Choosing the best way to finance your real estate deals can make or break your bottom line.
Selecting the best option can save you thousands of dollars a year and potentially hundreds of thousands over the duration of a loan.
Depending on what type of project you are doing will play a part in determining which type of loan is best for you.
Whether it be a buy and hold single family home or doing a short-term fix and flip on an apartment complex, understanding the different types of loans available will help you make an informed decision about how to grow your investments over time.
Real estate investors these days have no shortage of financing options, in this article we review 3 popular alternatives to convention loans; HELOCS, FHA loans and hard money loans.
HELOC stands for home equity line of credit.
They are kind of used like a credit card, but with much lower interest rates and are funded by traditional lending institutions like banks and credit unions.
Lenders will lend 75% to 90% of the available equity on a borrower’s homes depending on their credit and income.
In September 2020, the average interest rate on a HELOC was 4.29% with an 80% loan to value ratio.
- Variable interest rates. Using a HELOC makes you susceptible to rising interest rates which will increase your monthly payments
- Failure to make payments will result in foreclosure
- Low closing costs
- Unrestricted use of funds
- Low interest rates
- Increased financial flexibility, since you can tap in and out of a HELOC at any time
Federal Housing Loans aka, FHA Loans are government sponsored loans that require the buyer to have a low down payment of only 3.5% of the purchase price.
The government doesn’t actually lend you the money, the loan is just guaranteed by the government.
Since the loan is backed by the government, these types of loans are often easy to qualify for and come with much lower fixed interest rates than other types of loans.
- Low down payment, the down payment is only 3.5%, which is extremely low compared to other types of loans (though keep in mind you do need to still pay closing costs)
- Low credit score requirements, you can qualify for an FHA loan with a FICO score of only 550 in some cases
- Interest rates are fixed which helps buyers better project costs
- The FHA loan has to be in your name personally (you can’t use an LLC or other type of business entity)
- FHA loans require more paperwork and take a longer time to close than other types of loans
- You are required to personally live in the property for at least one year
- You can only have one FHA loan at a time
- The FHA comes with a MIP (mortgage insurance premium). You have to pay this insurance for the lifetime of the loan
- Stricter approval and appraisal requirements make it nearly impossible to use buy a fixer upper, making fix and flips nearly impossible
Hard Money Loan
Hard money loans generally come from private money lenders and have been widely used in the real estate investment industry since the 1950s.
A hard money loan is a loan where the lender will lend against the value of an existing asset, called the collateral.
If the borrower defaults on the loan, the lender will take possession of the collateral property.
These loans come with high interest rates, hence are often used in short durations in real estate (6 months to 5 years), before more traditional funding can be secured.
- Hard money loans can be closed quickly, sometimes in the matter of a few days
- They have less requirements than traditional bank loans
- Credit score is not that important, a lender is generally more interested in the value of the underlying asset
- Hard money loans have high interest rates 8% to 15%
- They usually require a larger down payment of 20% to 30%
- You must already have an asset to use as collateral
If you default on the loan you will lose your pre-existing asset
A successful real estate investor should become knowledgeable about the different types of loans available in the marketplace.
Loans are like tools in an investor’s toolbox. One type of loan might be great in certain short-term situations, whereas another loan might work better in another situation.