13 Debt Instruments Available to Real Estate Investors

There are a myriad of different ways to finance a deal and I think it's important for investors to know and understand the options that are out there. The more tools that are at your disposal, the better chance you'll have of closing a deal. Some of the more seasoned investors out there may think a post of this nature is too basic, but you have to remember I started passive income design to educate, inspire and motivate newbies as well. My approach to building www.passiveincomedesign.com is to start with a good foundation. This is a foundation post.

Fixed Rate Mortgage

A mortgage is a debt instrument, secured by the collateral of specified real estate property, that the borrower is obliged to pay back with a predetermined set of payments. The breakdown of these payments into the portions that will go towards interest and principal is laid out in the amortization schedule. Mortgages are used by individuals and businesses to make large real estate purchases without paying the entire purchase price up front. Over many years, the borrower repays the loan, plus interest, until he or she owns the property free and clear. Mortgages are also known as “liens against property” or “claims on property.” If the borrower stops paying the mortgage, the lender can foreclose.

A fixed-rate mortgage is a mortgage loan that has a fixed interest rate for the entire term of the loan. Generally, fixed-rate monthly installment loans are most popular mortgage product offerings.

Adjustable Rate Mortgage (ARM)

An adjustable-rate mortgage (ARM) is a type of mortgage in which the interest rate applied on the outstanding balance varies throughout the life of the loan. Normally, the initial interest rate is fixed for a period, after which it resets periodically, often every year or even monthly. The interest rate resets based on a benchmark or index plus an additional spread, called an ARM margin.

Also called a variable-rate or floating rate mortgage, ARMs take several different forms.

Interest Only Mortgage

An interest-only mortgage is a type of mortgage in which the mortgagor is required to pay only interest with the principal repaid in a lump sum at a specified date.

Balloon Payment Mortgage

In balloon payment loans, both the principal and interest can be deferred until the maturity date at which time the borrower is required to make a lump sum payoff. Balloon payment loans can also be structured with interest-only payments. In an interest-only loan the borrower pays regular payments of only interest and then makes a lump sum principal payment at maturity.

Payment Option ARMs

Payment option ARMs are one of the most flexible nontraditional loans offering numerous payment options for mortgage loan borrowers. These loans follow the adjustable rate mortgage framework however they give borrowers the option to choose the type of payment they would like to make each month.

Payment Option ARMs will require a fixed rate interest payment for the first months or years of the loan. After that the loan will reset to a variable rate loan, usually charging a high margin to compensate lenders for some of the higher risks. In a payment option ARM, the borrower can choose from several options offered by the lender when making their monthly installment payment. 

Payment options typically include a low fixed rate option usually based on the introductory period rate, an interest-only payment, or a 15 or 30-year fully amortizing payment.

Payment option ARMs can be complicated for both borrowers and lenders since they will involve negative amortization. With a payment option ARM any unpaid principal or interest below the standard payment amount will be added to the borrower’s outstanding principal, increasing the amount of interest they are charged on subsequent payments.

Non-recourse Loan

Non-recourse debt is a type of loan secured by collateral, which is usually property. If the borrower defaults, the issuer can seize the collateral but cannot seek out the borrower for any further compensation, even if the collateral does not cover the full value of the defaulted amount. This is one instance where the borrower does not have personal liability for the loan.

Because in many cases the resale value of the collateral can dip below the loan balance over the course of the loan, non-recourse debt is riskier to the lender than recourse debt, which allows the lender to go after the borrower for any balance that remains after liquidating the collateral. For this reason, lenders charge higher interest rates on non-recourse debt to compensate for the elevated risk. The loan-to-value (LTV) ratios are also usually limited to 60% in non-recourse loans.

This loan is used primarily by real estate investors to purchase property that is held in a personal self-directed IRA. 

Hard Money Loan

A hard money loan is a loan of “last resort” or a short-term bridge loan. Primarily used in real estate transactions, its terms are based mainly on the value of the property being used as collateral, not on the creditworthiness of the borrower. Since traditional lenders, such as banks, do not make hard money loans, hard money lenders are often private individuals or companies that see value in this type of potentially risky venture.

The cost of a hard money loan to the borrower is typically higher compared to financing available through banks or government lending programs, reflecting the higher risk that the lender is taking by offering the financing. However, the increased expense is a tradeoff for faster access to capital, a less stringent approval process, and potential flexibility in the repayment schedule.

Hard money loans are often used to purchase homes outright at a bank or foreclosure auction where you do not have time to go through a 30-day escrow that a traditional mortgage requires.

Alternative Financing Routes:

FHA Loan

If you are struggling to get in the game, explore some alternative financing routes below. It’s good to understand all your options so you can make an informed decision. However, if you can go the more traditional route with a fixed rate mortgage with 20% down, I would recommend doing so. Pushing yourself to your financial limits is never a good practice. 

An FHA loan is a mortgage issued by an FHA-approved lender and insured by the Federal Housing Administration (FHA). Designed for low-to-moderate income borrowers, FHA loans require lower minimum down payments and credit scores than many conventional loans. 

As of 2019, you can borrow up to 96.5% of the value of the home with an FHA loan (meaning you'll need to make a down payment of only 3.5%). You'll need a credit score of at least 580 to qualify. If your credit score falls between 500 and 579, you can still get an FHA loan provided you can make a 10% down payment. With FHA loans, your down payment can come form savings, a financial gift from a family member or a grant for down-payment assistance.

It's important to note that the Federal Housing Administration doesn't lend you money for a mortgage. Instead, you get a loan from an FHA-approved lender, like a bank, and the FHA guarantees the loan. You pay for that guarantee through mortgage insurance premium payments to the FHA. Your lender bears less risk because the FHA will pay a claim to the lender if you default on the loan.

