Figuring out the secrets behind financing a rental property is what separates the successful real estate investors from the dreamers. While cash is king in the world of real estate investing, having $100-$200,000 on hand isn’t always a reality for many investors. In some situations, financing can be a better option.
Benefits of Financing a Rental Property
There are plenty of real-life examples that show how financing a rental property may provide a better return on your real estate investment. Take this example for one:
Example of Financing a Rental Property
Mike has $100,000 in cash that he wants to invest in rental properties. Here are his options:
- Purchase one C-Class property for $100,000 that will produce $700 per month in income, or $8,400 per year, after expenses. This equates to an 8.4% net return on investment.
- Use the money to purchase five C-Class investment properties with a 20% down payment on each one. If each property were listed at $100,000, Mike would earn $300 per month per house, or $18,000 per year, after mortgage and expenses. This scenario equates to an 18% leveraged rate of return.
While this example uses a conventional mortgage, there are other financing options – like non-recourse loans, hard money loans, and private loans – to fit nearly any situation.
A conventional mortgage offers the smallest down payment and some of the lowest interest rates available. Even if you have a mortgage on your primary residence, according to Fannie Mae guidelines, you can hold up to 6 loans. A conventional loan is secured by an asset, usually the property you are purchasing. Conventional loans typically require 20% down, with an interest rate of 4-5% and a loan term of 15-30 years. To secure a conventional loan with favorable terms on a single family rental, your property will have to appraise, and you will need to pass a credit check and provide proof of income.
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A non-recourse loan is usually an excellent option for investors looking to finance a rental property. To secure a non-recourse loan, the investor will need to put forward an asset as collateral. However, the lender agrees that they have no rights to any additional property other than the agreed upon asset. Here’s an example of a non-recourse loan:
Example of Non-Recourse Loan
An investor places their retirement account as collateral for a non-recourse loan. If the investor defaults on the loan, the lender may only recoup their loss from the retirement account. If the retirement account doesn’t cover the full balance of the loan, the lender takes the loss.
Financing a rental property with a non-recourse loan is riskier for the lender. To minimize their risk, lenders may require 50-60% down with higher interest rates of 7-8% and 10-20 year terms.
Hard Money Loan
A short-term option for financing a rental property is a hard money loan. Hard money is a loan from an individual or business with the sole purpose of investing in real estate. The loan is based on the value of the property and doesn’t require any income verification, credit score references, and isn’t attached to a personal credit report. Hard money loans are generally shorter term – 3-36 months – with higher than normal interest rates – 8-15% – and fees. Hard money is an ideal short-term fix for many investors, and it can often come through quickly to close a deal in a matter of days.
A private loan is a lot like a hard money loan, except the borrower typically has a personal relationship with the lender. Private money lenders are individuals with extra cash on hand, but they are not professional lenders. These lenders do not receive an equity stake in the property. Instead, they hold a mortgage, just like a conventional bank. The private lender can foreclose if the agreed upon terms are not met. Interest rates and lenders fees on private loans are typically lower than hard money loans.
What is the Best Kept Secret for Financing a Rental Property?
Consider your goals, your cash position, your credit, and your risk profile before choosing your financing strategy. The “best-kept secret” is, there is no one-size-fits-all solution when financing a rental property. But there are mistakes that can be made if you make the wrong decision. Carefully weigh your options before making a final decision. If you are serious about financing your real estate investment, contact us to help you find the best lender for your rental property.