Home Equity Loans vs. HELOCs
This guide breaks it down the pros, cons, and best use
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Building a portfolio of investment properties takes a lot of capital. Most investors rely on a mix of real estate financing options to acquire and manage their investment properties.
The wise use of leverage, or borrowed money, when investing in real estate can deliver better returns than paying cash. Here are 12 sources of real estate financing that investors regularly use (in no particular order).
A conventional mortgage is a common real estate financing option for rental property investors who buy and hold for monthly cash flow and long-term appreciation. You take out a loan to buy a property, then make monthly payments until it's paid off. Your local bank or a larger financial institution are good sources for conventional financing at competitive rates.
The better your credit score and financial position, the better the rate you’ll qualify for. Most lenders limit the number of conventional loans to individual investors to 10. Beyond that, you’ll want to look into a portfolio lender.
This is a loan insured by the Federal Housing Administration (FHA). It’s intended to help first-time buyers break into homeownership by lowering the down payment needed to purchase properties.
FHA loans are a rarer choice for real estate investors because the borrower must live in the home. This is great for new investors who are going to "house hack," or buy an investment property to live in with roommates whose rental payments cover most or all of the mortgage payment and ownership costs.
A 203K loan is a form of FHA financing designed to let a homeowner purchase a fixer-upper or a home in need of some work. The lender finances the purchase price and the cost of repairs by building both into the loan.
Like FHA loans, 203ks are only available for owner-occupied properties.
Home equity loans and lines of credit
If you have equity in your primary residence, banks and other lending institutions will let you borrow money against that equity through the use of a home equity loan or home equity line of credit (HELOC).
The interest rates are typically one percentage point above the prime rate if you have good credit and you can usually borrow up to 90% of the value of your home. Let’s say your home is worth $500,000, you have a first mortgage with a balance of $250,000, and you’d like to borrow against your equity to buy an investment property. The lender would approve you for a $200,000 line of credit ($500,000 x 90% minus the $250,000 you owe). I use my HELOC regularly for real estate financing. It makes it easier to make cash offers on investment properties and provides the most hassle-free access to ready cash.
Hard money loans
Hard money loans are private loans, or loans provided by private lenders rather than government-regulated financial institutions.
Hard money loans are short-term loans typically used to:
- finance fix-and-flip deals where the goal is to quickly get your money back and repay the loan or
- bridge the gap between an investment property purchase and longer-term financing.
These loans have higher interest rates than other options and the qualification is much less stringent than institutional financing.
Self-directed IRA (SDIRA)
This is a special type of IRA account that lets the owner invest in a broad range of investments beyond the typical stocks and bonds. By going through an account trustee or custodian, you can invest retirement-qualified savings into real estate, precious metals, and other "alternative investments."
I bought my first three investment properties by transferring my 401K into an SDIRA. It’s an excellent source of funding if you have a sizable IRA and you follow the rules. You can even use financing to leverage a property in your SDIRA through a non-recourse loan. This is a special type of loan that uses just the property as collateral, rather than your personal creditworthiness (which is necessary because of the distance you must maintain from the funds in your SDIRA).
Private money loans
Sometimes referred to as "the bank of mom and dad," private money real estate financing often comes from family, friends, acquaintances, and high-net-worth individuals looking to get higher returns on their cash than a traditional bank offers.
There are no hard and fast rules that define the loan terms. Private money lenders will expect a return on their investment commensurate with the perceived risk. You might turn to private money if you believe you can raise the value of a property and return the capital with interest in a short period of time.
Two are better than one, right? If the acquisition and rehab costs of an investment property are beyond your scope, you can consider bringing in an equity partner to help finance the deal.
While the partnership can be structured in many different ways, it’s typical that a partner is given an ownership percentage of the project’s return on investment. Of course, there are advantages and disadvantages of working with a partner that you’ll want to consider carefully before jumping in.
Conventional loans have strict underwriting guidelines and it can be difficult for real estate investors and the self-employed to qualify as borrowers. Many credit unions and some banks offer portfolio loans with more flexible terms and less strict qualifying standards. That makes portfolio loans an especially valuable method of real estate financing for investors.
The interest rate can be even more favorable than having a bunch of one-property loans. However, not all banks offer these and you’ll want to carefully compare terms and rates among several portfolio lenders.
If a seller owns a property outright, they may finance it for you. You make the payments to them instead of a financial institution. If the seller has a mortgage on the property, that loan must be paid back in full before title can change hands unless there’s a clause that you can assume their loan.
Every home is unique, so every owner financing agreement is unique. You make arrangements to pay the owner in installments, typically of principal and interest. The specific terms of the loan, such as the interest rate, length of the loan, and down payment are all negotiable with the seller.
Life insurance loan
If you have a permanent or whole life policy, you can borrow against the policy’s value -- typically up to 90%. The insurance company uses the policy as collateral for the loan. I borrowed against the cash in my whole life policy to fund the rehab of one of my buy-and-hold properties. I was pleasantly surprised at the benefits of this type of real estate financing:
- It’s easy and quick to get funds, as there’s no underwriting process to qualify for.
- The amount borrowed doesn’t show up anywhere in your credit report, so it has no effect on your debt-to-equity ratio.
- You don’t need to make regular payments. Interest accrues each month, but there’s no repayment schedule you need to adhere to.
- The interest rate is very competitive; typically a percentage point above prime.
Real estate crowdfunding
Crowdfunding is a way of getting small amounts of capital from a large number of individuals. There are a number of crowdfunding platforms that loan money to real estate investors, including Roofstock, Patch of Land, Sharestates, Fund That Flip and LendingHome.
These platforms loan money to residential and commercial real estate rehab investors of all sizes, though some may only offer real estate financing to experienced investors. Compare different options to find out which is best for you.
Think carefully about real estate financing
As a real estate investor, you can find money to support your projects from many sources. What’s best depends on factors specific to the property and your financial situation, including the amount of money needed, your investment strategy, your exit strategy, your creditworthiness, and your experience.
While borrowed money lowers the amount of personal cash needed, you still need some cash -- and that’s a good thing. Buying a home with no money down led to the housing bubble that collapsed. Investors need skin in the game, too. Becoming overleveraged means putting at risk the loss of the asset, your creditworthiness, and your reputation.