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Financing Real Estate - Chapter 11

Considerations and Options for Financing Real Estate

Financing Real Estate

Whether you are purchasing your first home or an investment property, securing the appropriate financing is imperative. The goal of this chapter is to provide an overview of the financing process and to discuss conventional financing for the purchase of real estate. The next chapter will explore creative alternatives for financing real estate.

Generally speaking, buyers want to obtain the maximum loan possible from a bank. This is true for both first-time buyers and investors. Many first-time buyers simply don't have much for a down payment, while investors hope to get a better return by minimizing their cash investment. Borrowing money is called leverage, which has a very powerful effect when prices increase or decrease rapidly. Ideally, we would like to finance 100% of the purchase price, but in most cases it is not that easy. The reason lenders want a down payment is so they have adequate coverage for their loan. This means that you, as the buyer, will be required to have an equity exposure in the form of a down payment.

Before you can determine the type of financing that is most appropriate for your situation, you must have a clear objective for what you are trying to accomplish. The following questions will help guide you toward finding the most appropriate financing package.

Are you purchasing an Investment Property or as an Owner-Occupant? If you are purchasing investment property, you will typically be required to have a larger down payment and assume a higher interest rate. The reason banks charge more to finance investment property is due to the higher risk. When a property is owner-occupied, it is reasonably simple for a bank to assess the risk of the owner based on their credit history and income. As a result, the banks pass off more favorable financing terms to owner-occupiers. With investment property, the banks are not involved in evaluating the credit profile of the tenants. As a result, the principals of the investment property will be required to pay higher financing rates to offset the higher risk.

How long will you own the property? Having a good idea of how long you will own a particular piece of property will be very helpful in guiding the type of loan you select. For example, if you are buying an investment property to quickly flip, an interest-only loan may be the most appealing. The reason being that the carrying costs of an interest only loan will be the cheapest as you will not be paying any principle. However, if you were looking for a home to live in for the next 30 years, you would probably want a 30-year fixed loan where you would have a guaranteed fixed payment for the next 30 years.

Would you qualify for a government-backed loan? Government loans can be a great option, particularly if you do not have perfect credit or have little for a down payment. For example, the Department of Housing and Urban Development insures loans that allow down payments as low as 3%. Also, with these loans you can wrap your closing costs and fees into the mortgage.

Is the home you are purchasing a fixer-upper? There are great loans available for fixer-uppers but you need to be careful to find the right loan. For example, make sure your loan is not conditional on the condition of the property, as this can significantly delay the closing of your financing in the event your property does not qualify. A very good loan for fixer-uppers is FHA's Section 203(k) mortgage, which combines the cost of renovation and the purchase of the house within one loan. However, the downside to a 203(k) mortgage is that the maximum loan amount is typically under $230,000, which will not buy very much in states like California or New York.

Once you have answered the questions above, you will have a much easier time identifying the right loan for your needs. Now let's take a look at the different types of mortgages.

Types of Mortgage Loans:

Fixed Rate Mortgages: The most traditional loan available is the standard 30-year fixed rate mortgage. The appeal of a 30-year fixed mortgage is that you lock in your interest rate on the loan for its entire 30-year term. The means your monthly payment will remain unchanged for the life of the loan. Fixed rate mortgages are great loans for people who intend to hold the particular property for the long run. A fixed rate loan appeals to many people since there is security in knowing your mortgage payment will remain the same even if interest rates skyrocket during the term of your loan.

Adjustable Rate Mortgages: Adjustable rate mortgages typically have an initial fixed rate period lower than the rate of a comparable long-term fixed rate mortgage. The initial fixed rate period is followed by annual rate adjustments based on market conditions. For example, a "3/1 ARM" is fixed at an initial low rate for the first 3 years, and then adjusts every year based on an index. Adjustable mortgages have increased in popularity over the last several years as home prices have escalated. People are naturally attracted to the lower initial rates when compared to a fixed rate mortgage. Be cautious of how high your adjusted rate could go and ensure you can adequately cover increased payments. Otherwise, you may be setting yourself up for default and potential foreclosure.

Interest-Only Mortgages: Interest-only payment options were initially offered as a way to borrow more money while not increasing the monthly payment. Since there is no principal paid during the interest only period, your payments are smaller when compared to a conventional mortgage. Of course, sophisticated investors understand that with increased leverage comes increased risk. In this case, borrowers who leverage themselves into a more expensive home, with a larger mortgage, gamble not only that their income will rise in the years ahead, but that the home will appreciate as well. Since the principal balance is not being reduced, the owners are not building any equity in their home. Instead, they are counting on the market to do that for them. That's not so much of a gamble when homes are appreciating, but it could spell big trouble in a down real estate market. In the wrong situations, interest-only mortgages can backfire and cause you to find your investment has become distressed real estate. Have a solid strategy in place before engaging on interest-only loan.

Balloon Loans: These tend to be short-term loans. You borrow money for, say, three or seven years, and the loan is amortizedas though it were a 30-year loan. At the end of the three- or seven-year period, you owe the bank the entire remaining principal, in one lump sum -- like a big balloon. Again, these loans tend to have lower interest rates than the standard 30-year mortgage. If you're not planning to stay too long in your house, you might be interested in such a loan. The reasoning goes like this: You pay less in interest over the course of the loan than you would with a 30-year fixed loan -- saving potentially thousands of dollars. So, you're less out-of-pocket when it comes time to sell.

The key risk is if you ultimately decide to stay in your house. At that point, you will be required to secure a new loan to pay off the original balloon loan. With a new loan there will be the standard mortgage closing costs and depending on market conditions, your new interest rate could be substantially higher.

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