7 Sources Of Funding For Your Real Estate Deals
Investing in real estate requires having access to a sizeable amount of capital. Whether you’re building a portfolio of rentals or fixing and flipping for short-term profits, the biggest hurdle to doing deals is often funding—it takes money to make money.
In addition to the initial cash outlay to purchase the property, you need a budget of cash for other expenses. For fix and flippers, you’ll need to pay for materials to do renovations and repairs, labor and contractor fees, closing costs, listing and broker fees, holding costs, taxes, transactional fees and more.
Where can you get the money you need to fund your real estate deals? Here are a few common—and not so common—sources of funding and how each works.
#1: Traditional Bank Financing
The first place you might look for a loan is from the local bank where you hold a savings or checking account. In some ways, getting an investment property loan from a bank is just like getting any other kind of mortgage loan. You decide how long you want the loan term to be, provide the appropriate down payment and the bank provides the funds at closing.
On the other hand, it’s different. You’re seeking a loan for a rental property or fix and flip project. Traditional lenders prefer to make loans on homes that are in reasonably good condition with no health or safety issues. You may intend to fix those problems, dramatically increasing the value of the home for a profit, but lenders are most interested in lending for homes that are move-in ready. If the bank will consider loaning the amount needed for purchase and rehab, they may be hesitant to give you any money if you don’t have a track record of successfully flipping houses or managing a portfolio of rental properties.
And because the investment property you want to purchase will not be owner-occupied, the amount you can borrow will be less than you could borrow for your primary residence, typically 70% of the fair market value of the property in its current condition. Say, for example, you find a distressed property for $80,000 and you estimate the renovation will cost $20,000. Once the work is completed, the property will have a market value of $140,000. The bank would likely only loan you 70% of the purchase price of $80,000 or $56,000. You would need to have a down-payment of $24,000 and the $20,000 in funds for the renovation from your own resources or another source to do the deal.
The other problem is that the process of getting a traditional bank loan is typically between 45-90 days. That’s just too long for most real estate investors. For the best investment acquisitions, you must move very quickly.
#2: Seller Financing
Seller financing, or owner financing, is an arrangement between a homebuyer and seller. The buyer purchases the property in installments (which typically includes principal, interest and taxes) until the property is paid off in full. Seller financing is short-term—typically five years with a balloon payment at the end.
Seller financing can be beneficial for a seller who wants to sell during a time when credit is tight and borrowers are having trouble securing loans to buy the house.
For a buyer, it can be the perfect way to obtain financing when they do not meet all the criteria of a conventional loan. For example, a buyer may have a little less than the required down payment, or a credit score just a few points below the bank’s threshold, or not have a full two years of employment experience in the same profession. While banks are unwilling to make exceptions, a seller may feel comfortable offering seller financing if most of the criteria are met.
Technically, Seller Financing is not a loan, but an installment sale. There is no financial institution involved. Instead, the seller just agrees to let the buyer pay the purchase price over time with monthly installments.
No seller financing deal is the same! The option choices will ultimately be very specific to the particular property and the specific needs and desires of the buyer and seller.
The deal a lot less complicated because there are only two parties — the buyer and the seller. You make an offer to the seller, the two of you negotiate, and if it makes sense for both parties, you move forward.
#3: Hard Money Loan / Private Money
Hard money loans are short term financing alternatives often used by fix and flippers to finance the costs of both purchase and renovation of a property. Private money lenders can be anyone from a personal friend to an established private lending company and they may provide financing for just the purchase or for the purchase plus rehab expenses. Hard money and private money lenders provide loans that are 100% secured by the real estate asset.
These loans let experienced fix and flippers perform their own renovations while allowing novice flippers to use a licensed contractor. And since the approval and funding of a hard money loan can happen in 15 days, smaller fix and flippers can compete with all-cash buyers.
Typically, they have maximum loan amounts based on a percentage of a property’s loan-to-value (LTV) ratio or after-repair-value (ARV) ratio. A LTV ratio is based on a percentage of a property’s current fair market value while the ARV ratio is based on a percentage of a property’s expected fair market value after the rehab. Hard money and private money lenders will typically issue a loan up to 90% of a property’s loan-to-value (LTV) and up to 80% of a property’s after-repair-value (ARV).
Loans for flipping projects are more expensive than home purchase loans. The interest rates are higher, and you’ll often have to pay loan origination fees. However, hard money loans have lower qualifications for approval, helping fix and flip investors receive approval and funding in as little as 15 days. Hard money lenders focus attention on the property and its potential value more than about the borrower’s experience or financial qualifications.
To maximize the amount of money available for your project, lenders often allow interest only payments and there’s no prepayment penalty which gives you flexibility to sell and pay off the loan whenever you are ready.
Hard money lenders can either be found online or through industry relationships such as referrals from realtors, contractors, or mortgage brokers. Online hard money lenders conduct their business completely over the Internet. LendingOne is an example of an online hard money lender. Prequalification takes less than a day and funding can be received in as little as 15 days. Interest rates start at 7%, monthly payments are interest-only, and there are no prepayment penalties.
MyHouseDeals.com provides a listing of private money lenders ready to provide a loan on individual real estate deals which meet their criteria.Hard Money is the most expensive option detailed in this article, but it can be a great source of short-term financing. Just be sure you include the cost of paying the higher hard money interest rates and fees when you do the math on your project.
