Understanding Financing Options for Acquiring Rental Properties

Twenty-seven percent of people surveyed by Bankrate stated that real estate is the best investment out there when you won’t need the money for at least a decade. As the number 1 pick, it beats out cash investments, the stock market, precious metals, and more.

Introduction

Twenty-seven percent of people surveyed by Bankrate stated that real estate is the best investment out there when you won’t need the money for at least a decade.1 As the number 1 pick, it beats out cash investments, the stock market, precious metals, and more. While many people like the idea of investing in rental properties, there are only 7 million active real estate investors in the United States.2 The reason this number is so small is two-fold. Some people are afraid to dive in because of the previous housing crisis, which led to over 4 million foreclosures, and others simply don’t know how to secure the funds they need.

You can avoid the first problem by using VerticalRent to protect your investment. VerticalRent can help you screen applicants with tenant credit reports, ensuring that you end up with quality tenants in your property. That way, the money will keep coming in month after month, and you can make your mortgage payments. That is the key to avoiding foreclosure.

You can solve the second problem by learning about your financing options. You have more options that you can imagine. You can find the right option, regardless of your credit history, networking abilities, or portfolio. Look through everything from standard to unique financing options and find the one that works best for you. When you pick your option, you can move forward with your rental property, with or without a conventional mortgage.

Investment Property Loans

Investment property loans are the conventional option for investors who want rental property. These loans are available from banks of all sizes. Before you dive in and apply for a loan, you need to do your homework to understand what will be expected of you during the process.3

First, you will need a sizable down payment for your mortgage loan since you can’t carry mortgage insurance for an investment property. Most banks require a minimum of 20 percent down for investment property, and some require as much as 30 percent down. Consider putting as much money down as you can, as that might improve your interest rates. A sizable down payment will also help you build equity in the property sooner. That, in turn, can help you secure additional investment property loans in the future.

Speaking of interest rates, the rates for investment property loans are typically 0.25 to 0.5 higher than the rates for owner-occupied mortgages.4 In other words, if you buy a property to live in, you will pay less than you would for an investment property. This is typically true, regardless of the bank that you choose.

Most banks will also require that you have at least two years of experience in property management. You will have to use your taxes to prove that you have the experience. This can be a deal breaker for people who are new in the real estate investment game. Many people don’t have any property management experience, and they want to learn on the job with their first investment property. Learning on the fly scares banks, though. They want to stick with seasoned property managers to ensure that the money comes in every month.

Banks will also look at your credit score. The more rental properties you have, the higher your score will need to be. If you are buying your first one, you can find some lenders who will loan you the money, even if your score is under 600. Of course, you can expect to pay a hefty interest rate if your score is that low.

Most traditional banks require a higher credit score, though, and those standards will just increase as you build your portfolio. Your current credit score might help you be approved for your first loan, but it might not help you get subsequent loans. To ensure that you can get all of the money you can, work to get your credit score over 700. This is the sweet spot, and you will typically get all of the financing you need.

Refinancing an Investment Property Loan

If you do end up securing a loan with a high interest rate, keep in mind that you might be able to refinance it and get a lower rate. However, refinancing isn’t the same for a nonowner-occupied property as it is for an owner-occupied property. You will need to have at least 25 percent equity in the home to refinance it.5 Lenders are afraid you will walk away from the investment property if you are upside down or haven’t put a lot of money into it, which is why they have this requirement. Most lenders also won’t refinance the home for you if you already have a second mortgage on it.

While those rules are relatively hard and fast, banks might be a little more flexible when it comes to your credit score and refinancing. If your score isn’t high enough to secure a loan for another investment property, you might still be able to refinance it. It is best to talk to a lender to find out your options.

Finance the Home as an Owner-Occupant

Taking out an investment property loan can be a little scary for first-time investors. If you want to dip your toes in the investment water but you don’t want to take out that type of loan, consider financing the home as an owner-occupant. This type of loan offers some huge benefits, but you do need to make sure you follow all of the rules. You will have to stay in the home for a minimum of 12 months after you purchase it. During that time, you can make any improvements you need to the rental property. Then, when you move out, you will still enjoy all of the benefits that come with an owner-occupant loan. The terms won’t change, even when you leave the property.6

Understanding the residency requirements is the first step. Looking at your loan options is the second step. Owner-occupant borrowers can choose from conventional mortgages, FHA loans, and VA loans. You have to meet the eligibility requirements for an FHA loan or VA loan in order to get the financing. Regardless of the option you choose, you can expect a lower interest rate than you would get with a conventional investment property loan.

