Creative financing for real estate refers to uncommon or unique ways an individual can purchase land or properties that are for sale. An investor or homebuyer would typically use one or more creative financing methods when they want to use as little of their own money as possible.
Kevin Miles, a leading specialist, and finance analyst from loan advisor.sg suggests that “finding finance options for real estate can be quite hard. These days, investors try to find out a much more creative way to finance their investments. Though it sounds like an out-of-the-box approach, it has many benefits like avoiding hefty interest rates”.
Creative financing for investors peaked in the late 1970s when interest rates were as high as 18 percent. Because it was more difficult to qualify for a loan, the need for creative financing was born.
If you’ve decided you’re ready to buy a home, but traditional banks are accusing you of being a less-than-perfect candidate (whether it be because your credit score is low or you don’t have enough in savings to afford a 20 percent down payment), the following methods are your answer.
Understanding Traditional Financing
In traditional financing, there are typically four parties involved: the seller, the buyer, the bank, and the closing agent. Before the time of closing, the buyer and seller would have signed a purchase and sale agreement. The buyer would then approach the bank or other mortgage lender to finance the agreed-upon purchase price, usually with a down payment. Finally, the closing agent would oversee the closing process. During this time, the buyer obtains money from the lender, which they use to pay the seller. This transaction takes place in exchange for a promissory note and mortgage. Once the transaction is completed, the seller transfers the deed to the buyer. Currently, the sale using traditional financing is complete.
Today’s investors should be equipped with not one but several financing options before approaching a deal. Going straight to a traditional lender for a mortgage may seem simple, but this approach will not always guarantee the best loan terms. In many cases, finding the best financing will require investors to get a little creative. There are so many unique ways to finance real estate it can be hard to fully understand what’s out there. The following creative financing options are a great place to start:
· Cash-Out Refinance
· Home Equity Line Of Credit
· Personal Loan
· Seller Financing
· Lease Option
· Self-Directed IRA
· Hard Money
· Private Money
· FHA Loans
· Cross Collateral
1. Cash Out Refinance
A cash-out refinance for real estate is a transaction in which you tap into the equity of your home — you borrow enough to pay off the mortgage of your home and then pocket the difference — which can free up funds to invest elsewhere. What’s more, a cash-out refinance happens to be one of the best real estate financing options out there if you know what you are getting into.
A real estate cash-out refinance is different from a simple line of credit, in which you add a second mortgage to your home to take out cash. The interest terms on a cash-out refinance are much more favorable than a traditional home equity loan. And, unlike borrowing money from a hard money lender or conventional financial institution, the interest on a cash-out refinance is tax-deductible.
The risks with a cash-out refinance are that your mortgage term gets reset — the 30-year clock starts over again — and if something unforeseen happens, such as an illness or job loss, the new monthly payments can be challenging to contend with.
But if you have a great opportunity and need some ready capital to make that opportunity happen, it can be a good source of investment dollars.
2. Home Equity Line of Credit
Unlike a cash-out refinance, with a home equity line of credit, you don’t pay off the original mortgage. Instead, you borrow against the value of your home — up to 80% of the home value, minus the amount of the mortgage.
HELOCs generally have a draw period, typically lasting ten years, and a repayment period, often lasting no more than 15 years. As a cash-out refinance, a HELOC’s interest is tax-deductible, but only up to $100,000.
So, when would you use HELOC and not use a cash-out refinance? A HELOC is perfect for doing repairs, either to your primary home or a rental property. Situations where you don’t need huge sums of cash for an entire property purchase — maybe you need $10,000 to improve a bathroom in your rental property.
3. Personal Loan
Though a personal loan doesn’t offer the same great tax benefits as a refinance or HELOC, there are some compelling reasons to consider it, among other creative real estate financing techniques.
For one, you aren’t required to put up your house as collateral. In some cases, you aren’t even required to put up any collateral at all. And with a repayment term much shorter than a mortgage loan —five to seven years is a good benchmark — you’ll end up paying a lot less interest over the long term.
However, with that shorter repayment term comes a much larger monthly payment. You most likely must have excellent (or at the very least) good credit to qualify for a personal loan. Still, if you have good credit but very little equity in your home, this can be an effective real estate financing method.
4. Seller Financing
If you ever hear an investor talk about buying something “on terms,” they refer to seller financing. As any seasoned investor will tell you, the goal is to use as little of your own money as possible and instead rely on other people’s money. Seller financing, or seller carryback, is an excellent example of this philosophy.
In this method of real estate creative financing, the seller of a property agrees to hold on to the note of purchase. You then pay them a monthly payment until the note is paid off. Now, of course, this will only work with sellers who own their homes free and clear and don’t mind forgoing a bit of short-term cash for some long-term streams of passive income. (Motivated sellers who are underwater with their payments won’t work here.)
