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Qualifying for great real estate investment property loans is an essential part of turning a profit. If you don’t know how to get a good rate with excellent loan terms, then it’s unlikely that you’ll be able to purchase cash flow producing properties or amass a large real estate portfolio.
It’s tough to know where to look when you first get started, though. For the reason, this article will teach you the basics of how to identify the right real estate loan for your needs.
Let’s get started.
Finding Real Estate Investment Property Loans
The first way to seek out a real estate loan is to take the traditional route. By “traditional route,” I mean going through a bank to get a mortgage, just like you would when buying a house. If you’re a homeowner, you know this process well.
If you’ve decide to pursue a traditional bank loan, then try to get preapproved as quickly as possible. That way, you can know the price range that you’re able to afford and be sure that the bank will follow through with you for a loan for it. Traditional bank mortgages are highly dependent on your credit score and past borrowing history.
Naturally, a poor credit score or inconsistent borrowing history will increase the interest rate that you will have to pay on this kind of loan. Either that or you will not be approved for a loan at all.
Unfortunately, traditional loans that are issued for purposes of acquiring rental real estate typically require you to contribute a significant amount upfront in the form of a down payment. While down payments on a primary or secondary residence can be as little as 3 to 3.5% down (or 0% if you’re a military service member), this criteria changes when you are acquiring a property for purposes of renting it out.
Typically, banks will require 20 to 25 percent of the loan as a down payment if the intended use of the property is to operate it as a rental property. Although, if you have a sterling credit history, you might be able to do less.
Income From the Property
When you’re looking to purchase a property for purposes of renting it out, you might imagine that the income produced by property would be factored into the loan criteria. Unfortunately, if the property is categorized as residential real estate, then your bank won’t be willing to factor this in.
For lending purposes, residential real estate loans include those issued on single family homes, condos, or any multi-family property with 4 or less units (i.e., duplex, triplex, or quadplex).
Even though an income-producing property should more than offset the cost of the mortgage, that’s not something that will help you on the front of the process.
Your debt-to-income ratio as it stands before you purchase the property is another important factor. The more you can do to offset that ratio and cut down on debts, the better.
In the case of large properties, some lenders will expect you to have an existing store of money that could be used to cover the first few months of the mortgage (typically 3 to 6 months). This won’t always be the case, but it’s something to keep in mind as you start to shop around.
On the other hand, if you’re acquiring a property that is classified by your lender as a piece of commercial real estate, then you can use the net profit produced by the property to help you during the loan qualification process. Commercial real estate is property that is use for business purposes, instead of as living quarters.
Common types of commercial real estate include retail space, office space, industrial space, and apartments.
Fix and Flip Options
If a traditional loan isn’t an option that will work within your budget or credit, then there are fix and flip loans available. These are loans for properties that need a little bit of elbow grease.
Lenders know that fix and flipping is an effective way to build wealth and turn a property around. As a result, you can purchase a home at a low price, invest into rehabbing it, and then sell it for a profit.
Or, alternatively, instead of selling it you could rent it at a premium rate after rehabbing it. The idea is the same, but in this case, you’re allowing the property to cash flow for a while before you “flip” it for a sale.
Fix and flip loans are those given by lenders with an expectation that the property will be sold fairly quickly. Because most borrowers who use these loans are just starting out, the rates are high but the potential is also high.
You might have to specify the repairs or renovations that you plan to do on the property and give the lender some sense that you know what you’re doing. Just because the fix and flip loan contains the expectation of a sale, though, doesn’t mean that you have to get rid of it right away.
Once the renovations are done, you can refinance it to cover the cost of the fix and flip loan.
Fix and flip loans are hard money loans, meaning that that the loan is secured (backed) by the property. It’s called a “hard money” loan, because it is often harder to acquire this type of loan and the higher interest rate can make it more difficult to pay back.
Hard Money Loan Benefits
One thing that’s nice about having the loan secured by the property is that your odds of getting the loan are higher. There aren’t as many risks to the lender when the property is what they’re loaning against. This is especially true in the case of fix and flip loans. Odds are that the house will increase in value as soon as you complete your renovations.
