Real Estate financing and Creative financing Knowledge of real estate financing is of prime importance to your success as a real estate investor. I recommend that you read a few books on the subject.
I will cover here the basic concepts of some of the different ways of financing a deal. It is not unusual to find more than one method used to finance a property. Each state is governed by laws covering deeds of trust, and mortgages. You should familiarize yourself with the laws of your state by reading a text book such as modern real estate practices (for your state) Most college book stores will have this. Regardless of your state's individual laws on title and lien theory of mortgages, the security interest of the mortgage (the lender) is legally considered personal property. This property interest can only be transferred with a transfer of the debt, which the mortgage secures. To put it plain English, the liens (all debts owed) on the property follow along with any title transfers, or change in ownership.
Mortgage loans consist of two parts, the debt, and the security for the debt. The note is the promise to pay a debt with interest. The mortgagor (borrower) executes a promissory note, or notes in the amount of the debt. The deed of trust is the document that conveys the property (creates the lien) to the mortgagee (lender) as security for the debt. A properly executed mortgage is a negotiable instrument. The payee, or holder, may transfer his or her right to payment to a third party. Because the notes are secured by the property, lenders can control the risk of lending on real estate. This security allows for flexibility in payment plans, length of loan pay backs, interest rates, and other provisions of the note.
This flexibility allows for creativity in financing your properties. The information provided here is not definitive; rather, it is to get you thinking. Before using any method or type of financing, you should be sure you have researched it, and have a full understanding of the benefits, cost, and any disadvantages of using that method or type of financing.
Conventional loans
A conventional loan is a loan where the lender relies on the ability of the borrower to repay the loan, and the security offered by the property. Most lenders will not lend more than 75% to 80% of the value of the real estate financed.
FHA Loans
The Federal Housing Authority (FHA) insures loans on real estate property made by approved lending institutions. Most of the loans fall under section 203(b), which applies to loans on one to four family residences. The FHA sets regulations that govern the conditions that the property must meet, and the rules the lenders must follow to have the loan insured. The fact that the FHA protects the lender against loss allows for smaller down payments, thus more people can afford homes.
As the rules are re-issued from time to time, it is advisable to check with a lender for the latest requirements. The FHA has other programs for multi tenant buildings, such as apartments for the elderly.
VA (GI) loans
The Veterans Administration guarantees loans for eligible veterans. Approved lenders follow the VA guidelines when making the loans. V.A. loans cover from one to four-family residences. Non-veterans can assume VA loans, but the veteran remains liable unless the VA approves a release of liability.
PMI (private mortgage insurance)
Private mortgage insurance is available that allows a borrower to get a mortgage of up to 95% of the appraised value of the property.
Purchase money mortgage
A purchase money mortgage is a note, and deed of trust, or mortgage, given by the borrower as part of the purchase price of a property. It may be a first or second lien note, and in the event of foreclosure the lien has priority over judgments against the borrower, and any homestead exemptions.
Open End Mortgages
An open-end mortgage loan allows the borrower(s) to get future advances of funds against the credit limit set by the lender.
Package Mortgages.
A package mortgage covers the real estate, and any fixtures and appliances on the property.
Wraparound Mortgage
This type of financing allows a borrower to payoff an existing mortgage and get an additional loan amount from a new lender. The new lender assumes payment of the existing loan, and gives the borrower a new increased loan at a higher interest rate. The new loan covers the original loan balance and the new funds. The borrower makes payment to the new lender, and the new lender pays the original loan. Some owner financed deal are done this way. Due on sale clauses in most mortgages have reduced the availability of wraps.
Blanket mortgages
A blanket mortgage covers more than one parcel, or property. These are used to finance subdivision developments or, when the borrower is pledging more than one property to secure the loan.
Sources of Loans
Financing sources have not changed much over the years. What has changed is your access to the lenders via the Internet. Property owners (sellers) may be more inclined to carry the financing on their properties. If a Seller is looking at the funds received from the property sale to produce income for them, your mortgage payments could give the seller a better return on their money than they can get anywhere else, plus tax savings.
TYPES OF LOANS
1. Assumptions
2. Sale Lease Back
3. Contract for Deed
4. VA
5. FHA
6. SBA (small business administration)
7. Owner Carry
8. Rent to Own
9. Conventional loan (bank loan)
Creative Financing
Seller Carried financing allows you the most flexibility. The creativity is a matter of the contract clauses, and terms that you agree to. A lot of owners (sellers) will let you provide the paper work, and that gives you the most control. Let's go over some of the finance contract clauses to give you some ideas of what can be done. As you read about the real estate deals I have presented in this book you can see how some of these suggestions were used in actual practice.
