For many prospective real estate investors, one of the biggest hurdles to even getting started is securing financing for an investment property. Don’t be too discouraged if you’re unsure of where to come up with the money to buy a property. You don’t have to pay in cash. In fact, you shouldn’t! There are a multitude of financing options and strategies available that can help you to not only purchase your next investment but also to manage it efficiently.
Let’s take a look at some of the most common and viable financing routes specifically tailored for real estate investors, so you can make informed decisions on securing the best possible deal for your next Hampton Roads property investment.
Common Types of Loans
These are what many of your first-in-line options will be, whether you’re a new investor or an experienced real estate pro who is growing a portfolio.
Traditional Mortgage Loans
With a traditional mortgage, investors can usually borrow up to 80% of the property's value, although this can vary depending on the lender and your financial circumstances. When opting for a mortgage, it's essential to compare rates and terms from different lenders to ensure that you're getting the most cost-effective deal. Remember, factors such as your credit score, the amount of your down payment, and the condition of the property can all influence your eligibility and the rates you're offered.
Be aware of what interest rates look like right now. As mortgage rates remain historically high, it’s not as easy to get the loan you want in the amount you need. This should not preclude you from getting a traditional loan, it’s simply something to be aware of as you shop around for the best rates and evaluate your own creditworthiness.
Hard Money Loans
Hard money loans are a popular financing option for real estate investors, especially those who need quick cash to take advantage of a good investment opportunity or for investors who plan to flip the property they buy. These short-term loans are offered by private companies or individuals and carry higher interest rates than traditional loans. They are primarily based on the value of the property instead of the borrower's creditworthiness, which is why they can be approved much faster. Be mindful of the term of the loan; you’ll likely have to sell your property or refinance it within a couple of years.
Portfolio Loans
A portfolio loan is similar to a mortgage, but the major difference is that your lender originates and retains instead of selling on the secondary mortgage market. They keep your loan, which means you have more flexibility than you would with a traditional mortgage. You’ll have access to additional financing options, too, which you can use now or later. These include lines of credit, refinancing, and cash-out refinancing. Portfolio loans are ideal for investors with multiple properties who want to streamline their financing and payment processes.
Government Loans
There are several government loan programs designed to stimulate the property market and enable more people to invest in real estate. For instance, the Federal Housing Administration (FHA) offers loans to investors who wish to purchase a multi-unit property and occupy one of the units. These loans typically offer competitive rates and may require smaller down payments than traditional mortgages.
Home Equity Loans
If you already own property, tapping into your home equity can be a powerful tool. A home equity line of credit (HELOC) can provide you with funds up to a certain limit, which you can draw from to pay for your investment property. The interest rates can be lower than other types of loans, but bear in mind that your first home becomes the collateral, which presents its risks.
Seller Financing as an Option
Many investors consider seller financing to be one of the best lending deals you can find. The seller is actually taking on the role of the bank. The seller of the property you’re buying would put you on the title of that property, and in return, you will sign an all-inclusive trust deed and promissory note. Your documentation would include an agreed upon sales price, interest rate, and amortization schedule. You’ll know when your monthly payments are due, and how much they will be. You agree contractually to make these payments on a monthly basis.
Most seller financing agreements include a balloon payment, which is made in three, five, seven, or maybe 15 years. At that point, the full amount of the loan is due. The sellers sign the property over to you at the same time they’re signing the promissory note. If you default, they have the right to act as if they were the bank, and they can foreclose and take it back from you. It’s like any other foreclosure; it will ruin your credit and remove the asset from your possession. It’s not something you want to happen.
With a seller financed deal, you will agree to the price, payments, insurance, etc. You also agree to the period of time when that balloon payment is due, and you have to pay off the balance. We know property mortgages often have 20 or 30 year amortization schedules. These seller-financed loans are a little quicker. The idea is that at the exact point when your balloon payment is due, you do a rate in term refinance. This refinance allows you to take equity out of the home. You’ll get that equity by putting money into the home or paying down the loan balance or increasing the value. You’ll refinance the loan and pay off the seller, who was carrying the note.
You’ll want to have your contract reviewed by an experienced real estate attorney before you move forward with seller financing. It’s an excellent idea if you’re not a good fit for traditional financing, and you’re looking for terms and payment schedules that can be negotiated and flexible.
Buying an Investment Property with Retirement Funds
You can use the money you have vested in an IRA or a 401K retirement plan to fund the purchase of an investment property. This has become more common than it once was, but you need to make sure you understand the IRS rules and restrictions. Otherwise, there may be penalties that surprise you.
Here’s what you need to know:
Self-Directing Your IRA: To buy property with your IRA, you must have a self-directed IRA which allows for a broader range of investments, including real estate.
Unrelated Debt Financed Income (UDFI): If you leverage your investment with a mortgage, part of the income could be subject to UDFI taxes.
Prohibited Transactions: The IRS prohibits certain transactions between the IRA and disqualified persons, such as the IRA owner or family members.
Non-Recourse Loans: Any loan used to buy property within an IRA must be non-recourse, meaning the lender's only recourse in case of default is the property itself, not other IRA assets.
Direct Benefits: You and other disqualified persons are not allowed to get direct benefits from the property; it's strictly for investment purposes.
Here are the steps you’ll need to take if you decide to finance an investment property with your own retirement funds.
Step 1: Choose the Right Retirement Account
Set up a self-directed IRA through a custodian that allows real estate investments. Understand the difference between traditional IRAs, Roth IRAs, SEP IRAs, and Solo 401Ks to decide which is best for your situation.
Step 2: Identify the Investment Property
Research the market to find a property that meets your investment criteria. Consider factors like location, potential for appreciation, and rental income opportunities.
Step 3: Due Diligence and Financing
Perform due diligence on the property. If you require additional financing, secure a non-recourse loan. Remember, not all lenders offer non-recourse loans, and the ones that do might require a larger down payment and charge higher interest rates.
Step 4: Purchasing the Property
The investment property will be owned by your IRA or 401K, not you personally. All documents must reflect this, and all transactions must be made directly from your retirement account.
Step 5: Management of the Property
Choose a property management company or set up arrangements for maintaining the property, as you cannot perform maintenance yourself. All expenses must be paid from the IRA, and all income must return to it.
Step 6: Understanding the Tax Implications
Consult with a tax advisor to understand the implications of UDFI if you use borrowed money to purchase the property, as well as any other tax considerations.
Step 7: Planning for Retirement Distributions
Plan how real estate assets will be handled once you reach the age for required minimum distributions (RMDs). Real estate cannot be divided in the same way as stocks, so you’ll need a strategy.
Financing an investment property can be complex, but with research and due diligence, you can find the option that best aligns with your financial goals and risk tolerance. Whether you're looking at traditional loans, tapping into government programs, leveraging your current assets, or partnering with others, there are a plethora of ways to finance your real estate investments. Just remember, it's important to consult with financial advisors, mortgage brokers, or legal professionals to fully understand the implications and responsibilities that come with each financing option.
We are not mortgage brokers, but we have a lot of experience in real estate and property management. Let’s talk about your options. Contact us at Doud Realty Services, Inc. We provide expert property management in Norfolk, Portsmouth, Hampton Roads, as well as surrounding areas such as Virginia Beach, Suffolk, Chesapeake, and Newport News.