An FHA loan requires that you pay two types of mortgage insurance premiums – an Upfront Mortgage Insurance Premium (UFMIP) and an Annual MIP (charged monthly). The Upfront MIP is equal to 1.75% of the base loan amount (as of 2018). You pay this at the time of closing, or it can be rolled into your the loan. If you're issued a home loan for $350,000, for example, you'll pay and UFMIP of 1.75% x $350,000 – $6.125. The payments are deposited into an escrow account set up by the U.S. Treasury Department, and the funds are used to make mortgage payments in case you default on the loan.  

Despite the name, you make Annual MIP payments every month. The payments range from 0.45% to 1.05% of the base loan amount, depending on the loan amount, length of the loan, and the original loan-to-value ratio (LTV). The typical MIP cost is usually 0.85% of the loan amount. If you have a $350,000 loan, for example, you will make annual MIP payments of 0.85% x $350,000 = $2,975, or $247.92 monthly. This is paid in addition to the cost of UFMIP.

You will make Annual MIP payments for either 11 years or the life of the loan, depending on the length of the loan and the LTV. You may be able to deduct the amount you pay in premiums; however, you must itemize your deductions – rather than take the standard deduction (as much as $24,000 in 2019 if you’re married filing jointly) – to do so. 

FHA 203(k) Loan

An FHA 203(k) loan is a type of government-insured mortgage that allows the borrower to take out one loan for two purposes – home purchase and home renovation. An FHA 203(k) loan is wrapped around rehabilitation or repairs to a home that will become the mortgagor’s primary residence. An FHA 203(k) is also known as an FHA construction loan.

This loan allows low-income earners to afford to buy a home, especially one that needs fixing up. It applies only to individuals and families who intend on making the property their primary residence. This is a viable option to Get in the Game. I converted my first home into my very first rental property. You could live in the property and after a few years, pull equity out of the property to purchase your next property. 

Bridge Loan

A bridge loan is a short-term loan used until a person or company secures permanent financing or removes an existing obligation. It allows the user to meet current obligations by providing immediate cash flow. Bridge loans are short term, up to one year, have relatively high-interest rates and are usually backed by some form of collateral, such as real estate or inventory.

Although rare, bridge loans sometimes pop up in the real estate industry. If a buyer has a lag between the purchase of one property and the sale of another property, they may turn to a bridge loan. Typically, lenders only offer real estate bridge loans to borrowers with excellent credit ratings and low debt-to-income ratios. Bridge loans roll the mortgages of two houses together, giving the buyer flexibility as they wait for their old house to sell. However, in most cases lenders only offer real estate bridge loans worth 80% of the combined value of the two properties, meaning the borrower must have significant home equity in the original property or ample cash savings on hand.

Graduated Payment Loan

A graduated payment mortgage (GPM) is a type of fixed-rate mortgage in which the payment increases gradually from an initial low base level to a higher final level. Typically, the payments will grow 7-12 percent annually from their initial base payment amount until the full monthly payment amount is reached.

A graduated payment mortgage may or may not be a negative amortization loan. If the initial payment amount is less than the accruing interest on the mortgage loan, the graduated payment mortgage is a negative amortization loan. With a negative amortization loan, the payments made by the borrower are less than the interest charged on the note. This less than interest payment structure creates deferred interest which adds to the total principal of the loan.

VA Loan

A VA loan is a mortgage loan available through a program established by the United States Department of Veterans Affairs. VA loans assist service members, veterans and eligible surviving spouses to become homeowners. The VA sets the qualifying standards, dictates the terms of the mortgages offered and guarantees a portion of the loan. VA home loans are provided by private lenders, such as banks and mortgage companies.

The Veterans Administration offers a home loan guaranty benefit and other housing-related programs to help qualified veterans or their eligible surviving spouses buy, build, repair, retain or adapt a home for personal occupancy. VA loans offer up to 100% financing on the value of a home with no private mortgage insurance premium requirement. VA loan recipients do not have to be first-time home buyers. Also, they may reuse the benefits and assign the loan to another qualifying person. 

Some other advantages to a VA loan are closing costs are limited and may be paid by the seller, the lender cannot charge a prepayment penalty. Just as I mentioned in the FHA 203(k) loan section, this is an option to purchase a primary residence, live in it for several years and then pull cash out to continue investing. Cash-out refinance loans are also available and allow mortgage holders who are veterans to borrow against home equity to pay off debt, fund school or make home improvements. This refinancing option offers a new mortgage for a larger amount than the existing note and converts home equity into cash.

Interest rate reduction refinance loans (IRRRLs), also known as streamline refinance loans, help borrowers obtain a lower interest rate by refinancing an existing VA loan. This is a VA-loan-to-VA-loan process that allows homeowners to refinance a fixed loan at a lower interest rate or convert an adjustable-rate mortgage (ARM) into a fixed-rate mortgage.

Seller Financing

Seller Financing is a real estate agreement in which the seller handles the mortgage process instead of a financial institution. Instead of applying for a conventional bank mortgage, the buyer signs a mortgage with the seller. Seller financing is also known as owner financing and a purchase-money mortgage.

Seller financing rises and falls in popularity along with the overall tightness of the credit market. During times when banks are risk-averse and reluctant to lend money to any but the most creditworthy borrowers, seller financing can make it possible for many more people to buy homes. Seller financing may also make it easier to sell a home. Conversely, when the credit markets are loose, and banks are enthusiastically lending money, seller financing has less appeal. Often seller financing includes a balloon payment several years after the sale.

I hope this article gave you some ideas about how you might finance your first or your next deal.

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