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New Western

Financing Your Investment:

What Are the Best Ways to Finance Your Investment Property? Learn From the Experts

Written by The New Western Team

New Western is committed to delivering opportunities to aspiring investors and keeping them well-informed with timely and relevant content that follows strict editorial integrity.

At New Western, our vision is a world where every real estate transaction is simple, certain, and satisfying. Therefore, we promise strict editorial integrity in each of our posts.

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An Introduction to Financing Your Investment Property

We often get questions from aspiring investors asking us how to finance an investment property simply because there’s so much information to sift through.

People want to know what are their options, how secure financing, what kind of properties they should start with, and much more. 

New Western heard your questions and we want to help. In this extensive guide, you’ll learn about loan options where you don’t need $100k cash, government-funded owner-occupant loans, house hacking, and much more. 

Chapter 1: How to Finance an Investment Property: Is Now the Right Time?

Purchasing your first investment property is a huge leap toward generating passive income and getting to the point where you can retire from your 9 to 5 and start living off rental income alone.

However, before you can do that, you need to be 100% certain that you’re ready to make that commitment. 

So, how do you know if you’re ready to become a real estate investor?

Signs That You’re Ready to Invest in Real Estate

Income and Job Stability

One of the more common real estate myths is that you need to be employed with the same employer for at least two years in order to qualify for a loan. Yes, steady, long-term employment definitely works in your favor, there are some circumstances where that’s not an option. 

The truth is, lenders understand that not everyone will have an extensive work history.  Many lenders are willing to work with potential borrowers with a short work history or are just starting a new career.  For example: 

  • You may get approved for a loan if you’re just starting a high-paying career, like being an attorney or doctor. 
  • If you’re in between jobs, you may get approved if you include a copy of a job offer letter with your loan application. This may vary from lender to lender. 
  • For potential borrowers who are self-employed, contractors, or gig-workers, you may still get approved based on two years worth of tax returns. 

Ultimately, it is best to find a local accredited lender that will help guide you through the pre-approval process so you will have the confidence in knowing what you can or can’t purchase with a loan. 

Significant Amount of Money in Savings

From Q2 2020 to Q2 2022, real estate prices have increased by 38%, making the median sales price slightly over $440k. If you want to do the traditional 15% to 25% down payment, you’d need to have anywhere from $66,000 to $110,000 saved.

That’s a lot of money, for sure. However, if you expect your tenants to have 3 times the rent (before or after taxes is up to you), then you might want to have at least that much saved as well. 

Credit: FRED St. Louis

This money will be used to cover the mortgage, utilities, and insurance, but you’ll also want to have some extra cash for emergency repairs and other unplanned expenses. It’s better to have it and not need it than it is to need it and not have it.  

You Have a Detailed Investment Plan

Ask yourself what kind of investor you want to be? Do you want to be involved with the day-to-day operations of a rental property or do you like the idea of having your investments managed by professionals? 

"[Indirect investing] offers professional management, assurances for accountability and provides a great way with limited capital to have access to a large pool of properties that offer diversified income from properties located in cities with various economic development opportunities."

"Capital is the most important factor that prevents small investors from having access to good quality properties with many rental units. The indirect investment approach offers even small investors to participate in top quality properties and achieve good risk-adjusted returns."

"Rental properties are one of the most financially viable investment properties. They offer several tax benefits that other types of investment properties may not."

"For example:

Deductible operating expenses such as property management fees, repair, and maintenance, property taxes, leasing commission, advertising, etc. Depreciation deduction Deductible mortgage interest Ability to defer capital gains tax Avoid FICA taxes Deductible owner expenses"

"Therefore, the proceeds of the sale should be reinvested. Only experienced investors can navigate the transition to purchasing another property while the sale is finalized."

-

Mr. Alex Capozzolo, the co-founder of Brotherly Love Real Estate

You Have the Opportunity to Buy a Property with Potential

Although real estate prices have skyrocketed, there are still good deals out there — you just need to know where to look and how to spot them. If you’re on a budget, distressed properties aren’t the only options you have to find something affordable. 

You can find investment properties a number of ways. New Western, for example, is a great resource for finding pocket listings, also known as “off-market” properties for sale. You can join local real estate investor forums to find leads. 

The Cash-on-Cash Return and ROI Metrics Are on Point

If you have found a rental property for sale, don’t sign on the dotted line first because you need to figure out if it’s worth it.  There are two metrics that will help you determine if the property is worth the investment:  the cash-on-cash return and ROI (return on investment). 

Cash-on-cash (CoC) return is an annual measure of an investor’s earnings compared to the amount of money they initially spent to buy it and keep it operational. 

To figure out the cash-on-cash return, you have to divide the year’s pre-tax cash flow by the amount of money you’ve invested.

Credit: Avail

You can also use a cash-on-cash return calculator if you prefer.

ROI, on the other hand, is a measure of the property’s overall profitability for however long you own the property. 

To figure out the ROI for an investment property, you have to subtract the annual rental income from the annual operating costs. You’ll then want to divide that number by how much is left on the mortgage. 

Credit: Avail

You can also use a ROI calculator if you prefer.

Understand the Market: Neighborhood Analysis

As a new investor, it’s a good idea to learn as much as you can about the market you’re interested in.

By conducting a neighborhood analysis, you’re crunching numbers to determine if a certain neighborhood is a good investment or not. It can also be used to help you determine how much you may be able to charge for rent. 

Note: A market analysis is comprised of estimates, not actual numbers. While it may not be 100% accurate, it can give you a good idea of what the local market is doing.

What Data Is Used In a Neighborhood Analysis?

The data you’ll want to look at when you’re conducting your analysis should include:

  • Construction Age: The age of the homes are going to play into property values. Newer homes are usually valued higher than older ones, with the exception of historic districts or homes that are registered in the National Register of Historic Places.