The Federal Housing Administration backs FHA loans. Borrowers reduce the risk of the loan by paying for mortgage insurance. While many people think these loans are only available for first-time homebuyers, that isn’t true. In fact, many people get these loans when they don’t have enough money for a 20 percent down payment and their credit scores disqualify them from working with traditional lenders.

In fact, you can pay as little as 3.5 percent down with an FHA loan. In order to qualify for that amount, you need a credit score of at least 580. If your credit score is between 500-579, you can pay as little as 10 percent down. The lower your credit score, the more you will pay in interest, though, and that can get costly over the years.7

If you are a military veteran or an active member of the armed forces, you can apply for a VA loan. These loans are also available to the spouses of those who died while serving the country. As a rule, if you spent any time on foreign soil as a part of the military or lost a loved one who died while on foreign soil, you are likely eligible for one of these loans.8

The VA guarantees these loans, and you don’t need a down payment to get the mortgage. You also don’t need mortgage insurance. In addition, the VA doesn’t have a credit requirement, although lenders often do. You will actually get the money from a lender, and the VA will back the loan. Shop around to find a lender who will lend you the money with your specific credit score.

If you decide to move forward with a VA loan, you will have to pay a one-time funding fee. The amount of the fee varies, depending on factors that include the type of veteran you are and the amount of money (if any) that you put down. You can get a VA loan multiple times, so consider applying, even if you have been funded with a VA loan in the past.

See if you qualify for one of these loans or if you need to go with a traditional mortgage. Then, arrange to meet the residency requirements before moving forward. Once everything is in place, you can live in the home for a bit and then start renting it out. It can go from your home to your investment property just like that. Just make sure you use a service like VerticalRent to screen your tenants before making the switch. You could end up with a nightmare on your hands if a quality tenant doesn’t take your place. You need that money to come in so you can pay off the mortgage in a timely fashion.

Hard Money Loans

Commonly referred to as bridge loans, hard money loans are available on a short-term basis. Instead of getting the money from the bank, you will get the loan from a private lender.9

Hard money loans are popular with house flippers. Flippers pick up these short-term loans, flip homes, and sell them quickly. Then, they pay the lender back without much time passing. While that is the most popular option, they are also a tool for investors to use to purchase rental property.

This is a good option for investors who have poor credit scores that prevent them from securing traditional financing. Hard money lenders don’t look at credit scores. Instead, they assess the property’s value. They traditionally look at the value after the repairs, since these loans are often provided to investors who want to rehab the property. If you don’t intend to make repairs, let the lender know that you are going to put it up for rent immediately.

Several benefits come with securing hard money loans. First, they are incredibly convenient. While it might take months to secure a mortgage loan, you can get a hard money loan in weeks. If you are ready to dive in and get started with an investment property, saving the time is important. This is especially true if you already have your eyes on a piece of property and you don’t want to miss out.

The terms are typically pretty flexible with hard money loans, as well. You are working with private lenders instead of a big institution, so you can haggle the terms. That goes beyond the interest rate. You might even be able to negotiate the repayment schedule to something that works better for you. This makes it much easier to pay the loan on your terms.

You also have collateral built in place with the loan. The property work as the collateral, and some investors will let you secure it with your own home or retirement account, as well. This type of flexibility is nice for someone who needs money quickly.

Unfortunately, there are also some drawbacks with this type of loan. You can expect to pay a high interest rate if you go with a hard money loan. Many hard money lenders charge as much as 10 points higher for these loans. You won’t just pay more when it comes to interest, either. You can expect to pay more closing costs, loan-servicing fees, and loan-origination fees with this loan.

You also won’t have much time to repay your loan. This loan acts as a bridge, so you will be expected to pay the money back much faster than a traditional loan. You can secure a traditional loan for 30 years, but expect your bill to come due in as little as a year with a hard money loan. Some hard money lenders will extend the payment terms up to five years, though, so you might be able to get a decent amount of time to pay it back.

It’s very important that you make sure that you are able to meet the repayment terms before agreeing to a hard money loan. If possible, use this type of loan to finance part of the transaction instead of the entire one. You can quickly become overwhelmed if you use a hard money loan to get hundreds of thousands of dollars.

Private Money Lenders

Private moneylenders are also an option for real estate investors who want to pick up a rental property. Private moneylenders loan money to real estate investors to build their own investment portfolios. They earn a healthy return, and you are able to get the money you need for your investment property.

