We've all heard the old saying "It takes money to make money." And this is definitely true in real estate investing.
Investing in real estate requires having access to a sizable amount of capital. Whether you're building a portfolio of rentals or fixing and flipping for short-term profits, the biggest hurdle to doing deals is often funding.
In addition to the initial cash outlay required to purchase the property, you need cash for other expenses. For fix-and-flips, you'll have to pay for materials to do renovations and repairs, labor and contractor fees, closing costs, listing and broker fees, holding costs, taxes, transactional fees and more.
Where can you get the money you need to fund your real estate deals? Here are seven common — and not so common — sources of funding and how each works.
#1: Traditional Bank Financing
The first place you might look for a loan is from the local bank where you hold a savings or checking account. In some ways, getting an investment property loan from a bank is just like getting any other kind of mortgage loan. You decide how long you want the loan term to be and provide the appropriate down payment, and the bank provides the funds at closing.
On the other hand, it's different. You're seeking a loan for a rental property or fix-and-flip project. Traditional lenders prefer to make loans on homes that are in reasonably good condition with no health or safety issues. Sure, you may intend to fix those problems, dramatically increasing the value of the home for a profit. But lenders are most interested in lending for homes that are move-in ready. Even if a bank will consider lending the amount needed for purchase and rehab, it may be hesitant to give you any money if you don't have a track record of successfully flipping houses or managing a portfolio of rental properties.
The amount you can borrow will be less than you could borrow for your primary residence. This is because the investment property you want to purchase will not be owner occupied. Banks will typically lend only 70% of the fair market value (FNV) of such properties in their current condition.
Say, for example, you find a distressed property for $80,000 and you estimate the renovation will cost $20,000. Once the work is completed, the property will have a market value of $140,000. The bank would likely lend you only 70% of the purchase price of $80,000, or $56,000. You would need to have a down payment of $24,000 from your own resources or another source, plus $20,000 in funds for the renovation.
The other problem is that the process of getting a traditional bank loan typically takes between 45 and 90 days. That's just too long for most real estate investors. For the best investment acquisitions, you must move very quickly.
#2: Seller Financing
Seller financing, or owner financing, is an arrangement between a homebuyer and seller. The buyer purchases the property in installments until the property is paid off in full. These payments will typically include principal, interest and taxes. Seller financing is short term — typically five years with a balloon payment at the end.
Seller financing can be beneficial for a seller who wants to sell when credit is tight and borrowers are having trouble securing loans.
For a buyer, it can be the perfect way to obtain financing when they do not meet all the criteria of a conventional loan. For example, a buyer may have a little less than the required down payment. Or a credit score just a few points below the bank's threshold. Or not have a full two years of employment experience in the same profession. Banks are unwilling to make exceptions, but a seller may feel comfortable offering seller financing if most of the criteria are met.
Technically, seller financing is not a loan, but an installment sale. The seller is not lending money. Instead, the seller just agrees to let the buyer pay the purchase price over time with monthly installments.
No seller financing deal is the same. Ultimately, the option choices will be specific to the particular property and the specific needs and desires of the buyer and seller.
The deal is a lot less complicated, because there are only two parties: the buyer and the seller. You make an offer to the seller, the two of you negotiate, and if it makes sense for both parties, you move forward.
#3: Hard Money Loan/Private Money
Hard money loans are short-term financing alternatives often used by fix-and-flippers to finance the costs to both buy and renovate a property. Private money lenders can be anyone from a personal friend to an established private lending company. And they may provide financing for just the purchase or for the purchase plus rehab expenses. Hard money and private money lenders provide loans that are 100% secured by the real estate asset.
These loans let experienced fix-and-flippers perform their own renovations while allowing novices to use a licensed contractor. And since the approval and funding of a hard money loan can happen in 15 days, smaller fix and flippers can compete with all-cash buyers.
Typically, maximum loan amounts are based on a percentage of a property's loan-to-value (LTV) ratio or after-repair-value (ARV) ratio. An LTV ratio is based on a percentage of a property's current fair market value (FNV). The ARV ratio is based on a percentage of a property's expected FNV after the rehab. Hard money and private money lenders will typically issue a loan up to 90% of a property's LTV or up to 80% of a property's ARV.
Loans for flipping projects are more expensive than home purchase loans. The interest rates are higher, and you'll often have to pay loan origination fees. However, hard money loans have lower qualifications for approval. This helps fix-and-flip investors receive approval and funding quickly. Hard money lenders focus attention on the property and its potential value more than the borrower's experience or financial qualifications.
To maximize the amount of money available for your project, lenders often allow interest-only payments, and there's no prepayment penalty. This gives you flexibility to sell and pay off the loan whenever you are ready.
Hard money lenders can be found either online or through industry relationships, such as referrals from realtors, contractors or mortgage brokers. Online hard money lenders conduct their business completely over the internet. LendingOne is an example of an online hard money lender. Pre-qualification takes less than a day, and funding can be received in as little as 15 days. Interest rates start at 7%, monthly payments are interest only, and there are no prepayment penalties.
Hard money is the most expensive option detailed in this article. Still, it can be a great source of short-term financing. Just be sure you include the cost of paying the higher interest rates and fees when you do the math on your project.