#4: Cash Out Refinance
A cash out refinance involves pulling equity from an existing property by securing a new loan on the property. The interest rate on a cash out refinance is usually slightly lower than a traditional mortgage because the borrower already has a track record of on-time payments. However, lender fees are typically a bit higher because a cash out refinance is more complicated to process than a regular bank loan.
What’s nice about the cash out refinance transaction when you’re a fix and flipper is that you’re handed cash with no restrictions on how you spend the cash received from the refinance. Fix and flip investors can use a cash out refinance, also known as a “cash out refi,” on an owner-occupied home as well as a non-owner-occupied investment property up to 4 units.
Sometimes, fix and flippers use a cash out refinance to purchase a distressed property with all cash or to cover the down payment while using a hard money loan to finance the renovation costs of the project.
Closing costs are either taken directly out of the loan or paid out of pocket. Once the loan is issued, the lump sum amount is wired directly to a borrower’s bank account. It’s up to the borrower to pay off the existing mortgage.
A cash out refinance typically has a maximum loan amount of 75% loan to value (LTV)—a fix and flip investor can get a loan up to 75% of the existing property’s current fair market value (FMV). Typically, a cash refi is can be funded more quickly than a traditional mortgage.
#5: Home Equity Line of Credit (HELOC)
A home equity line of credit (HELOC) is similar to a second mortgage on your primary residence. It’s a home equity loan that works more like a checking account than a conventional loan. You are issued a line of credit based on the value of the equity built up in your primary residence and you can use that credit to purchase anything. Similar to a credit card, interest rates are charged on the amount borrowed until the amount is repaid.
Unlike credit cards, however, the interest rate is structured like an adjustable rate mortgage—much lower than the APR charged by credit card issuers. A HELOC typically has an adjustable interest rate that starts between 4% – 5% and resets over time. It’s common for interest rates to increase over the life of a HELOC. My own HELOC is a variable rate which is always just 1% over the current prime rate. Interest accrues only on the outstanding balance at any given time, not the entire credit line.
Unlike a cash out refinance, a HELOC can be taken out in addition to your existing mortgage. Also unlike a cash out refi, a HELOC can only be issued on an owner-occupied primary residence.
Since a HELOC is a home equity loan, the qualifications for approval are fairly standard. A big advantage of using money from a HELOC instead of a refi is you typically aren’t required to pay closing costs on the property.
Most HELOCs have a maximum loan amount equal to 85% of a property’s combined loan to value ratio. This means the first mortgage and second HELOC combined cannot exceed 85% of a property’s current fair market value.
The biggest issue with using home equity to pay for a house flipping project is the fact that your house serves as the collateral. If you fall behind on the home equity line of credit payments, the bank could decide to foreclose on your house.
#6: Your Own (or Someone Else’s) Self-Directed IRA
Most retirement accounts invest in traditional assets like mutual funds or bonds. A Self-Directed IRA (SDIRA) is a way to use retirement savings to invest in alternative assets including real estate, notes, tax liens, and more. An SDIRA is a special type of retirement account set up like a trust with a specialized custodian that holds assets, processes transactions and keeps records for the IRS.
There are rules to strictly follow as you “self-direct” your qualified retirement funds. You must be very careful not to engage in IRS-prohibited transactions, one is that you can’t invest in your own business or acquire assets in your own name. But you can acquire and hold real estate within your SDIRA if you follow all the rules—it’s your IRA that’s buying properties not yourself. You can even leverage your real estate investments within your SDIRA by taking out a non-recourse loan, a specialized mortgage vehicle designed for this purpose.
I moved my 401K money into a SDIRA three years ago and bought three income-producing rental properties. The transactions were easy, management is at an arms-length and each property is providing tax-free monthly income toward my retirement. (For more details on how I did this, see this article.)
Chances are you know someone who is looking to invest in real estate with a portion of their qualified IRA savings. They might just want to loan it to you in exchange for reliable principal and interest payments each month.
#7: Loan Against Your Whole Life Insurance Policy
You may have untapped cash you’re not aware of—built-up cash value sitting in a whole life insurance policy available for you to borrow.
This was a very useful financing tool for me when I got started in real estate investing. Both my husband and I had purchased whole life policies when we were in our twenties and have been paying the premiums ever since. Between the two of us, our Prudential whole life policies have a paid-up cash value of over $75,000—funds available for me to borrow against. I took out a loan against each policy and had cash to purchase a fix and flip at a very favorable price.
The interest rate is 5%, there’s no application process, there’s no repayment schedule and there was no loan payment due. I had to pay interest only at the end of the year making this option a very low cost and flexible source of funding.
Bonus Funding Option: Look Into Partnering With Someone
I know a few investors who swear by partnerships as a quicker way to get the money and experience to do fix and flips. Often, one investor provides the acquisition money to buy a distressed property with cash and the other provides the materials and labor for the rehab. They then agree to split the profits on a prorated basis after settlement.
I have never done a partnership on a real estate deal. I’ve looked at several properties with another investor, but quickly realized that we had different strategies that might become problematic with the multitude of decisions we’d need to agree on in the process. For me there’s enough risk to mitigate in any single real estate project without adding another person to the mix. That being said, it may be a great option for your strategy, personality and goals.
Of course, it goes without saying that if you do a joint venture or partnership, you’ll want to choose a partner with care and make sure you have a written, signed agreement before you move forward.
So there you have it—seven sources of funding for your real estate deals. Of course, the best one—or combination of sources for you—depends on the type and condition of the property, your experience with real estate investment and your personal financial situation.