Types of Real Estate Financing
Real estate investments offer investors several financial benefits, such as asset appreciation, a steady cash flow, and tax benefits. In fact, investing in real estate is one of the most popular vehicles to produce wealth. However, a lack of real estate financing knowledge hinders many new investors because they may not be aware of the different financing avenues.
Real estate financing describes an investor’s means of securing funds to buy or renovate a property. Investors have plenty of options to acquire capital. For investors with access to a significant amount of capital personally, cash financing is an excellent option for purchasing properties free and clear of interest or other charges. Besides saving on interest, cash financing allows investors to increase cash flow and obtain instant equity in their investments.
If investors do not have access to enough cash to cover the full value of the property, they can obtain capital from any of the financing options offered by the government, traditional lenders, or private lenders. A Federal Housing Administration (FHA) loan is one of several loans the federal government offers. It aims to increase access to home ownership for home buyers with less than perfect credit scores or who do not have the financial capacity to save up a large down payment. Typically, the down payment requirement for FHA loans can be as low as 3.5 percent.
Another government-backed loan is the 203K loan, explicitly designed for rehabilitating damaged or older properties. Investors can borrow the total purchase price of the property and the estimated cost of renovation. Investors must hire a licensed contractor to qualify for a 203K loan — DIY projects are not allowed. Also, investors cannot use the loan for a fix-and-flip strategy.
Outside of government-sponsored loans, investors can borrow capital through traditional mortgages. The investor borrows on a fixed or adjustable interest rate in a traditional loan and makes regular mortgage payments. Investors can choose different term structures based on their income or capacity to pay.
Funded by private individuals and businesses, hard money lenders offer short-term and high-rate loans. Investors looking for funds to flip a property typically choose hard money lenders to fund a percentage of the purchase price or the after-repair value. Hard money lenders usually do not conform to a bank’s standards of creditworthiness. However, besides the somewhat higher interest rates, they charge fees representing an additional percentage on the loan amount.
Another option to acquire capital is borrowing from private money lenders at a specified interest rate. The loan terms are established upfront and with a specified payback period, typically from six months to one year. Investors who are confident that they can raise the property value over a short period of time and turn the property over typically choose private money lenders.
The investors and the seller can also strike up a mutually beneficial seller financing deal. In this case, an investor makes direct payments to the property seller rather than going through a bank. Through a seller financing deal, investors can avoid mortgage lending hurdles, such as credit score minimums. The seller and the buyer can also enjoy a quicker transaction process and avoid closing costs.
