Last updated on June 4, 2014
As a real estate investor, your exit strategy will play a major role in deciding the kind of financing option you may need or want for your real estate investment. There are many options that are involved in getting the financing required which is the most suitable to your needs. The main factor, however, will be your anticipated time from loan initiation to loan payoff. One also needs to think of questions like whether one wants to use the profits to buy a new property or invest it somewhere else, how much money is one hoping to make, when will the money be required?
Short-term financing is a temporary source of money that you may use, assuming you’ll refinance or resell the property quickly. Short-term financing generally has a higher rate of interest and a balloon or payoff deadline within six to 12 months. Generally, you access short-term financing through smaller commercial banks or private hard-money lenders (called equity lenders) who make their money on up-front points and fees. Short-term financing is useful even when long-term financing may be a better deal for two reasons: availability and speed.
Availability of financing is often more important than cost. Although short-term loans are often costly, even a high-interest loan can make sense when you plan to keep the property for a short time before selling or refinancing it. This does involve some risk, though – if something unexpected happens and you can’t sell or refinance the property quickly, you’ll be forced to endure that high interest rate.
You can quickly obtain funds with short-term financing. Generally, long-term financing takes more time and requires more documentation from a property investment seminar, which potentially means a lost opportunity for a good deal. With short-term financing, equity lenders are more concerned with the collateral they are lending against than the credit or income of the borrower so funding can be completed in a matter of days. Availability of quick financing can be important to your real estate investing business because decisions are made by a smaller, more flexible lender who will finance deals that the big players won’t.
While equity lenders won’t go as high on loan-to-value as the credit based lenders, they base their loan-to-value calculation on whichever is highest: the purchase price or appraisal. Remember, credit lenders generally base their loans as a percentage of whichever is less: the purchase price or the appraisal price. This means that even if you purchase a property at 50 percent of value, you can’t do this type of loan with no money down.
Long-term financing will give you more options if you’re not pressed for time to close, when loan-to-value isn’t an issue or you plan to keep the property as a rental. Many options for long-term financing are available if you have good credit. These include fixed-rate, adjustable-rate, and interest-only payment loans, and the option adjustable rate mortgage (ARM).
In a rising interest rate market, fixed-rate loans may be the way to go if you plan to keep a property for a long time. However, a 30-year fixed-rate loan is generally the most expensive type of long-term loan in terms of fees and interest rates. Adjustable-rate and interest-only payment loans can be a cheaper option, depending on your back-end strategy. Generally speaking, a loan that adjusts based on the market rate of interest charged is less risky for lenders because it hedges their bets against rising interest rates. Accordingly, they’ll offer you a cheaper starting rate than if the rate were fixed over 30 years.
Of course, the same risk works against you if interest rates rise in the future. Many adjustable rate loans are fixed for a certain time period (e.g., three years) and/or can only adjust a certain percentage per year. You don’t want any big surprises. If you plan to sell the property on a lease/option within a few years, then an adjustable rate mortgage may be the way to go.
One of the most misunderstood loans is the called the option ARM. With an ARM, the interest rate is based on an index like the London Interbank Offered Rate (LIBOR). The loan has four payment options, each of which can change monthly based on the interest rate the loan is indexed to.
These options are: (1) interest only, (2) amortized for 15 years, (3) amortized for 30 years, and (4) minimum payment.
Depending on the market interest rate, the minimum payment may create a negative amortization, which means the loan balance may increase with time. Carefully used, an option ARM can be an excellent way to hedge your bets with rental properties because this provides a low-payment option if you have unexpected repairs or vacancies. The ARM is particularly effective in a rising price market because it gives you some breathing room if your loan balance is increasing.
Carefully check when you get a loan to see if there’s a prepayment penalty. Often, loan reps quote you a better rate than their competitors; you find out why when you go to sell the property and discover that there’s a prepayment penalty. A prepayment penalty is a fee you must pay to the lender for paying off the loan early. In most cases, the penalty only applies in the first few years of the loan. A prepayment penalty is typically three to six months of interest payments based on the original amount of the loan.
Prepayment penalties are not always a bad thing. If you have no intention of selling or refinancing the loan within the first few years, then having a prepayment penalty won’t be a problem. In fact, it may allow you to pay less in loan fees or have a lower interest rate. If you’re uncertain of your exit strategy and want the most options, you may have to pay a fee up front to get rid of the prepayment penalty.
Remember, the lending business changes often, and this can affect your exit strategy if you had planned to refinance the property a few years down the road. You need to work with a knowledgeable mortgage professional before you go into a deal.