Credit: Elfreth’s Alley in Old City Philadelphia (Lindsay Laraski/WHYY)

  • Neighborhood and Amenities: The neighborhood and amenities will impact the market because most people don’t want to live out in the middle of nowhere or in a bad area. Property values will be impacted based on proximity to things like schools, public transportation, shopping venues, restaurants, and recreational activities.
  • Employment Opportunities and Migration: Although some industries are shifting to a remote model, the job market is still an important factor to consider when looking at areas to buy investment properties in.

According to McKinsey and Company, 58% of surveyed Americans report they’re able to work remotely, either part-time (23%) or full-time (35%). As more industries embrace remote work, be it a hybrid model or fully remote, home prices are likely to continue to rise, according to The National Bureau of Economic Research.

Credit: McKinsey and Company

On one hand, this is good for remote workers who want to move away from the metro areas and relocate somewhere with a lower cost of living. But on the other hand, it could be problematic because when demand goes up, home prices and the cost to rent goes up too. 

  • Crime Rate: Crime in a neighborhood is going to have a huge impact on the overall desirability for investors, homebuyers, and renters.
    • Some investors like higher crime neighborhoods because they often produce a  higher ROI and less barrier of entry(price point) due to the risk involved in managing a property in these types of areas. 
    • Ideally, you will want to choose a neighborhood that you are comfortable with, and that will yield you the desired ROI for your property. 

The FBI Crime Data Explorer is an excellent source to get this information because you can look up data by the state and municipality, as well as specific crime data like specific types of crimes, expanded property crime, hate crimes, expanded homicide crimes and arrests. Unfortunately, you can only see the data up to 2020 and it doesn’t give you a look at specific neighborhoods, just by police departments.

Credit: FBI Crime Data Explorer

AreaVibes is another great source for finding out an area’s crime rate, as well as so much more. You can use the basic search features to sort locations by overall livability  score (which uses seven key data points, including crime rate, to determine how desirable a place is), best place to rent, and best place to buy.

Credit: AreaVibes

You can customize your search parameters based on things like population size, cities, cities and neighborhoods, or just neighborhoods, and specific scores for the seven categories shown in the graphic above. This is an excellent tool if you’re trying to find the perfect place to invest.

Other free sources where you can find detailed information (including crime rate) about location include: 

After Finding a Property: Comparative Market Analysis

If you’ve stumbled across an income property for sale and you want to know if it’s a good deal or not, you’ll want to do a comparative market analysis (CMA).

Step 1: Gather Data About the Desired Property

The data for a real estate CMA can be gathered should include as much detail you can get. If you’re working with a real estate agent, they’ll be able to do this part for you, since they have access to the Multiple Listing Service (MLS).

If you’re doing a CMA on your own, you can use sources like Zillow, Google Street View, House Canary, and county public records. At the bare minimum, you need: 

  • Location (street, neighborhood, county, municipality)
  • Square footage (livable square footage indoors and size of lot)
  • Year the structure was built
  • Number of bedrooms and bathrooms
  • Renovations and updates since the last time the house was sold
  • Interior finishes worthy of noting (hardwood floor, granite countertops, etc.)
  • Special features (fireplaces, finished basement, pool, etc.)
  • Current taxes that have been paid

Step 2: Compile Details about the Property’s Previous Sale and Listing Data

This data will help you determine how the market has moved since the last time the property was sold.

For example, let’s say the property you want was sold two years ago when the median price was $322,600, and today’s median price is $440,300. That’s about a 36% increase. Based on this information, it’s safe to assume that the property’s true value has increased by that much. 

Credit: FRED St. Louis

You can check this by gathering information about the last time the property was listed and sold. At the bare minimum, you need:

  • Price it was listed for
  • Price it sold for
  • Property details (elevation, floor plan, # bedrooms and bathrooms)
  • Any price changes
  • How many days the property was on the market

Step 3: Choose 3 to 6 Comparable Properties

Now you’ll need to understand how the property you’re interested in compares to similar properties that have sold in the last six months. When you’re choosing comps, you’ll want to take into account a variety of factors, such as:

  • Number of bedrooms and bathrooms
  • Square footage and acreage
  • Date when the structure was built
  • Number of stories
  • Special features (garage, storage shed, pool, etc.)
  • Location (proximity to schools, public transport, amenities, etc.)

Credit: Investopedia

After choosing the comps, you’ll want to figure out the average price per square foot for each property (include the one you’re interested in). The equation you’ll need to use is simple: 

Price / Square Footage 

Step 4: Note the Differences and Make Adjustments

In this step, you’ll want to figure out the differences and take note. These differences can vary significantly, but even small differences may make a difference in overall price. For example, if a comp doesn’t have a half bath and the one you want does, you’ll need to add the value of the half bath to the estimated value of the property you want. 

Credit: The Close

After figuring out the square footage and making adjustments, you can look back over the CMA and determine if the prospective property is, indeed, a good buy. 

Note: Remember to find comps that are as similar to the property you’re interested in as you can get. This will make figuring out the average price per square foot much easier.

Chapter 2: Traditional Financing Options

You’ve decided that, yes, you are ready to invest in real estate and you’ve even determined a property to be a worthwhile investment. Now it’s time to secure that financing! 

“There are many ways to invest in real estate and there are many perks associated with it. Investment property financing takes several forms and the borrowers must meet specific criteria,” Mr. Capozzolo says.

Let’s take a look at traditional ways people can finance an investment property.

Conventional Loans || Jumbo Loans

More than 78% of new homes purchased in the first quarter of 2022 were done with the help of a conventional loan serviced by a private lender, like a bank or a credit union. These loans are not backed by a government agency, but they may follow the guidelines put in place by Fannie Mae and Freddie Mac (which would mean they are a conforming loan). 

