When you’re moving towards your goal of investing in real estate, you’ll need to understand the basics of financing your property acquisitions. This holds true whether you’re purchasing your first rental property or aiming to expand your current portfolio of assets.
Securing the appropriate financing can be the start of a successful and profitable investment experience. A deep knowledge of investment property financing can be the difference between a thriving investment and one that turns out to be more expensive than you expected.
It starts with understanding your own financial readiness. There’s no sense in chasing after financing if you’re not prepared. There are some really great investment opportunities throughout the Nashville market. You can’t make an offer if you don’t have your money in place, however.
Let’s find out how prepared you are financially, and then we’ll offer some diverse and creative financing options that investors are commonly taking advantage of when they buy property.
How to Know You’re Financially Ready to Invest
Before you start browsing for properties or negotiating deals, take an honest and complete look at your financial situation.
- Assess Your Debt-to-Income Ratio
A critical factor that lenders will consider is your debt-to-income (DTI) ratio—the percentage of your monthly income that goes toward paying debts. To invest in real estate, aim for a DTI ratio that is within manageable limits, preferably below 36%. This shows lenders that you have control over your debts and can handle additional financial responsibility.
- Get to Know Your Credit Score
Your credit score is the briefest possible synopsis of your financial health, and it’s going to play a huge role in determining the loan terms offered to you. A high credit score can lock in lower interest rates, which can save you tens of thousands of dollars over the life of a mortgage. Make sure you’ve built a strong credit history before considering a real estate investment.
- Analyze Your Liquidity
Investing in real estate requires you to have some liquid assets available, not just for the down payment and the closing costs, but also for any unexpected bills like emergency repairs. Financial advisors typically recommend having at least six months’ worth of living expenses set aside as an emergency fund.
- Understand the Market
Being financially ready isn’t just about having the money. It’s also about knowing when to invest. Take the time to understand the real estate market trends, the local Nashville economy, and the historical appreciation rates of properties. Educated investments are often less risky investments, and you’re more likely to find some diverse financing opportunities when you’re educated about where they may be found.
- Calculate Affordability Beyond the Down Payment
Some of your most common expenses once you own investment property will be property taxes, insurance, maintenance, and property management fees. Run the numbers to ensure you can comfortably afford all associated costs.
- Forecast Your Return on Investment (ROI)
Create a realistic projection of your potential rental income and compare it against your ongoing expenses. A positive cash flow is a good sign you’re ready to invest, but also consider the long-term value appreciation of the property in your ROI calculations.
Investing in real estate can be an excellent opportunity to build wealth over time. However, determining if you’re financially prepared is critical to making a successful investment. Review your finances before you go in search of financing opportunities.
Traditional Mortgage Loans vs. Hard Money Loans
Two of the most common lending products that real estate investors use are traditional mortgages and hard money loans. Here’s how they measure up against one another.
- Traditional Home Loans
A traditional home loan, also known as a mortgage, is a loan provided by banks or other financial institutions that is secured by the property you intend to purchase. It’s the conventional route for individual homeowners, but real estate investors can utilize it when acquiring investment properties.
Advantages include lower interest rates and repayment periods that extend up to 30 years. Investors have more than enough time to recoup the initial investment and pay off their loans. A traditional mortgage is also subject to all government regulations, which provides a lot of security for borrowers.
There are some disadvantages, however, namely the lengthy approval process that’s required. It can be time-consuming and involve extensive credit checks and documentation. You may find yourself not getting funded in time to close the deal you want. There are also some strict qualification requirements. You’ll need a high credit score, verifiable income that’s high enough to meet the standards of your lender, and a low debt-to-income ratio. You may come across prepayment penalties as well, which can be expensive and frustrating.
- Hard Money Loans
On the flip side, hard money loans are a form of asset-based lending where the loan is secured by the real property itself. These loans are not issued by traditional financial institutions but rather by private investors or companies.
Investors benefit from fast approval and funding. There’s also more flexibility since hard money lenders are more interested in the property value and the potential for profit than the financial credibility of the borrower.
However, you should know that there are higher costs to hard money loans. Interest rates and fees are typically higher than traditional loans, affecting the overall cost of borrowing. These loans will usually need to be repaid relatively quickly, which means you’ll have to sell the property or refinance in as little as a couple of years. Defaulting on a hard money loan can lead to property foreclosure at an accelerated rate, so there’s also more risk.
Considering Portfolio Loans
A portfolio loan is a type of mortgage that a lender originates and retains instead of selling on the secondary mortgage market. The lender will instead keep that loan within their own portfolio. Usually, these are more flexible for borrowers than traditional loans.
They can also provide a range of financing options that go well beyond financing the purchase of a property. You can also use this type of loan for a line 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.
Qualifying for FHA Loans
Federal Housing Administration or FHA loans are designed for investors who will buy a multi-unit property (up to four units) while living in one of the units. If this sounds like your investment strategy, you’re in luck: FHA loans require a lower down payment (as low as 3.5 percent), consider borrowers with lower credit scores, and offer better interest rates.
These loans also come with mortgage insurance, which can increase the monthly payments but offer some protection against default. It’s a specific investor who will benefit from an FHA loan, but if you’re looking for a multifamily property that includes a home for yourself, this is an inexpensive way to finance your investment.
Seller Financing
Seller financing is a great option if you can’t get a loan from a traditional lender or need more flexible repayment terms. In this option, the seller agrees to finance the purchase directly. The terms of the loan, including interest rates and repayment terms, are negotiated between the buyer and the seller. However, not all sellers are willing to offer seller financing, and it may come with higher interest rates and stricter repayment terms than traditional loans.
Creative Financing with a 1031 Exchange
You can also finance an acquisition by selling an existing property.
This will only work if you currently own investment properties, but it’s a viable option and one that’s easily overlooked by a lot of investors. With a 1031 exchange, you can buy and sell without borrowing any money.
Instead of cashing out of the rental property you’re selling, you can re-invest those proceeds into another property. This can make sense for a lot of different investors, but there are strict timelines and requirements.
Here’s an example of how you can finance an investment property with a 1031 exchange:
Let’s say you want to buy a single-family rental property in Nashville, but you’re not sure how you’re going to pay for that property. Maybe you own a duplex that hasn’t been bringing in the rents you expected. Or, the maintenance costs on those properties are recurring and rising or you cannot seem to keep tenants in place for more than a single lease term. You can sell that duplex and use the money that you earn from the sale to finance the purchase of a single-family home you want. An additional benefit is that you defer the taxes you might have been responsible for on the sale of the initial property.
Financing is an essential part of real estate investing, and choosing the right option can make a big difference in what you earn and spend on your property. Consider the options available, and explore the benefits and drawbacks of each. Remember to work with a qualified lender who can help you make the best decision for your investment strategy. Talk to a Nashville property manager, too. We’d be happy to help. Contact us at Apex Ventures, Inc., and we’ll talk about what might be best for you.
