Nowadays, financing real estate has become easier thanks to the proliferation of different lending options that include government-backed mortgage, hard money, commercial loans, private money, among others.
The list below explains the pros and cons of each option in real estate investing and financing to help you decide which one is the most ideal based on your situation.
Most home buyers choose this financing option that typically requires a minimum of 20 percent down payment, although for investment properties it may be a bit higher, around 25-30 percent.
Meanwhile, most home buyers and real estate investors use a conventional mortgage to purchase a property.
Pros: Due to the relatively high DP expected on a conventional loan, the lender may not require the borrower to carry private mortgage insurance; this type of insurance is typically required in loans with low DP, which feels like applying for another loan approval.
Cons: If you have low credit scores, a conventional mortgage may come with high-interest rates. Also, it often carries higher interest rates compared to most government-backed loans.
All Cash Deal
First and foremost, this is a misnomer because it often entails writing a check to the seller, instead of giving cash per se. According to a recent study, about 24 percent of US investors prefer this financing option, which of course comes with benefits and caveats.
Pros: Because the sellers assume no risk and thus they are very partial to this financing option, borrowers perceive that they should be able to haggle for a lower price.
Cons: One of the major drawbacks is that you will not enjoy a mortgage interest tax deduction. Another possible issue is the loss of earning power on the money used to make the huge purchase.
Home Equity Loans
To access this financing option, your house is used as a collateral. Generally, it provides access to huge amounts of money that makes this ideal for financing real estate.
Pros: It is easier to qualify for home equity loans than other financing options because the lender assumes lower levels of risk. After all, people are more likely to prioritize this over other debts such as credit cards. Other benefits include lower interest rates and potential tax benefits.
Cons: Failure to repay means you’ll lose your home.
In bank financing, it is generally harder to qualify for an investment property than for a home loan because most financial institutions feel it comes with more risks. Hence, to counteract the perceived risk, they often demand a high DP–i.e., at least 20-25 percent of the property value.
Pros: It often comes with low-interest rates and flexible terms (lower monthly payments and/or longer repayment periods).
Cons: Borrowers with poor credit history, high debt-to-income ratio, and insufficient cash reserves (most lenders require at least a six-month’s worth of cash reserves) are often disqualified.
This financing option typically applies to properties with five or more units. Also, the lenders usually extend a business line of credit to help you in financing real estate or doing flips.
Pros: Commercial loans offer more flexibility in property type and ownership, and usually come with a 15-20 year amortization schedule.
Cons: The interest rates are higher than government-backed loans (about 6-7 percent), which means higher principal paid every month.
The Federal Housing Administration (FHA) loans have made homeownership easier for more and more Americans primarily due to their low DP, which can be as little as 3.5 percent. This financing option also suits people with credit issues that could make it difficult to get approved by conventional lenders.
While FHA loans generally exclude investment properties, there are exceptions or “loopholes” to the rule. For instance, borrowers who live in one of the units are eligible for this financing option, or they plan to use the property as a primary residence before moving out to buy another home.
Pros: Aside from its low DP, its standard 15- to 30-year fixed arrangement also suits many borrowers.
Cons: Low DP comes with several caveats: bigger monthly payments; mortgage insurance is a prerequisite and is paid for the entire life of your loan, and seller hesitation since paying a low DP might be a sign that you are not yet on a solid financial ground.
Also, the types of property that can be purchased with FHA loans are rather limited. For instance, some condos, foreclosed houses, fixer-uppers, and major bargains (which are generally in poor condition) are almost always excluded.
Despite being a subset of FHA loan, this type of financing allows you to buy (or refinance) a home that requires repairs or improvements.
Pros: Just like FHA loan, 203K loan also comes with low DP that makes it appealing to cash-strapped homebuyers.
Cons: Since it is basically a subset of FHA loans, 203K also comes with the same caveats.
HomePath Mortgage Loan
This is offered by government-backed mortgage giant Fannie Mae; this caters to both homebuyers and real estate investors who can even use it to finance repairs.
Pros: Even with a low DP, it does not require any mortgage insurance. Also, it comes with a more relaxed process.
Cons: Compared with other government-backed mortgage loans, it comes with higher interest rates and requires a lot of the closing cost if you can only give 3 percent down. However, the most notable downside is that Fannie Mae makes no guarantee on the property since it does not conduct any property inspection. Fortunately, you can bring your own property inspector, so you know what you’re getting into.
Private individuals and businesses provide this short-term loan (3-36 months) specifically to real estate investing. Consequently, a wide range of properties qualify for this loan, including those in poor condition.
Pros: Borrowers with credit issues who may not qualify for other financing options may consider hard money. After all, it rarely involves income verification and credit references, and so it allows for quick funding.
Cons: It comes with a high-interest rate, typically ranging between 8 percent and 15 percent.
Private money is almost similar to hard money, although the difference is that the lender-borrower relationship is more lenient. After all, as a borrower, you can negotiate the term length, interest rates, and fees provided that the arrangements will serve the best interest of both parties.
Pros: Because the relationship between the borrower and lender is less “business-like,” there is more room for negotiation.
Cons: The private money lenders can seize the property in the event of payment failure