Investors are always looking for additional ways to create passive income. The real estate market in the greater Colorado Springs region is a perfect place for creating this kind of residual income. However, one of the most common barriers to entry is that in order to buy real estate, a significant amount of capital needs to be made available up front. In this blog post, we are going to cover some of the different options investors have for financing their investment properties.
The three most common types of loans used in investment property transactions are Home Equity Loans, Conventional Loans, and Hard Money Loans. It is extremely important to understand the differences between these three types of loans. Choosing the wrong type of loan for a specific property can jeopardize the potential for your investment to become a profitable one.
Home Equity Loans
Especially in today’s current market conditions, most homeowners have a decent amount of equity in any property that they own. This equity can be used to grow a real estate portfolio and can be accessed through a Home Equity Line of Credit (HELOC), or through a cash-out refinance of the mortgage on the property. An owner can usually borrow up to 80% of the equity they have in their home if they are going to use it to purchase a second property. Depending which of these loan vehicles you decide to utilize in order to tap into the equity, there may be a different list of pros and cons. If you choose to get a HELOC, it will essentially function as a credit card. The monthly payments on the Home Equity Line of Credit will likely be interest only. However, a HELOC often comes with a variable rate, which means that if the prime rate it is tied to increases, your rate and payments will also increase. A cash-out refinance usually comes with a fixed rate, but the potential drawback is that it often extends the duration of the term of your current mortgage.
Hard Money Loans
These loans are generally the most beneficial when your intent is to purchase a property, fix it up, and then flip the property quickly by reselling it for profit. The loan will be more expensive than with other types of loans, and it will need to be repaid in full much more rapidly. A hard money lender is mainly focused on how much potential profit is wrapped up in the property itself. They care significantly less about things like the credit score of the borrower or what their payment history might look like. The terms of hard money loans are usually somewhat harsh comparatively speaking, and interest rates can be 18% or more. Penalties for missed payments are typically quite severe as well. However, these loans can be a great option because they are much easier to qualify for than home equity lines or conventional loans. Another benefit is that they fund very quickly (days instead of weeks) compared to the other financing options.This allows construction on the flip to begin ASAP.
A conventional loan must conform to standards set forth by Fannie Mae and Freddie Mac. In today’s market, conventional lenders often require a 20% down payment. However, if the property involved is an investment property, the lender may require up to 30% down. For conventional loans, things like whether or not an investor qualifies for a loan, and what interest rate they will have to pay will depend on their personal credit history. A prospective borrower will be asked to prove that they can afford the monthly payments on the investment property in addition to their other monthly obligations. Their debt-to-income ratio will be reviewed before factoring in the rental income the property will generate so that a decision can be made.
As you are choosing the best type of loan for your investment property, be sure to consider both the short and long-term implications of each type of loan to ensure that your venture will be as profitable as possible! As always, don’t hesitate to reach out to PMI Rocky Mountains with questions about any aspect of acquiring and managing rental property.