They might be making an investment, but private moneylenders typically offer good interest rates. They are also usually easy to qualify for, but they are short-term loans. Don’t expect to pay the money back over the course of 30 years. You might be able to spread the payments out over several years, though, depending on the lender you choose.

The interest rate isn’t the only difference between these loans and hard money loans. While hard money lenders enter into the relationship for purely business purposes, private moneylenders are typically more relationship based. They still want to enter into a solid investment, but because they are family, friends, or professional colleagues, the relationship is the foundation of the transaction.

You will have to do a little bit of work in order to secure funds from a private lender. Follow some steps so you can get this type of loan.10

First, create a list of anyone and everyone who might serve as a private moneylender. This includes investment-minded friends, family, and colleagues.

Then, create a presentation that you can show to the potential investors. The presentation should include a portfolio of potential rental properties that you can pick up now. Include all of the costs associated with the properties, including closing costs and how much you will spend on renovations. Then, go over the capitalization (cap) rate for each property. The cap rate is the annual return you and the lender can expect on the investment.11

In order to determine the cap rate, take the annual rent you expect to earn and subtract the property’s expenses. That will give you the net income. Then, divide that number by the cost of the property to get the cap rate.

After you create your presentation, invite your list of potential investors over and present it to them. If no one bites, you will need to pursue other investors. Search for investor groups and invite them to attend your presentation. You can also join the American Association of Private Lenders and do some networking through it. Continue this process until you find private investors. This is not an easy option, but you can find a lender if you put all of your energy into it.

Take Money Out of Your House

You have likely heard that there is no better investment than real estate. That includes the real estate you reside in. If you’ve been diligently paying your mortgage for years, you likely have enough equity in it to take some out and buy a rental property. You have three options for this. You can get a home equity loan, home equity line of credit (HELOC), or cash-out refinance.12

A home equity loan is just another name for a second mortgage. A second mortgage allows you to borrow against the home’s equity. It’s secured against your home, meaning you will use your home as collateral. As long as you have a lot of equity built into your home, you can take out quite a bit with this type of loan. You will also benefit from a fixed interest rate with a home equity loan. No matter what goes on with the market, you will pay the same amount every month.

A HELOC is also a second mortgage, but instead of getting a lump sum, you will get a line of credit. Your interest rate will go up and down, depending on what is going on with the market. This is a good option if you want to use the loan to make some repairs to your rental property, but you should look at another option if you actually want to buy a property. It doesn’t make sense to take out a line of credit when you need a lump sum of money to make a purchase.

A cash-out refinance replaces your first mortgage with a mortgage for a higher amount. You can take the extra money out in cash. As a benefit of this mortgage, you can often get a lower interest rate with a cash-out refinance.

Since this one is a little bit more complicated, let’s look at an example

Let’s say that you have a home that is worth $200,000. You have been paying on it for years, and now, you only owe $50,000. You want to borrow $50,000 so you take out a cash-out refinance loan for $100,000. That loan is worth $50,000 more than you owe, so you can pocket the $50,000 and make payments toward the $100,000. You will likely get a better interest rate since you are only borrowing $100,000 this time instead of $200,000.

Regardless of the type of loan that you want to get, you have to have a lot of equity. Simply having a few thousand dollars in equity won’t work.

Fannie Mae and Freddie Mac require that people have at least 15 percent equity in their homes if they’re cashing out their equity into a fixed-rate mortgage. If you want to move to an adjustable-rate mortgage, you need to have at least 25 percent equity in your home to take out the loan. If you want to take out a HELOC, you need to have 20 percent equity in the home. This extra money covers any costs the bank will have to go through to take back the home if you default on the loan.

Along with your equity, your lender will look at your debt-to-income ratio. The best-qualified applicants sit at around 45 percent.

You also have to consider your credit score. Even though the loan is secured by your home, lenders still require a decent credit score before releasing the funds. Most home equity lenders require a credit score of at least 660. You can increase your chances of being approved by boosting your score up over 700.

Cash-out refinances don’t have the same strict credit requirements. Fannie Mae backs cash-out refinances for people who have credit scores of 640, but you have to jump through a couple of extra hoops to get the money. You need at least 25 percent equity in your home and you need to have a debt-to-income ratio that is less than 37 percent. You also need to have a minimum of 6 months of reserves tucked away in your bank account. If you don’t want to have to jump through all of those hoops, you need to work on your credit first.

