A quick look at different types of investment loans
An investment loan refers to any kind of loan used to finance the purchase and/or renovation of an investment property. While the home one lives in may well be considered an investment, it is also a home; as such, it is not considered an investment property per se, as one has to have a roof over one’s head, whether owned or rented. Purchasing a property with the aim of leasing it or fixing it up to flip it and make a quick profit, makes it an investment property – a realistic alternative to investing one’s spare capital in stocks or bonds.
It is a given that leveraging one’s investment is key to maximizing ROI. $500,000 used to purchase a property outright may well produce a steady income for the owner, as well as appreciating over time. However, investing the same $500,000 in a property costing $1.5 million, with the extra million dollars being borrowed, will show far higher returns in both income and appreciation. If these returns exceed the cost of borrowing, then this is a no-brainer. This begs the question of what type of loan works best for real estate investors.
There are many ways to finance an investment property, and many different kinds of properties. The best loan for each investor will depend on personal circumstances and the type and scale of property they are looking to finance. Is the investor planning on a one-off purchase of a single-family home for long-term rental? A ‘fixer-upper’ that they can purchase cheaply, renovate, and then flip, usually in a short timeframe? An entire apartment building that will provide rental income from possibly hundreds of tenants? A warehouse? Self-storage units? An office building? There is no one-size-fits-all solution here.
Conventional bank loans/mortgages
Generally issued by major banks or credit unions, these loans likely require a down payment of 20 percent, but prospective landlords will find they face stricter requirements than those who plan to be owner-occupiers, and down payments may be as high as 30 percent. A higher down payment should also result in a lower interest rate, but rates will still be higher than those charged for a primary residence. Regarding interest, some conventional loans will offer three- or five-year terms at a fixed rate, converting to a variable rate at the end of the initial term. These loans may well suit those looking to turn over a property fairly quickly, whereas those looking for a long-term income stream will be cautious about any possible rise in interest rates a few years down the line, especially if their profit margin is already fairly narrow.
Such loans are usually based on income, employment, and credit rating – including other debt. Most conventional lenders do not factor future rental income into these calculations. This may mean that borrowers need to produce pay stubs, tax returns, bank statements, and information on debts and liabilities. Credit checks are also required. The loans are always secured on the property, so an assessment of value will be needed also. The property is subject to foreclosure if payments are missed. Typically, conventional loans take a fair amount of time to arrange.
Hard money loans
These may be more appropriate for those wanting bridge financing for ‘flipping’. They are likely to be both easier and faster to obtain than conventional loans, and criteria are based on equity rather than income or credit scores. They are usually short-term, up to three years. Interest rates will be considerably higher than those for conventional mortgages, but ROI is still likely to be reasonable on such properties, even when the higher cost of borrowing is taken into account. The relative speed with which such loans can be arranged makes them appealing to investors who are anxious to close quickly on a deal.
Evidence of equity in the property, and some knowledge of the potential borrower, particularly with regard to their investment history. The borrower’s cash reserves are also likely to be a consideration. A down payment of between 30 and 35 percent is usual. If the property is being purchased with a view to renovate and ‘flip’, the envisioned future value, after renovations, may be taken into consideration.
Private money loans/mortgages
The private lending market is attractive to those developers and investors who would not easily qualify for a more conventional loan. Inability to qualify can be for a number of reasons; the potential borrower may have a limited credit history due to being a recent immigrant, or they may not be able to show sufficient income without taking future rental income into account, for example. However, private loans offer flexibility, and interest rates can be favorable.
As with hard money, or ‘bridge’, loans, private lenders will carry out due diligence regarding a borrower’s reputation and history, however limited. Private loans are often arranged informally, through networking. Lenders will also have the right to foreclose on the property if conditions of the loan are not met.
Home Equity Loans
Home equity loans may allow potential borrowers to access as much as 80 percent of their home’s value (or the value of the equity in their home), though higher loan-to-value percentages will have strict criteria attached. Raising money by refinancing one’s home can sometimes release enough capital to invest in a second home or income property. Interest rates on these loans are usually competitive. As the name suggests, the homeowner’s equity provides collateral for such loans. In the event of default, borrowers risk losing both income property and their main residence. It is therefore imperative that investors are 100 percent certain of the financial return on their second investment.
Sufficient equity in one’s main residence to provide collateral for the loan – an appraisal on their first home will also be required. Additionally, a credit check and verification of employment.
Those who may not meet requirements for conventional loans, for a number of reasons, may be able to access a portfolio loan. The inability to meet requirements for conventional loans can be various, including: self-employment, previous bankruptcies, having a high net worth but low credit score, or the currently poor structural condition of the property the borrower wants to purchase. Portfolio loans are either mortgage loans held in a bank’s portfolio, or loans collateralized by the borrower’s own portfolio. For loans held in a bank’s portfolio, there is no requirement to comply with underwriting guidelines set by secondary market investors and these loans can therefore be more flexible. Interest rates will generally be higher.
Alternatively, investors can access cash from their own investment portfolios; borrowing against one’s portfolio will require obtaining a margin loan to access a portfolio line of credit. Such a loan would normally have much lower interest rates than other options as it is collateralized by the borrower’s own investments. The other major attraction of a portfolio line of credit is that borrowers can access their own investments, without disposing of them – a win-win situation.
Usually less strict than those for conventional bank loans, though a credit score above 620 is normally required. To borrow from one’s own portfolio, the investments held would obviously need to provide sufficient collateral for the loan.
These may be perfect for those with larger scale investments in mind; they can be used to fund multiple properties, or land that is yet to be subdivided. Investors looking at purchasing entire apartment complexes, and with sufficient reserves to qualify, will find blanket loans attractive. Developers, in particular, will find these loans advantageous as they allow borrowers to sell individual properties or separate lots, without the need to repay the entire loan. This has the advantage of involving far less paperwork with no need for multiple applications accompanied by evidence of income, employment, etc.; there is also a saving in closing costs. Because of the higher amounts involved – for multiple properties – blanket loans may grant the borrower higher status, resulting in preferred treatment. However, risk to the borrower is also greater as, in the event of a crisis, they could lose their entire investment, rather than ‘just’ one or two properties.
High down payment, between 25 percent and 50 percent. These loans are not provided by every lending corporation and are more difficult to qualify for, requiring a high credit score and high levels of equity.
Investors and/or developers wishing to finance investment properties come in all shapes and sizes. The type of loan that is best suited to each investor depends on multiple factors: the type of property they are looking to purchase, and what they want to do with it afterwards; their personal credit history (or lack thereof); their cash reserves; their level of risk aversion; the speed with which they need to close a deal; and the anticipated timeframe they will need the funds for.
All types of loans have advantages and drawbacks; it is up to the borrower to do their research and decide which type of loan best suits their particular purpose.