Minimum Requirements to Qualify for a Conventional Loan

Credit Score

DTI Ratio

Down Payment

Loan Term

624 to 640

36% to 50%

  • 3% – 5% (with PMI)
  • 20% (no PMI)

15-, 20-, 30-year

The Federal Housing Finance Agency sets a limit on how much borrowers of a conforming loan can borrow every year. 

2022 Loan Limits for a Conventional Loan

One-Unit Limit

Two-Unit Limit

Three-Unit Limit

Four-Unit Limit

$647,200

$828,700

$1,001,650

$1,244,850

“Conventional financing requires a down payment of 20% of the property’s purchase price. However, with an investment property, the lender may require 30%. A larger down payment could be a strong incentive and also provides the lender with greater security.” Mr. Capozzolo notes.

Benefits of a Conventional Loan: 

  • Low Cost: Well-qualified borrowers often get a lower interest rate with a conventional loan, but that’s not the only savings. Once your property has 20% equity, you can ask to have the PMI removed. 
  • Higher Loan Amounts: Conforming loans typically have higher limits than non-conforming loans. However, if necessary, you can take out a jumbo loan if necessary, but we’ll talk more about jumbo loans later. 
  • Some Flexibility: Some private lenders may offer qualified borrowers a little more flexibility than they could get with a government-backed loan since they can set their own terms. 

Drawbacks of a Conventional Loan: 

  • Higher Credit Score: To qualify for a conventional loan, lenders expect you to have at least a 620 credit score, which is higher than government-backed loans typically require.
  • Higher Down Payments: There are some programs where first-time buyers can put 3% down (or none at all), or 5% if you aren’t a first-time buyer. 
  • Stricter Qualification Requirements: Since the loan isn’t backed by a federal agency, lenders will put your financial situation under a microscope before making a decision. 

Jumbo Loans

If you need a loan larger than the conforming loan limits, a jumbo loan is an option. Mr. Capozzolo explains:

“A jumbo loan is designed for higher-end expensive properties that are not covered by conventional loans. A jumbo mortgage can give prospective buyers larger funds, provided that they can find a lender that offers one and meets the requirements. The conforming loan limit set by the Federal Housing Finance Agency (FHFA) is limited to $647,000 for the conventional loan.”

Minimum Requirements for Jumbo Loans

Credit Score

DTI Ratio

Minimum Down Payment

Cash Reserves

700 and up

45% or less

5% to 20%

Some lenders may require a cash reserve of 12-months of mortgage payments

Benefits of a Jumbo Loan:

  • Higher Loan Limits: Jumbo loans mean you can buy that $1 million multifamily property that otherwise wouldn’t be covered under a conforming loan.
  • Single Loan: Instead of securing multiple loans to finance a large purchase, a jumbo loan is one single payment. This simplifies the accounting and, if needed, you could even use some of the funds from a jumbo loan to finance other life goals like sending the kids to college, consolidating debt, or paying medical bills, on top of buying a first rental property.
  • Lower Down Payment: Although it’s a real estate myth that you have to put 20% down when buying real estate, that’s not always true. The same goes for jumbo loans. Some lenders will accept as little as 5% down, providing you meet their other requirements.

Drawbacks of a Jumbo Loan:

  • Higher Interest Rates: A jumbo loan is considered high risk  because the amount is so large and it’s impossible for lenders to resell the mortgage as a mortgage-backed security. So, to offset that risk, it’s very likely that you are going to get a higher interest rate. 
  • Excellent Credit: If you’re asking for a seven figure loan, you better believe that the lender is going to make sure you have an excellent credit history and that you have the means to repay that loan.
  • Stricter Qualification Requirements: Jumbo loan servicers will have stricter requirements for the property you want to buy. They will require an appraisal and if the appraisal reveals that the property isn’t worth as much as you’re asking for, they won’t budge. So if the property is listed at $200,000 more than the appraiser values it at, you’re going to need to secure additional financing. 

Fix and Flip Loans

A fix and flip loan is geared toward investors who aren’t going to buy-and-hold their investments. These loans are perfect for those who are using the BRRR strategy and plan on selling their newly renovated property within 12 to 18 months. 

Fix and Flip Loans vs Traditional Home Loans

 

Fix and Flip Loans

Traditional Loans

Loan Term

6 to 18 months

15 to 30 years

Interest Rates

12% to 18%

2% to 4%

Purpose

Short-term investment

Long-term investment

Collateral

The investment property

Borrower’s credit and property

Typically these loans are used to purchase residential properties from homeowners who want to sell before the foreclosure process begins,  but the loans can also be used to fund house rehab costs, and other expenses you might incur when you manage a rental property. 

Benefits of a Fix and Flip Loan:

  • Fast Funding: Instead of waiting weeks for a traditional loan to process and deposit money in your account, these loans can give you cash in your hand within a week. 
  • Low Risk: Instead of putting your personal credit and property on the line as you would with a traditional loan, the only thing on the line is the property you want to buy.
  • Flexible Loan Terms: Unlike with a traditional loan, fix and flip lenders tend to have more flexible terms and requirements. People who are unable to secure funding via a traditional lender, can still secure funds with a fix and flip lender. 

Drawbacks of a Fix and Flip Loan:

  • Higher Credit Score: From a lender’s perspective, there is more risk involved with a fix and flip borrower. Therefore, the interest rates are going to be significantly higher than a traditional loan to offset that risk. 
  • Higher Down Payments: “Qualifying for an investment property loan is challenging as lenders view investment properties to exhibit greater risk. Lenders expect a larger down payment for investment properties, generally between 20% to 35%,” Mr. Capozzolo says.
  • Investment Property is Collateral: Unfortunately, if you default on your payments, the lender can take your investment property, finish the renovations, and sell it for a profit. 

Home Equity Loan || HELOC || Cash-Out Refinance

When you take out a home equity loan, you’re using your home as collateral and the amount you can borrow is determined by the value of your home.  With this type of loan, you’ll receive a large, lump sum of money that you can use however you see fit. 