If you meet the requirements for your desired loan, you will be ready to move forward. Start the process by getting your home appraised. The bank will need to know the current value of your loan in order to determine how much equity you have. Before calling the appraiser to stop by, see if you can do anything to increase the home’s value. Walk around the home and look for any issues, such as cracked tile. Don’t go all out and redo the kitchen or bathroom, though. There isn’t a good return on investment with those types of upgrades. You will typically spend quite a bit, and it won’t increase your home’s value by very much.

Then, you need to find a lender who offers these types of loans. Check with your current mortgage company first, but if you can’t get it from it, you will have to look to another company.

Retirement Loans

Some investors choose to remove money from their IRAs or 401(k)s in order to get the funds they need to buy real estate. This is a risky move since borrowers might have to pay an early withdrawal penalty and will be forced to pay back the sum immediately if they lose their jobs. Only do this if your job is secure and you have ample time to build up your retirement portfolio.13

Even if you’re still a long way off from retirement, you need to be very careful with this. Do your homework to make sure that your return on investment will be solid enough to replenish your account in a timely fashion.

Build Your Portfolio with a Solo 401(k)

A Solo 401(k) is a self-directed retirement account. If you own a small business that only consists of you or you and your spouse, you can open up one of these accounts and direct your investments. You will act as the plan’s trustee, and you can choose where your investment funds go.14

Start by building up the fund and then direct it to real estate investments. You can choose to purchase rental property with your self-directed 401(k) and then fill it with renters. You will purchase the property as direct investments, and your retirement fund will actually own each investment. You will take the rental income and put it back into the plan, boosting your retirement account. This will set you up for retirement, and it will also make it easier for you to buy more rental properties. Soon, your self-directed retirement plan will be a well-oiled machine, taking in money and buying up rental properties all over the place. Plus, with the help of VerticalRent, you can find quality tenants who will help you protect your investment. That is an important component of your investment property machine.

The Cash/Finance Switch

Cash is king in real estate investments. For the first quarter of 2016, all-cash buyers paid a median of $91 a square foot. Compare that to the $118 a square foot that’s the median price for all buyers, and you see why cash rules in real estate. Cash buyers just snatch up property that no one else was interested in, either. When cash buyers and traditional buyers go after the same property, the property is often awarded to all-cash buyers, even when the buyers offer less. Sellers prefer to deal with cash, so all-cash buyers are awarded time and time again.15

There’s a problem though. Most investors don’t have the cash they need to take advantage of this. In fact, only a small number of investors put down more than 50 percent at the time of purchase.

You can change things up by taking a page out of the playbook used by experienced investors. Start with cash and then follow it up by financing the property with a traditional loan. While this is more complicated than other forms of financing, it can pay off with huge dividends in the near future. 16

Begin the process getting the cash in any way that you can. Use one of the other methods discussed, such as taking out a home equity loan or borrowing from a private lender.

Wait for six months and then take out a Fannie Mae-backed loan for 75 percent of the home’s value. For instance, if the home is worth $100,000, you will finance it for $75,000. You will get better terms than you would with a complete cash-out refinance, but your interest rates will be a bit higher than it would if you were an owner-occupant.

That all sounds pretty normal, but here’s where the real estate trick comes into play. When you use Fannie Mae, you can finance up to four properties with a 25 percent down payment, and that doesn’t just count for single dwelling homes. Fannie Mae counts duplexes all the way to fourplexes as single properties. This lets you quickly add to your portfolio with a single down payment.

With this simple technique, you can get a lower purchase price, quickly pay back the source of the cash, and get four properties with one down payment. This is a great way to build your investment portfolio quickly.

U.S. Small Business Administration Loan

When you think of the SBA, you don’t really think of using it to build up your investment portfolio, but you can do just that, as long as you own your own business and keep office space. The key is your business has to occupy at least 51 percent of the property to get the loan. You can get the loan for the entire piece of property and rent the rest of it out.

Let’s say, for instance, that you have an office building on the bottom floor of a two-story building. The top floor has apartment buildings. As long as your company occupies at least 51 percent of the property, you can take out a loan for the entire building, and then rent out the top-floor apartments. You can make a nice rental income and still run your business from the same location.

If you are able to do this, you will enjoy some huge benefits.

First, SBA 504 loans only require a 10 percent down payment. This is a great option for people who are new to investing and don’t have the capital to put a lot of money down. You can get started with real estate investing without draining your retirement account or taking equity out of your home.17

It’s important to note that in some cases, you can put down even less than 10 percent of the cost. This occurs when the city or state is working hard to attract small businesses. The SBA might offer a lower down payment in order to get your business up and running. Then, you can help the community.

