How to finance a rental property
Photo by Josh Appel on Unsplash
The thought of putting money down on a property can be scary. The thought of putting money down on a rental property is even scarier. Once you’ve found a property and you’ve done the math, then you need to decide how you want to finance it. There are several ways you can go about financing a rental property. The key is to first understand the concept of good debt and bad debt. I’ll break down the difference between the two, explain a couple different finance options, and which would be best for your situation.
First, what is debt? You probably recoil a little bit by just reading the word. Chandler David Smith, a real estate investor in Idaho compares it to a tool. Just as a car can be used for good, it can also be dangerous. “It’s a very dangerous tool if used incorrectly but if you use it correctly it can help you amass a ton of real estate control and wealth.” (https://www.chandlerdavidsmith.com/post/how-to-get-approved-for-any-loan)
Now you need to know how to finance a property. You can go the traditional route and get a loan through the bank or you can find a private lender. There are benefits to both. You can determine which financing route would be beneficial to your situation as well by determining the purpose of your property. Are you buying a duplex and plan on occupying a unit? Or is your plan to rent a property out completely? If you can occupy a unit as a primary resident, you can be offered loans with lower interest rates. We can get more into the key differences in financing options to help you find your fit for your real estate investment.
Bank: get approved
The first thing that a bank is going to do is to determine the risks of loaning money to you. A bank wants to see that you know how to handle your money. Are you responsible? Do you spend more than you make? They want to know if it would be a risk to approve you for a loan.
Getting approved for a credit card and/or a car loan are great ways to start building your credit. One thing to keep in mind is that your credit score can be affected each time you add a new line of credit. For example, if you have one credit card for a year and then get approved for another one at the end of the year, your credit history of a year will be averaged between the two lines of credit; shortening your credit history.
Considerations for loan approval:
· Credit score; if you have a credit card, keep monthly spending around 10% of credit limit (ex. Your credit limit is $1500, so your sweet spot would be around $150/month), pay on time and don’t miss payments (are you responsible?)
· Provide bank statements; have money in your bank (will you be able to pay off this loan?)
· Taxable income (are you making money?)
*1099 employees need to provide 2 years of commissions to prove income
· Debt-to-income ratio; most mortgage loans require around 43% or less DTI ratio (do you have more debt than your income can pay off?)
With real estate investment, a good rule of thumb is to have your go-to expert. This includes a loan officer, tax expert, and real estate agent. Make connections with loan officers in your area. Once you find a loan officer and get pre-approved for a loan, this will benefit you as properties come up. Having a pre-approval letter can put you ahead of other competitors in the area.
Remember, the higher your credit score, the lower the interest rates that can be offered to you on a loan. I would recommend you work on building your credit right away and maintaining it with good spending habits.
Now some criteria above might be difficult for some and a private lender might be a better suite.
Photo by Phil Hearing on Unsplash
Private Lender: find your fit
You might be wondering where you even start to find someone to fund your investment and from there, how to you go about it? What are the criteria, benefits, and drawbacks?
Angel Investment (https://www.angelinvestmentnetwork.us) is a resource where investors can look for investments to fund and for beginning real estate investors to seek funding. You’ve found a property and you’ve done the math, now sell that idea to an investor. What’s in it for them to help fund your real estate investment?
When making a pitch, make sure to do your research. Know your market. Know your target tenants. Know what you can get out of it and what the investor can get out of it. This will help you when negotiating terms with potential investors.
Benefits of a private lender:
· Easier approval (are you a *1099 employee who can’t prove a taxable income?)
*1099 employees need to provide 2 years of commissions to prove income
· Negotiate down payment, monthly costs (do you want more leeway in your down payment or other costs?)
Now a drawback to finding a private lender is potentially higher interest rates than that of a traditional bank loan. There are also different criteria that various private lenders will have. The more you know about the property you’re wanting to invest in, the better you can determine the fit of a lender.
Some thoughts:
Whether you finance your property through a bank loan or private lender, a good rule of thumb is to have reserves. Whatever your monthly costs are that you estimate for a property, set aside 6 months worth of it. This can help mitigate potential maintenance or vacancy problems that could arise in the future.
And remember, debt doesn’t have to be a bad thing. The very debt that you accrue in real estate assets can offer passive income and appreciation. As you pay down a mortgage and build equity, you can leverage that equity to buy more assets. So in essence; you can profit off of your debt. Just like any tool, there are upsides and downsides to how you use it. Real estate investment can be the same thing, and I want to help you feel confident as you begin investing.