Minimum Requirements for a Home Equity Loan

Credit Score

DTI Ratio

Equity in Home

Loan Term

620 and up

No higher than 43%

At least 15% to 20%

5- to 30-years

 After receiving your loan amount, you’ll need to consider the terms of repayment because it will impact how much total interest will be paid. We recommend working out a monthly budget to see how much you can comfortably repay each month. See the example below:

Credit: Lending Tree 

*Rates are from 2021 and are used for examples only. 

Rates as of September 2022: 

Credit: Bankrate

Benefits of a Home Equity Loan:

  • Fixed Rates: The interest rate you receive when you’re granted the home equity loan is the rate you’ll keep over the life of the loan, regardless of how  much the Federal Reserve raises rates.
  • Consistent Payments: Since you’re receiving one lump sum, your payments will stay the same over the life of your loan.    
  • Interest May Be Deductible: You may be able to deduct the interest from your home equity loan if you’re using the money to make improvements to your home.

Drawbacks of a Home Equity Loan:

  • Your Home Is Collateral: If you default on your payments, the lender could put your home into foreclosure and you could lose it. 
  • Closing Costs: You are probably going to have to pay closing costs on your home equity loan. The cost is typically 2% to 5% of the borrowed amount. 
  • Double Mortgage Payments: If you’re still paying the first mortgage, you’re going to have two mortgage payments that you’ll have to budget for. Granted, the second payment will probably be much lower than your primary mortgage payment, but it’s still something to keep in mind.

Home Equity Line of Credit (HELOC)

A HELOC, on the other hand, is very much like a home equity loan in that HELOC’s have the same minimum requirements as a home equity loan. However, there are a few differences between the two, as Mr. Capozzolo explains:

“A home equity line of credit (HELOC) allows you to draw funds as needed instead of a lump sum. HELOCs exhibit lower interest rates than home equity loans. However, the rates are variable and you might end up paying a higher interest rate in the near future.”

Home Equity Loan vs Home Equity Line of Credit vs Cash-Out Refinance

Home Equity Loan

HELOC

  • Receive one lump sum
  • Open line of credit that you can pull money from as needed.
  • Fixed Interest Rate
  • Variable Interest Rate
  • Equal payments every month
  • Monthly payments will vary depending on how much credit you draw from (think of it like a credit card)
  • Repaying the full loan amount, and interest
  • Repaying only what you borrow, and interest
  • Pay closing costs
  • On-going fees during the draw period on top of closing costs

Benefits of HELOC:

  • Borrow As Needed: Instead of getting a large lump sum, you can use the money when you need it. If you end up using less money than you expected, you’re only on the hook for paying what you use — thus having a lower monthly payment.
  • Low Interest Rates: HELOCs tend to have a lower APR than credit cards, which can be appealing to investors who don’t want to put small renovation projects on their credit card.
  • Flexible Repayment Options: There’s a lot of flexibility when it comes to HELOCs. You can pay off the balance right away or pay over time.

Drawbacks of HELOC:

  • Home Is Collateral: Although you’re only drawing from the HELOC as needed, your home will still be used for collateral. If you can’t repay what you borrow, no matter how small, you risk foreclosure.
  • Variable Interest Rates: When the Federal Reserve increases interest rates, the rate on your HELOC will increase as well. 
  • Potential to Spend More Than Needed: For borrower’s with strong impulses to overspend, a HELOC might not be the best thing because charges add up quicker than you think! 

Cash-Out Refinance

Like the previous two, your home and its equity will be key factors in how much you’ll qualify with a cash-out refinance.

A cash-out refinance is designed to replace your old mortgage with a new one that’s higher than what was owed on the old mortgage note. This option allows borrowers to get cash from their mortgages. Lenders will look at your property’s LTV ratio, credit history, and bank standards to determine how much money you’ll receive. 

Minimum Requirements for a Cash-out Refinance

Credit Score

Cash Reserves

LTV Ratio

Waiting Period

680 and up

At least 12 months’ worth of mortgage payments

25%or more

Must wait six months to refinance after the property was purchased

Benefits of a Cash-Out Refinance:

  • Large Sum of Money: Since you’re taking out a larger loan to pay off your existing mortgage, any left over money will be yours to do with as you see fit — perfect for investors who have investment properties with a lot of equity.
  • Predictable Payments: This is going to be a new mortgage, 30-year fixed-rate mortgage. You know how much your monthly payments will be and you won’t have to worry about a variable interest rate. 
  • Potential Tax Deductions: You can use the money to make improvements to your properties, or you could use it to purchase a new property. We recommend consulting a real estate CPA (certified personal accountant) to learn more about the tax implications.

Drawbacks of a Cash-Out Refinance:

  • Short-term Solution: If you’re doing a cash-out refinance to help consolidate debt, you’re just prolonging your debt load. 
  • New Mortgage Terms and Costs: Like HELOC and home equity loans, you will need to pay closing costs, which could be between 2% to 6% of the new mortgage. Plus, you’ll be paying a mortgage for another 15- to 30-years. This also means that if you wanted to sell the property, your profits would be much less than if you sold with just your original mortgage balance to pay off. 
  • Home Is Collateral: As with a home equity loan and HELOC, your home is collateral and if you default on your payments, your home could be repossessed. 

When Does It Make Sense to Take:

 

Home Equity Loan

HELOC

Cash-out Refinance

You Want: 

  • Borrow small amount
  • Interest only payments
  • Low monthly payments

You Have:

  • High credit score
  • High credit score
  • Low credit score

You Want:

  • Fixed, predictable monthly second mortgage payments
  • To use the funds when you need them
  • A single monthly payment that doesn’t change

You Can:

  • Handle two mortgage payments
  • Handle paying an additional mortgage when credit has been used
  • Not afford more than afford a second mortgage

You Want to:

  • Leave the first mortgage balance as is
  • Use funds when you want and pay them off as needed
  • Get a lower interest rate for a new mortgage than what you’re paying on the current mortgage

Hard Money Loans || Private Money Loans || Peer-to-Peer Loans

If you need cash in your hand right now, a hard money loan is the way to go. However, they can be predatory because in exchange for getting cash within a few days of approval, you’ll be slapped with a high interest rate. Also, these loans aren’t financed by a bank or credit union — they’re typically financed by financing companies, individual investors, or investing groups. 