These loans also come with a fixed rate, so you don’t have to worry about your payments going up. The prime lending rate can balloon, but you will still get the same monthly payments and interest rates you’ve always had.

These loans are also long term, which is critical for investors. You can get a 504 loan for 10 to 20 years. That means lower monthly payments than you would get with a short-term loan.

These loans also have low interest rates. Even when you consider the fees and closing costs, the rates are low.

Crowdfunding

The technological world has changed the investment landscape, even when it comes to real estate. Real estate might consist of physical properties, but more and more people are turning to technology to get the money for them. They do this with crowdfunding.

First, it’s important to understand what crowdfunding is. Crowdfunding sites connect people who need funds with those who have them. You have likely seen crowdfunding sites in the past. GoFundMe is a great example of a crowdfunding site. People in need use the site to raise money for medical costs and more.

In regards to real estate, though, you should take an example from Kickstarter. Kickstarter is quite a bit different from GoFundMe. Instead of giving out of the goodness of their hearts, people typically give money to get something in return when they use Kickstarter. They help someone make something and they get some sort of prize for their money.

Real estate crowdfunding is similar to this. People aren’t going to give you money because you are a nice person and they believe in your project. They are going to give you money because they are getting something in return.

In some cases, investors get equity stakes in the project. In other cases, the investors collect returns that are passed on from the crowdfunding site.

This might sound like an amazing opportunity, but it’s important to understand that it is already incredibly saturated, so you really have to stand out in order to get the money.

You also have to comply with the rules. Nonaccredited individuals can make investments on crowdfunding platforms, but you have to watch how much of their money you take. Investors can only raise $1 million a year from nonaccredited people for a project. Those limits might be lifted in the future, but in the meantime, watch out so you don’t break any SEC laws.18

You also have to make sure you stick with a legitimate crowdfunding website. Some sites are little more than brokers hiding behind the guise of running a crowdfunding site, while others charge exorbitant fees.

If you need proof that the real estate crowdfunding market needs some work, look at the research conducted by real estate developer Ian Ippolito. Ippolito researched more than 100 real estate crowdfunding sites. He looked at transparency, pre-funding, volume, fees, bankruptcy protection, and more, and found that only 1 out of 5 sites was actually reputable.19

If you are interested in trying crowdfunding, stick with one of Ippolito’s recommendations, such as Peer Street or Realty Mogul. If you venture off the beaten path and try something else, you could end up losing your investment before it has the chance to take off.

Choose the Right Option for Your Needs

Each of these options has benefits and drawbacks. Weigh your options and choose the one that works best for your specific needs. If you have stellar credit, you might want to go with a traditional financing option. If your credit leaves something to be desired, consider bucking tradition so you can pick up some investment property.

Regardless of the route that you choose, make sure to utilize the free tenant screening available from VerticalRent. It doesn’t matter how you finance your investment. You want to protect it, and VerticalRent can help. Check your tenant’s credit, run a background check, and more with this free service.



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14Dmitriy Fomichenko. “Investing in Real Estate for Retirement With a Solo 401(k), NerdWallet.com, November 30, 2015, https://www.nerdwallet.com/blog/investing/real-estate-investing-retirement-solo-401k/.
15“Q1 2016 Cash Homebuyers Bought at an Average Discount of 23 Percent Nationwide, But Paid a Premium in 9 Markets,” Realtytrac.com, April 26, 2016, http://www.realtytrac.com/news/home-prices-and-sales/q1-2016-cash-buyer-institutional-investor-housing-report/.
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17Stephen Umberger. “U.S. Small Business Administration Loan Funds Available to Purchase Commercial Real Estate,” SBA.gov, https://www.sba.gov/content/u-s-small-business-administration-loan-funds-available-purchase-commercial-real-estate.
18Patricia Clark. “Inside the Real Estate Crowdfunding Land Rush,” Bloomberg.com, May 9, 2016, https://www.bloomberg.com/news/articles/2016-05-09/inside-the-real-estate-crowdfunding-land-rush.
19Ian Ippolito. “Top 100+ Real Estate Crowdfunding Sites: Rankings and Reviews,” TheRealEstateCrowdfundingReview.com, http://www.therealestatecrowdfundingreview.com/top-100-sites-ranked-and-reviewed.


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