Important Information: With owner (seller) financing, property appraisals are not mandatory (I do them anyway, unless it is an obvious good deal), neither are the other common inspections required such as termite inspection. Without a property appraisal the seller can sell the property for any price the buyers are willing to pay. This last statement can make the more knowledgeable party in a transaction some money.
If you sell a property and the buyer gets a new loan the appraisal sets a limit on the price you can get. If you carry the note you can set the price at anything the buyers will pay, same is true for terms and interest rates.
Payments: The amount of payment can be for any amount you both agree to. You could have a loan that pays out the principle and interest over a 10 year, 15 year, 30 year term, or any number of years. You can do a 20-year amortization with a 5-year balloon payment, or any combination of those. You can do interest only, with no payment towards the principle. Or a small payment in the beginning, increasing at set intervals (may create a negative amortization. You can include or exclude taxes and insurance payments. You can also set the first payment to start on any day, or month you agree to.
Interest Rate: You can set the interest rate at whatever the two parties can agree to. If rates on bank savings accounts are low, you can get the seller to carry the note because they can make more from you than from alternative investments. You might get a lower rate than you could get on a conventional loan.
Closing Cost: Either party can pay the closing cost, or they can be split any way you can agree to. There is less paper work, and the closing cost are lower. The closing is faster.
Title Insurance: I always get title insurance even if I have to pay for it even though it is not required on owner-financed deals.
Down Payment: Any amount that the seller will take - even zero down.
Repairs: Again, any repairs needed can be deducted from the price, with you doing them later. Or you can buy as-is.
Surveys: I always get a survey, not always before closing. If the deal is a really good one, and if I do not care exactly where the property lines are, I might wait rather than delay closing. As a rule, it is best to survey the property even if the seller will not pay for it. It is cheap insurance.
Prepayment: You always want a no pre-payment penalty clause. You want to be able to pay off the mortgage without paying a penalty. I have agreed to prepayment clauses when I was sure I would be holding the property long term.
Due on sale: You DO NOT want a "due on sale" clause if you are the buyer. Without this clause you can sell the property and do a wraparound mortgage. You can trade the property, with the new buyer assuming the old loan. Avoiding "due on sale clauses" gives you maximum flexibility. As a seller you DO want the clause.
Points: None, you can almost always get around paying points on owner carry notes.
Variable interest Rates: Fixed term loans at a low interest rate are best for you and the buyer. If you firmly believe interest rates will drop, a variable rate tied to a national indicator (like the prime rate plus 1%) can work to your advantage.
Late Fees: Never, unless you are the seller, then always.
Tax and Insurance reserves: Most owners will let you the buyer, pay the taxes and insurance yearly. This lets you to avoid tying up your money in an escrow account, interest free.
Rent To Own with right to sub-let
When an owner wants you to put up more down payment than you have, try a rent to own with right to sub-let. Have a part of each payment apply to a set future purchase price. If you find a house that you can rent for more than your rent payments, then this will work. I know people who started their whole real estate investment career with this one.
The owner gets the steady income of your leasing the house, and you get to build up money applied to the down payment. Just be sure the numbers work before agreeing to the deal, and put everything in writing. There is an more indepth article on this technique on this site.
Contract For Deed
My favorite way to sell. With a contract for deed, you, as the seller, finance the buyers purchase with a contract that spells out the terms of the loan. The C.F.D. contractually obligates the seller to deliver the deed or title free of liens and unencumbered, to the buyer after the buyer has met the terms of the contract. Those terms can be anything the two parties agree on, subject to state law. State law governs contract for deeds, so check your states' rules before using a contract for deed.
Lets say you want to sell a property to a buyer and take a low down payment. You decide to use a contract for deed because you can do any of the following with this type of contract.
You can do anything the parties involved agree to, as long as you do not violate the state usury laws (as to the interest rate) and execute a valid contract. The contract for deed is recorded at the county court house, not the deed, The title remains in the sellers name.
Wrap Around Mortgage
This type of loan can be used when there is no "due on sale" clause contained in the underlying mortgage, and the seller wishes to control the underlying mortgage. The buyer makes payments to the new lender, (or seller if owner financed) and the new lender (or seller) makes the payment on the old loan. The total amount of the new wrap around loan includes the existing loans balance, and the additional money owed to the seller.
