Real Estate Financing

One of the most important aspects of real estate investing is the financing. Your success is largely dependent on how well you understand the different programs and techniques available to you, the investor. It is very important to know your goals and strategies before you finance a property. If you only plan to hold a loan on a property for 5 years, then there is usually no point in getting a 30 year loan. Keep in mind that there are many factors that affect the loan programs available. FICO scores, ratios, interest rates, etc. can have a dramatic effect on the financing you get and how well your portfolio will perform.

When purchasing new properties, keep in mind that construction can take 6 months to a year. There is a bit of a gamble that interest rates are not going to increase by the time your property is available. Interest rates can change and you may go from positive cash flow to negative cash flow unless you consider a different type of loan. The opposite is also true. Rates may drop and you may find that a so-so deal turns out to be a good one with better rates.

When making an offer on a property, request for the seller to pay 2% of the closing costs. In some instances you may have to offer 2% more than the asking price of the property to get the seller to pay for them. This allows you to buy the property with the least amount out of pocket. Instead of $5,000 in costs due at closing, you may only have to pay $2,000 for example. It’s another way to increase your leverage.

When you are purchasing property, make sure that the property is ready to rent. You will want to be sure that it is landscaped and has window coverings, garage door opener (if applicable), and the customary appliances for that area of the country. In some cases, in new construction, you might be able to have the builder add these items to the purchase price and then you can finance most of the costs. Ask your property manager what is customary for the area you are buying in. By putting the cost of these items into the price of the property, you again decrease your out of pocket and increase your leverage.

Down Payments

 Down payment requirements are different for owner occupied homes and investment properties. Typically banks require more down payment on an investment property because there is usually a higher rate of default. The higher risk of investment property loans also adds to the interest rate that the bank will charge. However there are many programs available to the investor.

The less money you put down, the harder it will be to get cash flow. However, your leverage will be greater. That means that your total return with appreciation can be much higher with 10% down than if you had put 20% down. You might need to be able to afford negative cash flow though.

For example, Let’s say you buy a property for $150,000 that gets $1,250 a month in rent. If you put 5% down you might break even. If you put 20% down you might cash flow $175 a month. If the property goes up in value by 5% and you put 5% down, you just doubled your investment. If you put 20% down, your investment grew by 25%.

Again you can see how leverage can work towards your advantage. However it can also work in reverse to your detriment. If prices go down you can easily wipe out your equity with only 5% down. It really comes down to your risk tolerance.

Loan Programs

 The type of loan that you employ when buying a property can have a dramatic affect on your returns. There are many different loan programs available and new ones are being added on a regular basis. I will explain the most popular programs available and illustrate how they affect the outcome and performance of your purchase.

The most common loan program is the 30 year fixed. Most institutions require 20% down or they will require Private Mortgage Insurance or PMI. Another way around paying PMI is by getting a second loan simultaneously. For example, you can get a first mortgage for 80% of the sales price and a second for 15% of the purchase price. In this case you will only be putting 5% down. Keep in mind that the interest charged on the second mortgage will likely be higher. If you take a fixed rate, consider paying the mortgage insurance on a higher loan to value purchase. The insurance premium is tax deductible on an investment property and you might be able to remove the insurance after a couple of years. This way, you do not have exposure to a higher rate on the second mortgage and will not need to refinance your low rate first.

For lower payments, there are adjustable rate mortgages. Adjustable rate mortgages usually have lower rates initially. However they can rise and fall with the indexes that they are tied to. The most common indexes are LIBOR and Prime. Both rates are posted in the local papers. If you anticipate low interest rates or if you plan on selling a property in a few years, this may be an alternative.

Another option is a short term loan with a long term amortization schedule. That means that you may have a 3, 5 or 7 year loan that is amortized over 30 years. These programs will have a lower interest rate than a standard 30 year loan. The down side is that you will be at the mercy of interest rates at the end of your term. If you are planning on refinancing or selling the property within the term of the loan, this is a good way to go.