Minimum Requirements for a Hard Money Loan

Interest Rate

Processing Time

Minimum Down Payment

Loan Terms

10% -15%

1 – 2 Weeks

70% LTV x ARV

12- to 36-months

Mr. Capozzolo: “Hard money and private lenders are quite helpful when it comes to financing investment properties. Their conditions are more flexible than conventional lenders and they work with all types of borrowers. Qualifying for an investment property loan is challenging as lenders view investment properties to exhibit greater risk. Lenders expect a larger down payment for investment properties, generally between 20% to 35%.”

Benefits of a Hard Money Loan:

  • Credit Score Not Needed: Hard money lenders are more interested in the value of the collateral (the property) than whether the borrower has a good credit score. 
  • Quick Processing: The processing time for traditional financing can take several weeks, whereas hard money loans are processed and doled out within a matter of days.
  • Short-terms: Investors who intend on paying off the loan quickly, the higher interest rate may not be a problem. 

Drawbacks of a Hard Money Loan:

  • High Interest Rates: Since the lender isn’t going to factor in your credit score when looking at your application, they see you as a risk and to offset that risk, they are going to give you a higher interest rate.
  • Lower LTV: Hard money lenders typically only allow a borrower to take out 75% of the property’s value, whereas a HELOC or home equity loan will allow you to borrow more.
  • Lose Assets: As with the HELOC and home equity loan, your property is going to be the collateral. So, if you default, your property can be foreclosed on. 

Private Lenders

Taking out a loan through a private lender is much like a hard money loan in that there’s a faster processing time, there’s no minimum credit score requirements, and there’s more repayment flexibility. Since private money lenders are usually a singular individual or an organization unaffiliated with any banking institution, each lender can set their own requirements and terms for repayment. 

Hard Money Loans vs Private Money Loans

 

Hard Money Loans

Private Money Loans

Credit Requirements

  • Relies on collateral as primary source of credit rather than credit score and DTI
  • Borrower’s history of credit, DTI, borrower experience, and financial standing

Repayment

  • Less interested in income and more interested in asset value
  • Looks at income, cashflow, DTI, and project success

Collateral

  • Primary source of repayment if borrower defaults
  • Property is seen as a backup whereas the ability to repay is more important

Flexibility

  • Collateral is most important and is less willing to negotiate terms
  • Willing to negotiate terms of the loan with a borrower

Loan Terms

  • More expensive than bank loans and they are less willing to customize terms to suit the borrower
  • More expensive than bank loans but they are more willing to customize a repayment plan with the borrower

Property Type

  • Flexible with property type and its location
  • Prefers to work with in-demand properties in desirable markets

Benefits of a Private Lender:

  • Easy Qualifications: Because the lender creates their own requirements and terms, it can be easier to get funding without needing private mortgage insurance. 
  • Short Approval Process: Since there are fewer hurdles to jump through, the approval process is usually much quicker. Just be aware that some private lenders may require home appraisals and home inspections to ensure that they’re funding the purchase of a property that’s in good condition.
  • Some Flexibility: If you’re working with a private lender that you know personally (be they a family member, friend, close acquaintance, etc.), you might be able to negotiate the terms of the loan, including repayment plans, fees, or interest rates. 

Drawbacks of a Private Lender:

  • Fewer Protections: There are loan qualifications in place that protect the borrower to make sure they can afford the debt. Things like credit score, DTI, and proof of income may not be key factors for private lenders when deciding someone’s creditworthiness.
  • Short-Term Loan: Although repayment terms can be negotiated, private lenders rarely allow for 15- to 30-year repayment plans. This means you’ll be faced with larger monthly payments. Some lenders may even require balloon payments. 
  • Potentially Harmful to Personal Relations: Some borrowers will turn to family, friends, and people they have some kind of relationship with. While this may be beneficial in some regard, if you default, there’s a risk of damaging those relationships.

Peer-to-Peer Lenders (aka Crowdfunding)

Borrowers can secure peer-to-peer loans by going to an online platform like Prosper, Peerform, or Funding Circle. These platforms connect investors who can supply the funds borrowers ask for. The online platform will coordinate the loan, transfer the funds from the lender to the borrower, and will repay the investor when the borrower makes a payment. 

Credit: Corporate Finance Institute

Each peer-to-peer lending platform will have their own borrower requirements, so it’s strongly recommended to compare platforms before signing with anyone

Note: Peer-to-peer lenders can be regular folks who want to grow their money though the borrower’s interest payments. 

Benefits of Peer-to-Peer Lenders:

  • Convenient Application Process: Peer-to-peer lending platforms are online, which makes the application process convenient and easy to do. 
  • Competitive Interest Rates: If you have good credit, you’re more likely to get an interest rate that’s on par (or better) than with traditional lenders. If you have a low credit score, you may be approved for a lower sum, whereas a traditional bank may deny you outright. 
  • Some Flexibility: Some platforms won’t penalize you for paying off the loan early or making larger than required monthly payments.

Drawbacks of Peer-to-Peer Lenders:

  • Additional Fees: Not only will you have to pay a higher interest rate (if you have poor credit), but you may also incur additional fees, like application (or origination) fees.
  • Defaulting Could Lead to Debt Collection: If you’re unable to make your payments, the peer-to-peer platform could pass on the debt to a debt collection agency, which could lead to a lawsuit. 
  • No Regulations: The peer-to-peer lending industry is still trying to classify their services and that means there’s little to no regulations in place to protect you, the borrower. If you choose to go this route, you need to read the terms of services thoroughly so you know exactly what you’re getting into. 

