The content from this article comes from Billy Epperhart’s book, Strategic Real Estate Investing, and episode 61 of The WealthBuilders Podcast with Karen Conrad.
The most important part of real estate investing isn’t the real estate–it’s the finance. Real estate financing involves how to purchase properties, how to make money from those properties, and how to repeat the cycle efficiently and often. So, this blog post will cover 8 secrets to help you understand real estate financing. In addition, you will learn how to obtain the best interest rates on your investments through managing your credit score and obtaining the best loan product for your needs.
Why Understand Real Estate Financing?
Real estate financing comes back to leverage. The textbook definition of leverage is using borrowed capital for an investment, expecting the profits made to be greater than the interest payable. In other words, it’s good debt. To expand your net worth, you must expand your debt, too. Leverage is foundational to understanding the value of real estate investing compared to other passive income streams.
Let’s say that I have $10,000 to invest. If I made a 10% return in the stock market, I would end up with $11,000 on my $10,000 investment. Not bad, right? However, let’s say I used my $10,000 as a down payment for the mortgage on a $100,000 piece of real estate instead. If I got a 10% return on that investment, I would make $10,000—that’s a 100% return! The return is on the entire asset, not just my down payment.
A 10% return on real estate is common when you factor in appreciation and cash flow obtained from the property. CoreLogic’s price forecast for this year anticipates that appreciation will exceed 10 percent for the first months of the year but will fall steadily to 3.5 percent by December 2022.
There are real estate strategies you can employ, such as a cash-out refinance or HELOC, that allow you to capitalize on that appreciation and continue to build your investment portfolio. As you come to understand real estate financing, your money will stretch farther, and you can continue to purchase investment properties.
8 Secrets to Real Estate Financing
1. Understand How the Lending Markets Work
There are two primary lending markets: the retail lending market and the secondary lending market. In the retail market, the mortgage brokers and banks intersect with the retail buyer or investor. Then, lenders underwrite the loan and sell it on the secondary lending market, which is where you get your conventional Freddie Mac and Fannie Mae loans. If you can qualify for a secondary market loan, they usually provide the lowest interest rates and fees. However, there is a cap for how many loans you can obtain on the secondary market, and there are stricter guidelines for investment properties. So, it’s important to build a relationship with your local bank even when you are just getting started.
Community banks often have real estate programs that they keep in-house. This means they hold mortgage loans in the bank rather than selling them to a secondary market. This gives them the flexibility to adhere to their own underwriting standards rather that the strict standards of the secondary market. Here are the benefits of working with a community bank: they know you and how you handle your finances, they can be flexible, and they understand the local market better than anyone.
2. Know Your Credit Score
Your interest rate, approval, fees, and your down payment all relate to your FICO (Fair Isaac and Company) credit score. I recommend subscribing to a report from Experian, TransUnion, or Equifax. The highest FICO credit score you can obtain is 850. 760 or above is outstanding, and 680 or above is good. Anything below that needs some work.
[Read Next: Cracking Your Credit Score]
3. Know What Matters to an Underwriter
As we just mentioned, your credit score is extremely important to an underwriter. In addition, they pay close attention to your capacity to handle loan payments. Most loan products on the secondary market require full documentation. That means they want to see your payment stubs, bank statements, W2s and other tax documents, and confirmation of your assets.
Using that information, they will calculate your debt-to-income ratio. The ideal DTI is 28%. The upper end of that scale is 36%. This includes your PITI–principle, interest, taxes, and insurance. You may be able to push your DTI ratio higher with a great credit score and cash reserves.
4. Know What Loan Products Are Available
There are several loan products available, but here are the three main categories:
- A Fixed-Rate Loan: These loans lock in your interest rate so that the principal and interest never go up. You can choose a 15- or 30-year loan. With the low interest rates today, it is hard to justify anything else!
- Adjustable-Rate Mortgage (ARM): The interest rates on these loans can fluctuate over time. They typically come in 3-1 (the interest rate is locked for 3 years and can change after that), 5-1 (locked for 5 years), and 10-1 (locked for 10 years) packages. ARMs can be a good option if you know you are going to sell or do a fix and flip before the adjustable period is over.
- Government and FHA loans: There are great options available for first-time homebuyers, veterans, people who qualify for affordable housing, and more. Do research and ask your bank and/or mortgage company which options you might qualify for.
5. Expect Turbulence
Obtaining real estate financing can be a long process, so expect turbulence and don’t let it discourage you. Here are some things that can cause turbulence:
- Lying on your loan application
- Late credit payments
- Changing jobs or moving
- If the buyer is short on money at closing
There are several other things that could happen, so do your due diligence and be prepared to pivot.
6. Negotiate the Cost of a Loan
Mortgage lenders aren’t hurting for clients right now, but they still want your business. This is especially true if they know you are an investor with a likelihood of being a repeat customer. So, there is always room to negotiate.
The main place you want to look for room to negotiate is with junk fees. The bank or the lender adds these fees on to cover their operations. To find these, look at the top of your good faith estimate. The government requires junk fees to be listed to ensure transparency in real estate financing. Here’s what to look for: underwriting fees, administration fees, doc prep fees, and the mortgage origination fees.
Ideally, you want to cut your closing costs to 3% of your loan amount. Remember that you can’t negotiate taxes, insurance, or title company fees.
7. Manage Your Credit Score
We return to the credit score because it’s so important! A way to manage your credit score is to keep your credit card balance at or below 33% of your total allotted credit. If you are an active investor and you refinance a property, make 90 days’ worth of payments before you refinance another property.
8. Know How to Raise a Down Payment
There are several ways to raise a down payment besides saving. This a blog post that goes more in depth on how to raise a down payment, but here are some quick bullet points:
- Use the equity in your home
- Draw from your IRA or retirement account
- Reach out to relatives and friends. They can gift you money for a down payment. Speaking from experience, it is really great as a parent/grandparent to be able to set your loved ones up for success with real estate.
- Get into a real estate deal with partners
- Use seller financing. This is a win-win—the seller carries part of your financing, and they don’t have to claim capital gains taxes on that property
- Your insurance policy
I hope these tips on real estate financing have helped and encouraged you to take the next step in your wealth building journey. If this information spoke to you and you want to learn how to apply it, I recommend coming to The WealthBuilders Real Estate Workshop April 22-24th, 2022. We will have 1-1 coaching and live Q&As in an intimate group setting. (And the money you will make from this information will be well worth the price of the ticket.) Click here to learn more about this real estate conference.