Understanding how to finance a deal is just as important as finding it. This is especially true for novice investors. Unlike security investments, which can be purchased in increments of as little as $20, real estate property investment requires a large amount of funding.
When you don’t have a huge bankroll, taking out a loan may be the only way to seal the deal. There are a variety of financing options available for real estate investing. It’s important to understand how they work before approaching a lender, as the kind of loan can impact the success of your investment.
Here’s a list of financing methods to purchase real estate investments.
For investors, cash is vital to getting what they want. Cash financing is the easiest and quickest method of purchasing investment properties. According to BiggerPockets, 24% of US investors use 100% of their own cash to finance a real estate investment.
Aside from getting more offers accepted, cash financing enables real estate investors to receive instant equity, increase their cash flow, and save on interest. Most importantly, investors can purchase property at a lower price.
Conventional Bank Loans
This is arguably the most popular financing option in real estate. If you’re already a homeowner, you’re probably familiar with conventional financing. Unlike an USDA, VA or FHA loan, a conventional mortgage is not backed by the federal government.
With conventional financing, lenders are required by law to follow strict guidelines. For example, you’re required to include a sufficient down payment, an adequate credit score, and sufficient documentation of income.
Using bank loans as financing options is a great option for beginner investors. Nonetheless, you need to make sure that you fully understand the process and what is required for approval.
Hard Money Lenders
Hard money loans, also known as predatory loans, are the most expensive and restrictive. It’s a financing option usually used by rehabbers looking to renovate a property. Hard money loans are backed by the value of the property, rather than the creditworthiness of the borrower.
In order to receive a loan from hard money lenders, lenders first need to analyse the “After Repair Value” of the property. Also, they typically just fund a part of the after repair value or the purchase price.
These loans have a lower loan-to-value ratio than traditional loans. Before considering this financing option, real estate investors need to be fully aware of what they’re getting themselves into.
Private money is similar to hard money in many ways. The only difference is the relationship between the borrower and the lender. Usually, with this financing option, the lender isn’t a professional, but an individual looking to achieve higher returns on their cash.
Private money lenders are integral to the growth of every new investor. They’re usually from individuals with vested interests, such as friends or relatives. Because of that, private money loans are often informal agreements.
For private money borrowers, the terms of payment and the interest rate can be the most attractive form of financing. If you’re trying to build relationships for private capital, developing credibility is a must.
Tapping Home Equity
Drawing on your home equity, either through a cash-out refinance, HELOC, and a home equity loan, is another way to finance a flip or secure an investment property for long-term rental. To obtain a home equity loan or line of credit, you must first have equity in your home.
Typically, it’s possible to borrow up to 80% of the home’s equity value to use towards the purchase of another home. Depending on the type of loan you choose, using equity to finance a real estate investment has its ups and downs.
Some of the pros include:
- Complete ownership of the property
- Loan payments are predictable from month to month, and the interest you pay on debt financing is tax deductible
- You have to repay the investor or bank with interest
- Lending requirements are strict
- Forced liquidation of personal assets should your business fail to take off
When you’re unable to personally finance an investment property, establishing partnerships can be helpful. One major advantage of partnerships is that it can be structured to fit the needs of the individuals involved.
There are no set “rules” with equity partnerships. However, you will need to come up with some guidelines. For example, how will profits be split at the end? Who makes the final decisions?
The Bottom Line
When it comes to real estate, financing is something to take seriously. If you’re looking to invest in real estate, it’s on you to determine which financing option is best for you.