Rapidly rising home prices are making paying cash for a property increasingly difficult, and even buyers who are able to pay in cash choose to finance instead. By wisely using real estate financing, investors and homeowners may receive better returns and diversify risk.
In this article, we’ll look at some of the benefits of financing real estate, along with 12 options for financing real estate.
- Real estate financing is used by investors and homeowners to control 100% of a property while making a small down payment.
- Financing real estate is also an investing strategy used to generate higher returns compared to purchasing a property for cash.
- Options for financing real estate include conventional loans, private money loans, and self-directed individual retirement accounts (SDIRAs) for real estate.
Why investors finance real estate
There are 2 options for purchasing real estate. You can pay all cash or finance the real estate by making a small down payment and borrowing money in the form of a loan to pay for the balance of the purchase price.
Benefits of using financing
Real estate financing is also known as leverage because of the way a down payment is used. By leveraging a real estate purchase, you can claim 100% of the cash flow, tax benefits, and any appreciation in property value by investing a small down payment, usually around 20% of the purchase price.
For an investor, some of the biggest potential benefits of using financing to purchase rental property include:
- Control of 100% of a rental property with a small down payment
- The ability to deduct interest and reduce taxable net income
- Potential risk reduction through diversification of investment capital across several properties instead of a single property
- Boosted returns on the amount of cash invested by using financing
Investors who finance rental property using a 30-year, fixed-rate mortgage also can lock in today’s interest rates as a hedge against future interest rate increases.
The property mortgage rates calculator from Roofstock is a good tool for calculating rental property mortgage rates using different down payment amounts, credit scores, and loan terms. Investors also can connect with experienced, third-party investment lenders through Roofstock and get preapproved entirely online.
Cash purchase vs. financing
Financing real estate has a significant impact on cash-on-cash return, which is the ratio of cash received (before paying taxes) from the total amount of cash invested. The cash-on-cash return formula looks like this:
- Cash-on-cash return = Annual before-tax cash flow / Total cash invested
A common example of cash-on-cash return is the interest rate paid by Treasury securities. The current interest rate on a 5-year Treasury is 2.39% (Bankrate as of March 23, 2022). That means a $30,000 investment would generate a cash-on-cash return of $717:
- $30,000 total cash invested x 2.39% = $717
The following example illustrates how financing can boost cash-on-cash return for a real estate investor. To illustrate, we’ll assume that Investor #1 purchases a single-family rental (SFR) home for $150,000 using all cash, while Investor #2 purchases the same home using a 20% down payment of $30,000:
|Investor #1||Investor #2|
(principal and interest)
|Annual cash flow||$10,000||$2,700|
Based on the above example, Investor #2 is generating an additional yield of 2.3% on the cash invested compared to an investor who pays all cash, even though the annual cash flow amount is much less.
Keep in mind that changes to rental income and operating expenses year after year will also increase or decrease annual cash-on-cash return, as will additional cash invested for capital repairs, such as replacing a roof or heating, ventilation, and air conditioning (HVAC).
12 options for real estate financing
Here are 12 options to consider for financing a real estate purchase:
Conventional loans for real estate are offered by banks, credit unions, and savings and loan associations. Conforming conventional loans must adhere to standards set by Fannie Mae and Freddie Mac, including minimum credit scores and maximum loan amounts.
Conventional fixed-rate loans with a 30-year term may be a good financing option for real estate investors buying and holding rental property for the long term, because interest rates and the monthly mortgage payment amount do not change.
Loans backed by the Federal Housing Administration (FHA) are another option for financing real estate. FHA loans are intended for people purchasing a primary residence and not rental property.
However, investors planning to “house-hack” by renting out part of their home or a unit in a multifamily property may find an FHA loan worth considering. That’s because the down payment amounts and loan qualification criteria are usually less strict than with conventional financing.
FHA 203(k) loan
A 203(k) rehab loan backed by the FHA allows a borrower to wrap the purchase price of a home, plus any needed renovations or repairs, into a single loan. FHA rehab loans are usually available with fixed interest rates and 15- or 30-year loan terms, or with adjustable interest rates.
FHA 203(k) loans may be used for home purchases and renovation projects, such as installing roofing or flooring, bringing a property up to code by repairing health or safety hazards, or replacing plumbing or electrical systems. As with FHA loans, 203(k) loans are only available for owner-occupied homes.
Veterans Affairs (VA) loans are available to service members, veterans, and eligible surviving spouses to help make owning a primary residence more affordable. The V A guarantees a portion of the loan that is originated with a conventional lender.
Some of the benefits of a VA loan include no down payment requirement, no private mortgage insurance (PMI), limited closing costs, and low interest rates. While VA loans are intended for people purchasing a primary residence, they may also be used to purchase a multifamily property, provided that the borrower lives in one of the units.
SDIRAs for Real Estate
An SDIRA may be a good option for purchasing real estate for investors who have a significant amount of savings in a retirement account. A SDIRA for real estate is created by transferring a traditional retirement plan, like a 401(k) or SEP IRA into an SDIRA. Funds in the SDIRA may be used to purchase real estate and for the down payment of a non-recourse loan.
When using an SDIRA to purchase real estate, investors should ensure there are sufficient funds within the retirement account to pay for any needed capital repairs or operating expenses during periods of negative cash flow.
Home equity loan and HELOCs
Home equity loans and home equity lines of credit (HELOCs) are 2 ways of borrowing against the equity in an existing property without having to sell. As a rule of thumb, an investor may be able to borrow about 80% of the equity in a home to raise funds for the purchase or down payment of a rental property, or to make renovations or repairs.
For example, if a home has a market value of $350,000 and the mortgage balance is $200,000, an owner may be able to borrow about $120,000 ($350,000 home value - $200,000 mortgage balance = $120,000 equity x 80%).
A HELOC is a line of credit against the equity in a home and is used to access equity when and if an investor needs it. HELOCs work similar to credit cards, with any borrowed funds repaid with periodic payments of principal and interest (P&I).
Private money lender
Private money lenders are typically business people or other real estate investors who prefer to invest in real estate debt rather than equity. A private lender makes money by collecting fees and interest on funds loaned to a borrower. An investor who can’t qualify for a traditional loan or is looking for creative financing options may find a private money lender to be a good option to consider.
Hard money loan
Hard money loans are intended for borrowers looking to raise funds fast for a short-term loan. Interest rates and fees are typically higher than other sources for financing real estate but may be a good match for a borrower with poor credit or an investor seeking flexible loan terms.
A portfolio loan is a mortgage that is held by a lender instead of being sold on the secondary mortgage market, as conventional loans usually are. Because a lender holds a portfolio loan on its own books, down payment amounts and loan terms may be more flexible, with stricter qualifying standards, although interest rates and fees may be higher.
A blanket mortgage is a single loan used to finance multiple properties, with the individual assets serving as collateral for one another. Blanket mortgages generally have a release clause, which allows a borrower to sell a property and pay off the property’s share of the outstanding loan balance without having to refinance the remaining properties.
Limited liability company
Limited liability companies (LLCs) are another option for financing real estate. Rather than owning real estate directly, the LLC owns the property and investors own membership shares of the LLC. Depending on how the LLC is structured, members may loan money to the LLC in exchange for P&I payments, or invest in equity and share a percentage of any net operating income and profits made when the property is sold.
Sometimes sellers who own a property outright, or with a small outstanding mortgage balance, are willing to provide owner financing. Rather than receiving a lump sum payment from a buyer, a seller acts as a bank and receives a down payment plus installment payments of P&I from the borrower. Any existing loan must be paid off before seller financing can occur, unless the existing loan has an assumption clause.