#4: Cash Out Refinance
A cash out refinance, also known as a "cash out refi," involves pulling equity from an existing property by securing a new loan on the property. The interest rate on a cash out refinance (COR) is usually slightly lower than a traditional mortgage. This is because the borrower already has a track record of on-time payments. But lender fees are typically a bit higher. This is because a COR is more complicated to process than a regular bank loan.
What's nice about the COR transaction is that you're handed cash with no restrictions on how you spend it. Fix-and-flip investors can use a COR on an owner-occupied home as well as a non-owner-occupied investment property of up to four units.
Sometimes, fix-and-flippers use a cash out refinance to purchase a distressed property. The cash can be used as a down payment, or perhaps it will be enough to buy the property outright. Investors will then use a hard money loan to finance the renovation costs of the project.
Closing costs are either taken directly out of the loan or paid out of pocket. Once the loan is issued, the lump sum amount is wired directly to a borrower's bank account. It's up to the borrower to pay off the existing mortgage.
A COR typically has a maximum LTV loan amount of 75%. Typically, a cash out refi can be funded more quickly than a traditional mortgage.
#5: Home Equity Line of Credit
A home equity line of credit (HELOC) is similar to a second mortgage on your primary residence. It's a home equity loan that works more like a checking account than a conventional loan. You are issued a line of credit based on the value of the equity built up in your primary residence. You can use that credit to purchase anything. Similar to a credit card, interest rates are charged on the amount borrowed until the amount is repaid.
Unlike credit cards, however, the interest rate is structured like an adjustable rate mortgage. This is much lower than the rate charged by credit card issuers. A HELOC typically has an adjustable interest rate that starts between 4% and 5% and resets over time. It's common for interest rates to increase over the life of a HELOC. My own HELOC is a variable rate that is always just 1% over the current prime rate. Interest accrues only on the outstanding balance at any given time, not the entire credit line.
Unlike a cash out refinance, a HELOC can be taken out in addition to your existing mortgage. Also unlike a COR, a HELOC can be issued only on an owner-occupied primary residence.
Since a HELOC is a home equity loan, the qualifications for approval are fairly standard. A big advantage of using money from a HELOC is you typically aren't required to pay closing costs.
Most HELOCs have a maximum combined loan amount equal to 85% of a property's LTV ratio. This means the first mortgage and the HELOC combined cannot exceed 85% of a property's current FNV.
The biggest issue with using home equity to pay for a house flipping project is the fact that your house serves as the collateral. If you fall behind on the payments, the bank could decide to foreclose on your house.
#6: Your Own (or Someone Else's) Self-Directed IRA
Most retirement accounts invest in traditional assets like mutual funds or bonds. A Self-Directed IRA (SDIRA) is a way to use retirement savings to invest in alternative assets including real estate, notes, tax liens and more. An SDIRA is a special type of retirement account set up like a trust with a specialized custodian that holds assets, processes transactions and keeps records for the IRS.
There are rules to strictly follow as you "self-direct" your qualified retirement funds. You must be very careful not to engage in IRS-prohibited transactions. One is that you can't invest in your own business or acquire assets in your own name. But you can acquire and hold real estate within your SDIRA if you follow all the rules. It's your IRA, not you, that's buying properties. You can even leverage your real estate investments within your SDIRA by taking out a non-recourse loan. This is a specialized mortgage vehicle designed for this purpose.
I moved my 401(k) money into a SDIRA three years ago and bought three income-producing rental properties. The transactions were easy. Management is at arm's-length. And each property is providing tax-free monthly income toward my retirement. (For more details on how I did this, see this article.)
Chances are you know someone who is looking to invest in real estate with a portion of their qualified IRA savings. They may just want to lend it to you in exchange for reliable principal and interest payments each month.
#7: Loan Against Your Whole Life Insurance Policy
You may have untapped cash you're not aware of: built-up cash value sitting in a whole life insurance policy available for you to borrow.
This was a very useful financing tool for me when I got started in real estate investing. Both my husband and I had purchased whole life policies when we were in our 20s and have been paying the premiums ever since. Between the two of us, our policies have a paid-up cash value of over $75,000 — funds available for me to borrow against. I took out a loan against each policy and had cash to purchase a fix-and-flip at a very favorable price.
The interest rate is 5%, there's no application process, there's no repayment schedule, and there was no loan repayment due. I had to pay interest only at the end of the year. This makes it a very low-cost and flexible source of funding.
Bonus Funding Option: Look Into Partnering With Someone
I know a few investors who swear by partnerships as a quicker way to get the money and experience to do fix and flips. Often, one investor provides the acquisition money to buy a distressed property with cash, and the other provides the materials and labor for the rehab. They agree to split the profits on a prorated basis after the property is sold.
I have never done a partnership on a real estate deal. I've looked at a few properties with another investor but quickly realized that we had different strategies that could become problematic with the multitude of decisions we'd need to agree on in the process. For me there's enough risk in a real estate project without adding another person to the mix. That being said, it may be a great option for your strategy, personality and goals.
Of course it goes without saying that if you do a joint venture or partnership, you'll want to choose a partner with care and make sure you have a written, signed agreement before you move forward.
So there you have it — seven sources of funding for your real estate deals. Of course the best one — or combination of sources — depends on the type and condition of the property, your experience with real estate investment and your personal financial situation.