If you only plan on keeping a property for a few years, or if you are trying to maximize your cash flow, you may want to consider an interest only loan. Under this program, your loan balance will not change over the years. No, you will never pay off your mortgage this way, but paying off the mortgage may not be your goal. These programs are great for cash flow. These programs typically are fixed for a certain period of years, the most popular being 5 years. However, there is a 30 year program that is fixed interest only for 10 years, then it converts to a fully amortized loan for the next 20 years. By then your rents should be higher so that you can afford the higher payments.

Talk to a loan officer that specializes in loan programs for investors. Tell them what your goals are and ask them what programs are available for the type of properties you intend to buy and the type of investing you want to do. A good loan officer can be a great resource in helping you select the best loan program for your purchase. How you structure the loan is one of the most critical factors in buying an investment property.

You can see that by changing the loan program on the same property, you can affect the profitability of the investment. The programs that are the most profitable usually carry the most risk. Remember that in our illustration above, we assumed the interest rate on the variable did not go up. You should take a realistic view that your variable rate will go up and run the returns at 1% higher and 2% higher. If you want to see the worst case, most variable rate loans have a cap of 5-6% over the starting rate. One of the most important things when picking a loan program is your time frame. Make sure you have your exit strategy planned.

Loan Fees and Closing Costs

 Many lenders, especially mortgage brokers, charge an origination fee.  This is the mortgage company's fee for securing financing for you. The origination fee will vary from lender to lender.  If you have had a rocky employment history that requires a lot of work to document - or have numerous late payments on your credit report, you should expect to compensate the lender for the additional work that is required to secure your loan approval.

However, if you are very creditworthy and provide all the necessary documentation at the time of the loan application, it is not unreasonable to expect between 1% and 1.5% - depending on the applicant and mortgage amount.  These fees go to the mortgage company for preparing and placing your loan.

Points can be defined as simply the cost of obtaining a certain interest rate - think of points as paying interest in a lump sum upfront to lower your interest rate in the long run. A point is 1% of the mortgage amount (not the sale price or appraised value).  The more points you pay the lower the rate on your mortgage loan.  Most lenders will also offer no point interest rate options, but at higher interest rates.

Your lender will require title insurance.  However, the lender's title policy insures the lender's interest in the collateral for the loan (your property) against loss due to title defects that were not discovered at the time of the sale - it offers no protection for the property owner. Make sure you get an owner's policy (most title agencies will provide this automatically).  An owner's title insurance policy protects your equity against titles defects up to the face amount of the title policy, not just to the amount of your mortgage.

Although the chances of someone challenging your interest are slim, if it does happen you could stand to lose one of your largest investments - your home.  How could this happen?  Isn't the title checked carefully before closing? A title exam, which is basically an in depth investigation of the property including rightful owners, liens, easements, and restrictions is completed before closing but isn't foolproof.  For example, one of the previous owners could have been married and potentially his or her spouse (who had an interest in the property based on the marriage) did not sign the deed when the property was transferred three owners back. It may be difficult for the title examiner to detect this.  The previous owner's spouse technically still has an interest in the property and could attempt to claim it from you at any time.  The typical title insurance policy will provide for payment of this claim if it is legitimate.

You will also have to pay for an appraisal. An appraisal will give the lender the assurance that the property is worth the selling price or more. This helps ensure that the lender can recoup its investment if you default on your loan and the lender has to foreclose. Appraisals can vary depending on the type of property you are buying.

I suggest you get an inspection as well, especially if your property is over 5 years old. An inspection will give you a good idea of the condition of the property you are buying. You will see a lot of disclaimers about how the inspector can’t see everything, but the information in that report can be vital in the decision making process. If you find that the property is not in the shape you thought it was, you may want to rethink your purchase.

Some additional fees are for the escrow company, document preparation fees, Home Owner Association transfer fees, tax service fees, attorney fees, courier fees and notary fees. Not all of these fees are found in every purchase. In addition to these fees, you may also need to prepay taxes, insurance and interest until your first payment is due.