Special Consideration: Government-Backed Loans

Technically speaking, FHA and VA loans cannot be used to buy investment properties because the funds can only be used to purchase a primary residence. They’re designed to help low- and moderate-income buyers buy a home without having to put down a large down payment. 

If the loans are intended for borrower’s to purchase a primary residence, how can the funds be used for investment properties? Two words: owner occupancy

You can purchase a multifamily home with two, three, or four units, as long as you intend on living in one of the units and renting the remaining. This is called house hacking. So while you’re collecting rent from the units that you’re not living in, you’re paying down your mortgage, building equity, and dipping your toe in real estate investing if this is your first investment. 

Minimum Requirements for an FHA Loans and VA Loans

 

FHA Loans

VA Loans

Credit Score

500

No minimum score

Down Payment

  • 3.5% for credit score above 580
  • 10% for credit score below 579

$0

DTI Ratio

50% or less

41% or less

Income Requirements

  • Two established credit accounts
  • No delinquent federal or tax-related debt

FHA Loan Limits

  • $420,680 for single-family home in low-cost areas
  • $970,800 in high-cost areas

Must meet VA’s minimum property requirements

FHA 203(k) Loan

A FHA 203(k) loan is a loan that will allow borrowers to purchase flip houses for sale and add the cost of repairs into the mortgage. There are two types of 203(k) loans available:

  • Limited 203(k) loans are geared for minor repairs or improvements. You are not allowed to do any structural work, which means no large renovations like adding a room or tearing down walls. 
  • Standard 203(k) loans are geared for large renovations and you’ll need to work with an FHA-approved 203(k) consultant throughout the process. They will oversee the work that’s being done by a licensed contractor. While you can build new additions, you cannot do any “luxury” projects like adding a swimming pool or building an outdoor kitchen. 

Minimum Requirements for a FHA 203(k) Loan

Credit Score

DTI Ratio

Minimum Down Payment

Other Considerations

500 and up

43% or less

  • 3.5% for credit score above 580
  • 10% for credit score below 579

Renovations and repairs must be done by a licensed contractor — not the borrower

With a limited 203(k) loan, there is no minimum improvement cost, but you cannot exceed $35,000 in improvement costs. A standard 203(k) loan has a $5,000 minimum improvement cost. The maximum improvement cost must be the lesser of either the purchase price plus renovation costs or 110% of the ARV.

Benefits of FHA 203(k) Loans:

  • Single Monthly Payment: You can buy a property and make some renovations with a single mortgage payment. And since it’s under the FHA umbrella, you’ll have a lower interest rate on the repairs than if you used  a credit card or an unsecured personal loan.
  • Lower Credit Scores Approved: You can qualify for one of these loans with a lower credit score than what’s usually required by other renovation loan programs.
  • Borrow Based on ARV: Instead of borrowing what the property is worth before improvements, you can borrow based on the ARV.

Drawbacks of FHA 203(k) Loans:

  • FHA Loan Limits: Even though you can borrow up to the property’s ARV, the loan amount will ultimately be restricted by FHA loan limits. 
  • Higher Expenses: Mortgage insurance premiums and other fees for this type of loan are typically higher than standard mortgages.

Out-of-Pocket Expenses: Since you can only borrow as much as the property’s ARV, you might have to pay out of pocket for unexpected costs.

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Chapter 3: Non-Conventional Finance Options

There are a lot of conventional loan options for financing an investment property, but there are also some non-conventional options that might work for your specific needs.

Seller Financing (AKA Owner Financing)

Under seller financing, the investor will pay the homeowner in installments until the purchase price has been paid off.

With this type of financing, you won’t have to pay in cash right off the bat or take out a mortgage. Since this arrangement is made between the investor and the homeowner, the terms can be negotiated to suit both parties. 

There are four primary ways seller financing agreements can be structured: 

  • Promissory Note or Mortgage: This structure is about the same as a regular mortgage. The buyer will sign a document that states the lender will hold a security in the property until the loan is paid in full. With this model, the buyer will get the title and the mortgage will be recorded with the local authorities.
  • Deed of Trust: This is similar to the promissory note mentioned above. Under a deed of trust structure, the title of the property will be held by a third-party trustee. Once the loan has been paid in full, the buyer will receive the title free and clear.
  • Contract for Deed: Unlike the previous two structures, a contract for deed means the seller will hold the deed and title of the property until the property has been paid in full. Once the terms of the arrangement have been satisfied, that’s when the investor will receive the title and deed.
  • Lease-Purchase Agreement: A lease-purchase agreement (also referred to as rent-to-own agreement) is when the buyer will lease the property for a certain amount of time before settling on the final terms to purchase the property. If at the end of the lease period the buyer decides to go ahead and purchase the property, any rent that has been paid during the time will be used toward the sale of the property. 

Benefits of Seller Financing:

  • Easier Path to Securing Financing: Instead of dealing with banks or other lending institutions, you’re dealing directly with the seller, which means borrowers may find it easier to secure financing that they may not have had access to with traditional lending options.
  • Everything Is Negotiable: The appeal of seller financing is that the whole deal (down payment, repayment terms, interest rate, etc.) can be negotiated to suit both parties. 
  • Reduced Costs: You can save hundreds of dollars by foregoing the home appraisals, closing costs, bank fees, and the like.

Drawbacks of Seller Financing:

  • Existing Mortgage Problems: If the seller currently holds a mortgage on the property, there could be issues (liens or judgements)  that could cause a few bumps in the buyer’s road to loan repayment.
  • Higher Interest: Unfortunately, the flexibility that comes with seller financing typically has a higher interest rate and shorter repayment terms. 
  • Balloon Payments: Some sellers will include a balloon payment clause in the seller financing agreement. If this is in the agreement, the buyer may have to pay a large lump sum at some point.

