incCountless Americans have built enormous wealth by owning investment real estate. However, the biggest challenge for entry into this lucrative field is raising the capital to buy properties and pay for renovations and repairs. Here’s a quick study on investment property financing.
Two main categories of investment properties
Although there are several ways that investors can build wealth through real estate, they all generally fall within two categories. The route you intend to follow affects your financing choices.
- Fixing and flipping property. These investors search for properties that they can successfully buy, renovate and repair, then sell for a profit. Typically, the investor owns the property for a few months at most.
For these investors to turn a profit, their properties must be in a neighborhood with rising home values. The property needs to be distressed in some way so that the investor can buy at a discount (ideally 70 percent of market value), and the cost of the work to be done must leave room for a decent profit. If he’s qualified, the investor can increase his profit by doing the work himself.
Profits on flip houses are subject to capital gains taxes, which must be considered in determining whether this investment route will be profitable.
- Purchasing properties and renting them. Whereas home flippers make all their money within a few months, owners of rental properties recover their investment steadily over months or years through rental receipts.
Investors can follow the traditional route and sign tenants to leases of a year or longer. However, investors can also now offer properties as short-term rentals, often to vacationers. Short-term rentals can garner higher rental rates and generate better monthly cash flow. But they bring logistical challenges and costs such as managing a continual flow of renters and cleaning and repairing between guests.
Mortgage approval criteria for investment properties are more rigorous than for owner-occupied homes. For a conventional loan, the lender will want at least 20 percent down and a credit score of at least 720. In addition, the lender will likely require you to have six months of expenses in savings or other liquid assets. If you are borrowing to purchase rental properties, it may be advantageous for you to pay “points” (which means more money down) to lower the interest rate and save thousands over the long term. With approved credit, you can have mortgages for up to four properties.
The Federal Housing Administration (FHA) backs bank loans for investment properties with two to four housing units, but only when the investor lives in one of the units. In addition, FHA loan terms are less stringent; you can get a loan with only 3.5 percent down and a credit score as low as 500. You can even obtain a gift or grant money for your down payment, effectively paying nothing out of pocket.
The Veterans Administration (VA) backs loans for investment properties with up to four units as well as for duplexes and triplexes. You must live in one of the units for at least one year. No money down is required. You can even count rent from other units in the property as income qualification. The property is subject to approval by a VA inspector.
If you want to purchase an investment property, you can borrow from yourself by taking a home equity line of credit (HELOC), borrowing against the equity in your home. Typically a HELOC has a “draw” period, perhaps ten years, for tapping into the money, and you use only as much as you need. In addition, interest on a HELOC is tax-deductible. One big drawback: Your home is collateral for a HELOC, so if you default, it’s your personal living space that goes into foreclosure, not the rental property you are buying with the loan.
Seller investment property financing
Occasionally the seller of investment property will finance the buyer’s purchase. Seller financing is possible only where the seller owns the home free and clear of any mortgage. These loans generally must be paid off in five to ten years, which means monthly payments are high.
Hard money loans
Hard money lenders are a specialized group of lenders who loan money to investment property buyers. The advantage of a hard money loan is speed: Approval often happens within a day, with funding in just a few days. On the other hand, the costs and terms of these loans are more daunting than other options: interest rates of 9 percent or more and payback terms of three to five years. As a result, hard money loans are best suited for flippers who need to scoop up a house deal quickly (sometimes at auctions), renovate and repair the property, and sell it before their first payment is due to the lender. Hard money loans are not suitable for rental property investors.