Example: You have a house for sale with an existing mortgage note at 6% interest, with no "due on sale" clause. You sell the house for more than you owe, with the buyer giving you a wraparound mortgage at 8% interest with a "due on sale" clause. You collect on the new loan and keep making your existing payments. Some of the benefits to you of using a wraparound mortgage in this example are: Your buyer is paying you at a higher interest rate, allowing you to make money on the interest rate spread. You can report your taxes on the sale's profits to the IRS using the installment sale method. Your buyer cannot resell without paying you off, (the due on sale clause), so that you can pay off your loan.
This works well when the buyer wants to make a low down payment and cannot qualify for a regular mortgage. For the buyer, it can solve a finance problem. For the seller, this type of loan can create extra profits because of the interest rate spread.
If you buy a property with a wraparound mortgage have your attorney check the contract. You will want a clause that allows you to make the payments directly to the existing loan holder if the seller fails to keep the payments up to date.
Assumption
If you find a house with a existing mortgage at a low interest rate that is assumable, you should take over that note and get a new loan for the difference. This works best when interest rates are high.
Trade
A Like kind trade delays any income tax due on a sale. Always check with your CPA before doing a trade to protect your tax position.
Example: Lets say you are in a 22% tax bracket, of every dollar you make on a sale, 20% goes to Uncle Sam. You want to sell a property for $100,000 that has an 80% building to land ratio. You have taken all the depreciation on the building, and if you sell, you will owe taxes on the $80,000 at 20% - or $16,000 in taxes. That money will no longer be out there making you money. Solution? You trade the property for a higher priced property to keep the money all working for you.
In a two-way trade you find a property you want and trade with the seller. They take over your property and mortgage, and you take over their property and mortgage, and give them a note for the difference. Trades do not have to be between one buyer and one seller. You could do a three-way trade.
For example: say you find a buyer for your property but you need a trade to keep all your money working. You get the buyer to buy the property you want, and then make the trade with them. This is a very simple explanation, and trades are not simple.
When you are doing trades, work with experienced people such as your CPA and/or attorney. Trades must be handled by a third party. Discuss this with your CPA, and your real estate agent. If you do the trade wrong, or miss the time constraints, the IRS will want the taxes paid. More info at the IRS web site. More info on this site.
Trade For Non-Real Estate Items
You can take anything in trade when selling, or give any thing in trade when buying. Keep in mind, the IRS will consider the receiver as having got BOOT and will consider a trade as a taxable event.
Creativity Examples
There are many creative financing scenarios that can be done with real estate deals. Here are a couple of examples. The main thing is to find out what all the parties need out of the deal, and work a deal that gives everyone what they want. When you deal directly with the sellers you can be creative. When a Real estate sales agent is involved they tend to get in the way as they will always want to protect their sales commission.
Example: You find a property you want and the owner wants to be cashed out. You have very little money for a down payment and can not get the bank to go along. Try to get the buyer to borrow the cash they need with a new loan on the property. They then sell the property to you on an owner carry basis. Your payments to them covers their note payment. You can sell this idea by reminding the sellers that they will postpone part of the taxes they would owe on an out right sale.
Example: You find a property where the owner is tired of being a landlord. The purchase would require a new loan to give the seller his equity, and to pay off the sellers mortgage. You propose a lease/purchase with very little down. You will refinance after you build up enough equity to cover the required down payment. Or, you propose a wraparound mortgage with the seller collecting from you, and they continue to pay the existing mortgage. If they did not wish to deal with making the payments, their bank could do that chore for them each month, and you pay enough to cover the extra bank service fees.
The possibilities are as varied as the properties you have to choose from, and the people you will deal with. Each party involved in a deal has wants and needs. Find out what they are then, find a way to give them what they want in a manner that accomplishes your goals. Every problem that comes along is only an obstacle to be overcome.
Zero Down
Zero down deals can be done. I recommend them only for experienced property investors. After you are confident of your ability to evaluate the investment potential of a property, and know with reasonable certainty what you plan to do in order to carry the debt with out defaulting. By all means use maximum leverage. I only caution that you not risk the success of your overall plan. If you are not comfortable with a deal, don't do it. I use this question as my acid test
"Will I lose sleep over this deal, or worry if I did the right thing?"
My advice about the zero down deal is - think twice.
Ways to do zero down deals are as varied as the people involved and the circumstances. As you read through the actual real estate deals presented in this book, you will see some of the zero down or almost zero down deals that I have done.
IRA: You can use individual retirement account savings to finance your real estate investing. Visit with your CPA on the rules and procedures to do this. You must follow the IRS rules to avoid penalties and taxes. In can be done using a self directed IRA.