Portfolio Loan

Unlike conventional mortgage lenders, a portfolio loan will stay with the servicer instead of being sold off to an entity like Fannie Mae or Freddie Mac. By keeping the loan, the lender can customize the underwriting requirements. Consequently, this means each lender may have their own guidelines. 

Minimum Requirements for a Portfolio Loan

Credit Score

DTI Ratio

Minimum Down Payment

Loan terms

Varies by lender

43% or less

3% to 25% for better terms

10-years or less

Portfolio loans are ideal for people who have experienced divorce, bankruptcy, or a previous foreclosure — all of which can be damaging to your credit history.

The trade-off for the flexibility of these loans, lenders may tack on higher interest rates, higher origination fees, and include prepayment penalties in the contract. 

Benefits of a Portfolio Loan:

  • Relaxed Qualification Requirements: Since each lender will have their own rules, you may be able to secure financing that you otherwise may not qualify for. 
  • Work Closely with Your Lender: You’ll be able to work closer with your lender for the entire life of the mortgage. They’ll know your situation, your goals, and offer advice when you have a problem or question about the loan.
  • More Flexibility: Lenders can work out terms that typically aren’t seen with conventional loans. They may allow borrowers to apply for more money, have a lower down payment, and may be able to avoid needing PMI despite the lower down payment. 

Drawbacks of a Portfolio Loan:

  • Higher Interest Rates: Lenders typically do not resell a portfolio loan, therefore they’re losing the opportunity to recoup their loss in the event that you default. To compensate for that lost opportunity, they may impose a higher interest rate.
  • Higher Fees: Since lenders are generally more flexible with some of the underwriting terms, they might charge higher fees.
  • Flexibility May Not Be an Option: Although portfolio loans can offer some level of flexibility, there may be some instances where the lender will craft underwriting rules that conforms to Fannie Mae or Freddie Mac standards. This would allow them the possibility of selling off the loan, therefore the borrower might lose that flexibility.

Land Contract

A land contract is a form of seller financing in that the deal is conducted between the investor and the seller.

The seller will agree to finance the property if the investor agrees to certain terms. Since the deal is between the seller and investor, the terms can vary widely from seller to seller. 

That said, with these types of contracts, the seller will keep the legal title until the land contract is paid in full.

As the investor is paying off the contract, they are building equity by way of an equitable title. This can be beneficial if the investor wanted to pay off the contract by getting a traditional mortgage.

Benefits of a Land Contract:

  • More Relaxed Qualifications: It might be easier for those with low credit scores to purchase property when they deal with the seller directly to form a land contract. Also, borrowers can have time to improve their creditworthiness so that they can get a traditional loan in the future.
  • Tough Market Be Damned: In markets where interest rates are on the rise and credit isn’t given so easily, a land contract may be your chance to purchase property that you may not otherwise be able to otherwise.
  • No Traditional Lender: Since the deal isn’t being financed via a traditional lender but through the seller directly, there’s more flexibility and room for negotiations.

Drawbacks of Land Contract:

  • Fewer Protections for the Buyer: Unlike traditional financing, land contracts lack the provisions that protect the buyer. For example, if the buyer misses one payment, they could be evicted quicker and lose all the payments they have made toward paying off the contract.
  • Buyer Could Lose the Property: If the seller is still paying on an existing mortgage on the property, you are at risk of losing the property if they default. 
  • Higher Fees and Interest: Unfortunately since you’re agreeing to a land contract, the seller can assume that you were denied traditional financing. To them, you’re a high risk borrower, therefore they may charge you higher origination fees and interest rates.

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Chapter 4: Tips for Preparing to Apply for Financing

If this is your first time applying for financing, then you’re probably not going to know the ins and outs that’ll lead to a smooth application process. Don’t worry — we got your back.

Here are some useful tips that’ll help you get everything in order so that when you do submit your application, you’ll have a better chance of being approved.

1. Research, Research, Research

Mr. Capozzolo advises: “Aspiring investors must be aware of the pros, cons, and due diligence associated from beginning to end. 21% of aspiring investors show their cards by not being aware of the market conditions.”

“My professional advice would be to conduct research and due diligence in depth regarding the investment property, physical features, market growth, and future trends. They must also be aware of who they are getting into business with. Around 10% of new investors don’t take verifying the other party into heed and end up on the wrong side of the business.”

2. Check Your Credit Report

Your credit score and credit report is an important, perhaps the most important, factor lenders look at when determining your creditworthiness.

It impacts the interest rate you’ll get, what type of loans you qualify for (if any), and repayment terms. The minimum credit score most lenders will work with is 620, but you can find some lenders who’ll work with borrowers with poor credit.

You can get a free credit report from all three credit unions by going to AnnualCreditReport.com. You’ll be able to review your full credit report, check for inaccuracies and dispute anything that you don’t recognize as your debt. 

Between now and when you actually receive the funds, keep paying your bills on time, don’t take out any more debt or incur a lot of credit card debt, and don’t quit your job!

3. Pay Down Existing Debt to Lower Your DTI Ratio

If your DTI ratio is higher than 40% (yes, 43% is the industry standard, but it’s always better to be safe with a lower DTI than to be sorry), you’ll want to work on paying down that debt. 

Some ways you can pay off your debt quickly include: 

  • Paying more than the minimum payment
  • Pay more than once per month
  • Pay the debt with the highest interest rate first
  • Consider using the snowball method
  • Consolidate debt

4. Have an Emergency Fund for Surprise Expenses

Sometimes lenders will require that you have a sizable amount of cash in savings in case of an emergency. The amount of cash reserves you’ll want to have will depend on your investment goals, your budget, and the type of loan you’re trying to get approved for.

Some lenders only require three months of mortgage payments worth of savings, while others will require a full year’s worth of mortgage payments. Experts, on the other hand, recommend having three to six month’s worth of total living expenses on reserve. 