Meaning, if the borrower defaults on the payments, the lender will usually get a return on their investment even if they have to take back the property.
As we noted earlier, the main disadvantage of hard money loans is that they have high interest rates. The term of the loan is typically short, so lenders don’t have a lot of time to rack up interest payments.
As a result, they charge high interest and try to collect as much as they can from fees and interest over a short period of time.
For example, you might see hard money lending rates of 10, 12, 15, or even 20%, while traditional mortgages tend to get issued at or below 5%. You’ll need to factor this higher interest rate into the estimated amount of time it’ll take you to repair the home and turn it over.
Cash-Out Refinancing
Those of you who are existing homeowners have another interesting option to work with. If you’re looking to buy a second property, there’s a chance that you can borrow against the value of your first property to acquire the cash that you need.
The idea is that you refinance your first property to extract the equity it has accumulated over time. If you’re on good terms with your lender, they may be willing to let you refinance your home for 75% to 80% of your home’s current value.
For example, let’s say that you bought a house 10 years ago for $300K, using a $30K down payment and a bank mortgage for $270K. Over the past 10 years, the house has risen in value to $600K. If you have a good credit score and income history, a lender will now be likely to approve you for a new loan worth 80% of the current value of the home ($600K x 80% = $480K).
Using that new mortgage for $480K, you can then pay off your old mortgage of $270K and collect the remaining $210,000 in cash. Best of all, any money you extract using a cash-out refinance is entirely tax-free, so you won’t owe the IRS a single cent.
As shown by this example, a cash out refinance can be an excellent option for those who don’t have a lot of free cash on hand.
Cash-Out Considerations
One thing to note is that doing a cash-out refinance will extend the life of your existing mortgage and you’ll be responsible for a larger mortgage than you were previously. This can be a good or bad thing, depending on your situation. If your credit has improved since you took out the loan, you might be able to refinance at a better rate.
You also have to consider the monetary value of the investment you’re making. Make a spreadsheet that includes the expected returns from your investment property, the costs of the property, and the added cost of the refinanced mortgage.
Having a clear idea of this will help you think more clearly about whether cashing out on your mortgage is the right choice. As you think through those factors, note whether or not you’ll be renovating the investment property.
A renovation will inflate the value of your new property and potentially allow you to refinance at a better rate, pay off existing debts, and potentially, save money on future interest payments.
Invest With Others
If the options above don’t fit into your financial situation very well, then you still have other options.
Many people can’t afford to take on the financial risk associated with owning a rental investment property. You have to contend with marketing the property, finding tenants, dealing with tenant issues, affording landlord insurance, finding a management company, and paying for all of the coffee you’ll need to make it through. The expense is large, so you need a little cash to work with.
In this case, investing with a group or buying a property with a couple of other investors can be a great idea. Sure, your profits will be distributed, but so will the risk. Further, your initial investment will be smaller and take less of a toll on your current finances.
Groups might be in a better position to get a solid loan on an investment property as well, because there’s more cash pooled together. If you can find individuals with good credit and the ability to make a significant down payment, working as a team is a great way to reduce your load.
If you want to invest with others, though, it’s important to lay down the obligations and expectations in writing. You might want to work with a lawyer to draw a contract that ties all of you together.
The last thing you want is for someone to back out or fail to pay, putting the others in the group in a difficult spot financially.
Larger Investments
Another great thing about working in a group is that you can afford to put more money into a larger investment. This way, you can acquire larger, higher quality properties or ones that are located in a premium location.
Because the risk is distributed, your costs and risks might still be lower than they would if you were to invest in a smaller property by yourself. It’s not an option for everyone, and it certainly requires a measure of trust.
You have to find the right people to work with or you might be in for more trouble than the investment is worth.
It’s also wise to avoid investing with close friends and relatives. Although it’s exciting to enter into a venture together, close relationships complicate business dealings.
More About Loans for Real Estate Investors
When it comes to real estate investment property loans, there a lot of interesting options. It can get a bit complicated at times, but it doesn’t have to be.
Use the options described above—traditional mortgages, hard money loans, cash-out refinancing, or personal loans from friends and family—to find the option that will work best for you.