So, you’re interested in investing in real estate. Great! But where’s the money going to come from? Fortunately, there are several different avenues for purchasing your first investment property.
Some may be more useful than others, depending on your financial situation, the market you want to invest in, the state of the property, and rental experience, among other factors.
In this blog, I will go over three different methods to buy a rental property. These methods can be used in conjunction to secure the optimal deal.
1. Traditional Mortgage
A traditional, or conventional, mortgage is a secured loan issued by a bank that is used to buy a rental or any other property. You have an agreement with a lender who loans you a set amount of money to make the purchase. You have to make a down payment in order to obtain the loan.
While there is a wide range of acceptable down payments, a larger one will typically grant you better terms and a lower monthly payment on the mortgage. There are programs that allow you to put down as low as 3.5%, and even 0% if you plan to use it as a primary residence. However, most banks will require you to put down at least 20-25% for a traditional mortgage on an investment property.
The monthly payment consists of a set portion of the principal, or amount left to be paid back on the loan, and interest, which is a percentage of the monthly principal. Interest rates vary depending on your personal credit score and the current market.
Recently, rates have been on the rise and borrowing has become more expensive, which makes it extremely important that you have a clear vision of what a deal is for you.
Pros and Cons
Just like every other financing method, there are pros and cons when using a traditional mortgage.
For starters, most banks will require you to have a certain credit score, debt to income ratio, and reserves in the bank. If you do not have these things, it can be very difficult to qualify for a traditional mortgage.
Additionally, most traditional mortgages will require the property to be in a certain condition and will often need an appraisal to grant the loan. This means no buying distressed homes with traditional financing, unless you are using a specific program such as the FHA 203k loan.
The good news is that conventional mortgages traditionally have the best rates among other financing products. This is due to their thorough vetting process of each deal. In addition to backing from large mortgage companies such as Fannie Mae and Freddie Mac.
2. Hard/Private Money Lending
A hard money, or private money loan is sourced from an individual or private company instead of a bank. These loans are less dependent on your creditworthiness and more dependent on the value of the property.
This is due to the property being used as collateral in the agreement. Because of the flexibility around credit, interest rates are often higher and the lender will often charge “points” as a part of the terms. One point is equal to one percent of the total mortgage amount. These points are paid upfront to the lender, and the number of points varies depending on the terms of the loan.
A hard money loan often ends up being more expensive than a traditional mortgage, but is more ideal for individuals with poor or no credit, or limited experience in real estate investing.
3. Seller Financing
Seller financing is a form of private money lending in which the individual or company that is selling the property serves as the bank.
Here’s an example:
You want to buy a rental but don’t have the credit for an ideal traditional mortgage. Or maybe you want to do extensive work on the property that a bank won’t cover for you. So, you propose to the seller an arrangement where they will serve as the lender. You agree on a 5-year term that includes a 10% down payment, monthly payments amortized over 30 years (meaning you pay the monthly payment as if it was being paid off over 30 years), and an 8% interest that’s paid over the 5 years, with a balloon payment at the end. The balloon payment is the remainder of the loan that must be paid off. By this point, because of your improved creditworthiness and increased equity in the home, you are able to refinance. By using a traditional lender with better interest rates you can then pay off the balloon payment.
This loan benefits the seller because it grants them continued passive income even though they’ve sold the property. It benefits the buyer through its flexibility of terms and low or no down payment. This can be great for individuals with poor credit or with other obstacles to obtaining a traditional loan.
Although, be mindful, it is important to be vigilant when negotiating a loan. The relative lack of regulations can result in unfavorable terms for the buyer or seller.
Bonus: House Hacking
This is not a financing method, but rather a savvy method for obtaining your first investment property. It can also be used with any of the above methods! “House hacking” is when you buy a rental property, live in one of the rooms (or units if it’s a multifamily property), and rent out the remainder of the house/units to others. If done correctly, you can live in the home essentially for free and even generate some profit! For more information, check out Jared’s piece on house hacking at How-To House Hack, A Beginner Investment Strategy.
Conclusion
There are many ways to purchase a rental property, and they all work with the proper deal vetting and preparation. Although the methods mentioned in this blog are among the most popular, there are many more ways to buy a rental property. In fact, there are many other creative ways to obtain financing if you have a good deal. Some of these methods include DSCR loans, purchasing subject-to, HELOCs, and utilizing partnerships. Some scenarios may require you to get more creative than others. But no matter what your situation is, there is always a way to purchase your first rental property.
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