5. Determine Your Budget

In order to apply for a loan, you first need to know how much you can afford to borrow. Housing is the largest monthly bill that Americans have — it’s recommended that no more than 30% of your gross monthly income goes to housing, but on average, that figure is more around 35% (or more!) on average

When you’re trying to figure out how much you can afford to borrow, you’ll need to consider upfront costs and recurring costs. 

Upfront Costs:

  • Down Payment (if necessary)
  • Closing Costs
  • Cash Reserves 

Recurring Costs:

  • Landlord insurance
  • Property Taxes
  • Property Management Fees (if applicable)
  • Vacancies
  • Homeowners Association Fees
  • Maintenance and Repairs

6. Gather Necessary Documents

Most lenders will require that you provide them with a bunch of documents for them to review with your application. The most common documents you’ll need to supply include: 

  • Two years worth of tax returns
  • Pay stubs, W-2’s, 1099 forms, direct deposit statements, and other forms of proof of income
  • Bank statements, investment statements, and retirement statements
  • Letter explaining negative marks on your credit report
  • Letters from someone who has gifted you money to help fund your purchase
  • Photo ID
  • Renting history and references

7. Apply with Different Lenders within a 14-Day Window

Did you know that there’s a 14-day window where you can apply for loans with different lenders without hurting your credit score? When you submit mortgage applications with different lenders in that period, it will only show as a single hard credit inquiry. 

That said, you’ll want to shop around for a mortgage to find the lender with the best terms. Some lenders will have more relaxed qualification requirements, while others may offer lower interest rates. This is your chance to cast your net wide!

8. Review Offers and Choose the Best 

As you hear back from lenders, don’t go with the first one who says that you’ve been approved. You’ll want to go through the offers to see which lender has offered the best terms. Pay close attention to interest rates, closing costs, and prepayment penalties. 

Chapter 5: Terms to Know

Debt-to-Income (DTI) Ratio

The percentage lenders use to determine how much of your monthly income goes toward making debt payments. You can use a DTI calculator to figure this out or use the equation:

(Total Monthly Debt) / (Gross Income) x 100 = DTI

Private Mortgage Insurance (PMI)

To protect themselves, some conventional loan servicers may require that you take out a private mortgage insurance (PMI) if you don’t have an adequate down payment. Sometimes PMI is paid in one lump sum at closing, but usually the premium is rolled into your monthly mortgage payment.

You can use a PMI calculator to determine how much you’ll pay over the life of the loan. However, once you have accrued 20% equity in the property, you can remove the PMI, thus saving you a little bit of money.

Fannie Mae and Freddie Mac

Fannie Mae and Freddie Mac are organizations that were created by Congress to “provide liquidity, stability, and affordability to the mortgage market.” These organizations buy mortgages from lenders and will either hold them or resell them as mortgage-backed securities.

Conforming Loan

A conforming loan meets guidelines set by Fannie Mae and Freddie Mac, but they aren’t backed by the federal government. Conforming loans are readily available and they often have lower interest rates and fees. That said, to qualify for these loans, a borrower must have good credit and a low DTI ratio.

Non-Conforming Loan

A non-conforming loan does not follow the guidelines set by Fannie Mae and Freddie Mac. These loans typically exceed the maximum loan limit for an area; but, there are other reasons a loan could be considered non-conforming, like being backed by the government like FHA, VA, and USDA loans. 

After-Repair Value (ARV):

This is a term often used by investors who buy flip houses or use the BRRRR method of real estate investing to figure out the property’s value after renovations have been completed. The ARV is also used to secure certain types of loans.

You can use an ARV calculator to figure out the property’s ARV value or you can use this equation:

Property’s Current Value + Value of Renovations = ARV

ARV can also be used by investors when they’re submitting an offer on a property that needs work. They use something called the 70% rule where they will use the ARV and cost to make the necessary repairs to come up with their offering price.

You can use a 70% calculator to figure out your maximum offer price or use this equation:

(ARV x 70%) – Estimated Cost for Repairs = Maximum Offer Price

Loan to Value Ratio (LTV):

When applying for a home equity loan, HELOC, or cash-out refinance, lenders will use this ratio to determine the amount of risk they’ll take on should you default. Higher LTV ratios won’t disqualify you from being approved for funding, but you will have a higher interest rate and may need PMI. 

You can use an LTV Ratio calculator to figure out the LTV ratio on your property, or you can use this equation: 

Mortgage Amount / Appraised Property Value = LTV Ratio

Chapter 6: Final Thoughts for Securing Funds for Investment Properties

The very first step in becoming a successful real estate investor is deciding that you’re ready to dive in without any reservations.

You can’t go into this business half-hearted and unknowledgeable because it’s very likely that you’ll make mistakes that could cost you a lot, financially, mentally, and professionally. It’s not a decision that should be taken lightly.

After taking the time to really think about your goals and how you’d like to achieve them, you’ll want to look into the area that you’d like to begin investing in.

By researching the local market, you’ll be able to see what properties are being sold for, how active the market is, and there’s a demand for rental properties. Fortunately, that’s not an issue considering 36% of households in the United States are renters. Even if you prefer to fix and flip, the demand for housing is there. 

Once you find the area you’d like to begin investing in and you’ve found an investment opportunity, you need to figure out which financing option is right for your situation.

There are many options out there and it’s in your best interest to research all of your options before making any concrete plans because you don’t want to fall victim to predatory lenders who will foist high interest rates and strict repayment conditions on you. 

Our goal with this guide was to provide you with easy to digest information regarding the different financing options available to new investors.

If you need some more in-depth advice about how to finance an investment property or have questions about investments in general, you can always count on New Western’s experts for great advice. 

Unlock access to our exclusive inventory of off-market investment properties.

Business isn’t about deals. It’s about relationships and we’d love to begin one with you. Interested in buying a property? Have a question about our process? Curious about a local market? Let’s talk.
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