence. This aspect needs to be weighed against the anticipated returns that an investment property can bring in.
Tapping Home Equity
A fourth avenue to secure an investment property involves leveraging your home equity through options like a home equity loan, home equity line of credit (HELOC), or cash-out refinance. In most cases, it is possible to borrow up to 80% of the equity value of your home, which can be used towards the purchase, rehabilitation, and repairs of an investment property.
Using equity as a means of financing a real estate investment has its pros and cons, depending on the type of loan chosen. For instance, with a HELOC, borrowing against the equity is similar to using a credit card, and monthly payments often consist of interest-only installments. However, the interest rate is typically variable, meaning it can increase if the prime rate fluctuates.
Understanding the Requirements for Approval in Investment Property Financing
The specific requirements for approval of investment property financing can vary depending on the lender and type of financing. Private lenders, for instance, may prioritize having a personal relationship with the borrower as a key factor. Hard money lenders, on the other hand, may place emphasis on a thriving real estate market and a favorable estimated after-repair value (ARV). Lenders offering home equity loans, home equity lines of credit (HELOCs), and conventional loans typically have stricter criteria regarding income and credit scores.
Choosing between a Home Equity Loan and a HELOC for Investment Property Financing
While home equity loans and HELOCs share similarities, there are crucial distinctions between the two. If your intention is to purchase a single property and require a specific amount of funds for the purchase, repairs, and rehabilitation, a home equity loan is a suitable option. Conversely, if your plan involves buying and selling multiple properties in rapid succession, a HELOC offers greater convenience. With a HELOC, you have revolving access to cash, allowing you to draw from and pay down your credit line with each purchase and sale. This eliminates the need for multiple home equity loans and their associated repayment processes.
The Final Verdict
Investing in rental properties or undertaking house-flipping projects entails inherent risks, but they also hold the potential for significant rewards. Acquiring the necessary funds to seize investment opportunities should not be a major obstacle if you know where to seek financing. As you evaluate different borrowing options, it is important to consider both the short-term and long-term costs associated with each choice and how they can impact the overall profitability of the investment.