Despite the many benefits of traditional real estate investing (including passive income, appreciation, and tax advantages) there is one major hurdle for real estate investors to overcome: financing the purchase of the new property.
Financing investment properties is more complicated than financing the purchase of a primary residence. Lenders may have stricter requirements, interest rates may be higher, and some mortgage types simply aren’t available for income properties.
But don’t worry, you still have options! In this article, we’re going to discuss five different ways to finance your next real estate investment. Whether this will be your first investment property or just another addition to your real estate portfolio, you’re sure to find a viable financing method here!
1. Traditional Financing
Traditional financing includes mortgage loans and home equity loans from financial institutions. Within this category alone, you have a few distinct ways to finance your next real estate investment:
- Conventional mortgages,
- Government-backed mortgages, and
- Mortgage refinancing/home equity loans.
Let’s take a closer look at each of these traditional financing options.
Conventional mortgages are the most popular traditional home loan type, and they can work well for real estate investments as well…if you have a substantial amount of cash available.
While requirements vary by lender, many lenders look for a down payment of 20-30% for an investment property. You’ll also need cash to cover closing costs, which can equal 3-6% of the purchase price. And you may be asked to have cash reserves to cover your existing debts plus this new mortgage for at least six months.
Additionally, most conventional lenders won’t consider future rental income when calculating your debt-to-income ratio (the comparison of your income to your debt payments to calculate affordability). This can make it harder to qualify for this loan type if you carry a lot of debt and/or don’t have a high enough income.
Generally speaking, government-backed mortgages, like FHA loans and VA loans, are intended to help buyers purchase primary residences; they are not designed for investment properties.
However, so long as you live in one of the units, you may be able to use an FHA loan or VA loan to purchase a property with up to four units. This style of house hacking is ideal for new investors who want to learn the ropes of managing rentals while conveniently living onsite.
Alternatively, you could purchase a fixer-upper with a government-backed loan and live onsite during the renovation process. This strategy can help increase the amount of money you can make flipping houses by giving you favorable loan terms. Just check with your lender to see if there is a minimum hold period during which you need to retain possession after the purchase.
Note: VA loans are reserved for military service members, veterans, and their spouses. FHA loans are open to a wider range of buyers. Both of these government-backed loan types come with specific criteria, so check with a lender before expecting to use this type of financing on your next deal.
Mortgage Refinancing and Home Equity Loans
If you own property with substantial equity, you may be able to tap that equity to cover the upfront cost of your next real estate investment.
Cash-out refinancing is one option. This would mean completely refinancing your existing home loan (paying off your current balance with a new loan under different loan terms). The new loan could put cash in your pocket, so long as you retain at least 20-30% equity in the property (depending on your lender’s requirements). And this cash could potentially be used as the down payment, closing costs, and/or renovation expenses for your new investment property.
Or, if you don’t want to refinance your existing loan, perhaps because you locked in a low interest rate when the loan originated, you might apply for a home equity loan. This would allow you to borrow against your home’s equity with a new loan. Just like your primary mortgage, home equity loans are secured by the property. So it is never advisable to borrow more than you are sure you can comfortably repay. Failure to repay a home equity loan against your primary residence could potentially result in the foreclosure of your home.
2. Private Money Lenders
If you cannot qualify for traditional financing, or you’re unhappy with the terms offered by financial institutions, you might consider asking for a private money loan to finance the deal.
A private money lender is any individual who personally loans money to another party. In many cases, real estate investors are able to borrow funds from friends or family to finance real estate investments. Depending on your relationship with the lender, you might be able to get favorable loan terms, like below-market interest rates.
The lender would benefit from recurring payments with interest. In most cases, the loan is secured by the property, meaning that the lender could potentially take possession of the property if you fail to repay the debt.
If you are investing in a short-term flip project, you might consider a hard money loan. This is a high-interest, short-term loan, typically used specifically for projects with quick payouts. It may be easier to qualify for a hard money loan than a long-term mortgage. And, if you decide to hold the asset after the renovation, you may be able to secure a long-term conventional loan based on the after-repair value of the asset, which you can use to repay the hard money loan.
3. Seller Financing
Seller financing could be considered a form of private money lending, but it comes with the distinct advantage of not requiring any prior relationship.
Seller carry-back financing is when the seller essentially acts as the bank, effectively loaning money to the buyer so the buyer can complete the purchase. At closing, you would pay the agreed-upon down payment to the seller, then you would make monthly installment payments of principal and interest to the seller until the loan is paid in full.
The seller benefits from the upfront cash influx from your down payment, as well as recurring income as you repay the loan. The seller also holds a lien against the property, meaning that they could potentially reclaim possession of the property if you fail to repay the loan as agreed. The interest incentivizes sellers to work with you on financing, and the lien gives them a level of financial protection against default.
You benefit from adding a new investment property to your portfolio that may have been inaccessible otherwise.
4. Retirement Accounts
Retirement accounts are typically full of stocks, bonds, and funds. But self-directed retirement accounts allow for alternative investment holdings, like real estate investments within the retirement account.
To invest in real estate through a retirement account, you first need to establish a self-directed retirement account with a custodian (a business or professional that manages the transaction, paperwork, and IRS reporting. The custodian is in place to keep a clear separation between you as an individual and your retirement account, which is its own entity.
Since the owner of the property is your retirement account (not you), all income is held within the retirement account. As with other retirement accounts, the funds will be effectively unavailable to you until you reach retirement age. Furthermore, the traditional tax benefits of real estate investing are largely nullified by investing through a retirement fund. As real estate held in a retirement account cannot be mortgaged, there is no mortgage interest to deduct. Nor are depreciation deductions available to investment properties held in a retirement account.
It’s also important to note that retirement account real estate holdings must be exclusively for investment and cannot be used for personal purposes. You would not be able to use the property as a vacation home or as a dwelling for any disqualified person, which includes yourself, your spouse, children, grandchildren, parents, grandparents, etc.
The benefit would be that you can hold a property long-term, with all rental income growing tax-free within the retirement account.
Pooling funds from individual investors can give you the capital you need to finance your next real estate project. Real estate crowdfunding has exploded in popularity since 2012, when a clause in the JOBS Act made way for “broad-based funding” of real estate developments, renovations, and rentals. Deals that were once reserved for private networks of wealthy investors could suddenly be made available to the public.
But crowdfunding isn’t without complexities. There are SEC financial reporting requirements, for example. You would also need a system to market your deal to potential investors, track incoming investment funds, keep your investors updated on the progress, and disperse funds back to investors. Many real estate developers and general contractors choose to partner with an existing sponsorship platform to handle all of this administrative management.
On the other hand, instead of collecting investments from multiple investors, and attempting to manage the project, you could join other investors in existing crowdfunded real estate projects. Not only would this remove the administrative burden from your shoulders, but it would also shift the hassle of project management to the project’s sponsor, allowing you to benefit from purely passive returns.
Just as importantly, by pooling your funds with those from other investors, you’re dramatically reducing your upfront capital requirement, effectively removing the need to secure financing for your next real estate investment!
Join in a Crowdfunded Project with Gatsby Investment
Rather than struggling to secure financing for your next real estate investment, why not join in a professionally management project with Gatsby Investment?
Gatsby Investment is a California-based real estate investment company that specializes in Core, Core +, Value-Add, and Opportunistic deals with high-return potential. With Gatsby, you get all the benefits of investing in real estate without the hassle and financial risk of doing it alone.