If you see a great investment opportunity and realize that you will probably end up refinancing anyway at some point, seller financing as a real estate investment option can be a great arsenal to add to your toolbox.
5. Lease Option
A common school of thought among real estate investors is that it is always better to buy than rent. The problem with this sentiment is the word “always.” It ignores the fact that lease option contracts are a very viable route to homeownership. Real estate investors of all experience levels may occasionally encounter a property they are not ready (or sometimes able) to purchase, which is where lease option contracts come in.
A lease option property allows investors to work with landlords so that they can purchase the property at the end of the lease agreement. This allows investors to build equity through monthly rent payments and provides landlords with the opportunity to generate interest income. Depending on the specificities of the contract, a portion of the rent payments will then count toward the down payment on the home.
The most prominent challenge investors face when searching for a lease option contract is finding the right landlord to work with. This setup is most introduced when an owner has difficulty selling a rental property, but that’s not to say it can’t happen under other circumstances. Investors hoping for a lease option scenario should be prepared to shop around and know how to approach the conversation when they find a potential property.
6. Self-Directed IRA
Investors with existing retirement savings can consider yet another creative way to buy real estate: through a self-directed IRA. This technique allows investors more control compared to other retirement options and several tax benefits. It is worth noting that all returns must flow directly to the IRA instead of straight to the investor. Depending on your preference, this can either be a pro or a con.
What is important to remember is that a self-directed IRA can allow investors to ramp up their retirement savings, one property at a time. Just make sure you have a sound system in place for analyzing deals. While a self-directed IRA is largely beneficial, there are always risks involved when it comes to investing.
If you don’t already have an IRA, the setup process is relatively straightforward. Research different options and closely examine the fee structures involved. You want to make sure your cash flow covers your account’s required costs and with enough returns leftover to be lucrative.
7. Hard Money
An investor can obtain hard money from a private business or individual to invest in real estate. While the terms of hard money will vary from loan to loan, there are several traits that almost all hard money loans possess. Firstly, the approval requirements for a hard money loan are much less stringent than that of a traditional lender. The lender's income does not have to be verified, nor does their credit score.
Secondly, hard money loan stipulations can vary. Term lengths are typically shorter, interest rates are typically higher, and hard money can often fund a deal in just a few days. Lastly, hard money lenders understand the process of investing in real estate better than traditional lenders (real estate is their specialty, after all). Instead of analyzing your credit score and asking for references, hard money lenders will review your rehab blueprint, the scope of work, and ARV to determine loan terms. Be sure to have your exit strategy in mind before employing this creative financing option because the last thing any investor wants is for their loan to run out (remember, hard money loans are short-term).
8. Private Money
Private money is very similar to hard money in several aspects but is identifiable due to the relationship between the lender and the lender. Hard money lenders are professional real estate investment lenders, while private money lenders typically know their borrowers for more personal reasons. A private money loan can come from your friend, family member, neighbor, coworker, or essentially anyone else you feel comfortable asking for money from. Investors can negotiate more flexible loan terms with their private money lender because the entire transaction is less “business” oriented. Lastly, private money lenders rarely receive additional cash flow based on equity other than their pre-determined interest rate.
9. FHA Loans
Backed by the Federal Housing Administration, FHA loans are perfect for first-time homebuyers who don’t qualify for a traditional loan. While you are still technically borrowing from a conventional lender, this loan allows those with credit scores of 580 or above to pay as little as 3.5 percent for a down payment. Keep in mind that this real estate financing loan requires an upfront insurance premium of 1.75 percent as well as an annual insurance premium of 0.85 percent of your loan balance for as long as you have the loan (note, this is different from PMI).
This financing strategy is relatively new and allows investors to use money from the public. Several well-known crowdfunding platforms like GoFundMe and Kickstarter authorize users to raise money for anything they want. However, sites like Hatch My House and Feather The Nest are crowdfunding platforms designed specifically for real estate investors and homebuyers. Choose a site, create an account, make your case to the public, and wait for funds to roll in.
11. Cross Collateral
If you are expanding your real estate portfolio, one option is to tap into your equity on an existing property to finance another. Instead of borrowing against that equity, like a home equity loan, you are using that property as additional collateral. The lender will then have a lien on both your existing property and the new property if you were to default. In exchange, you can finance your deal without the need for a down payment or additional loan.
A traditional mortgage can be a great way to purchase real estate, but it is not always the best option. For example, seller financing could provide a lower interest rate, while a personal loan may have a faster approval process. The right way to finance will vary from project to project and property to property. What’s important to note is how many options you have available and how to use them. After all, real estate investors are required to get creative from time to time.