Different ways to finance your investment

Real estate is likely the oldest form of investing, but it wasn't until later in the 20th century that financing a home became a necessity for most Americans. This is especially true for those looking to engage in the real estate market, not just for their first home, but to expand and diversify their portfolios or generate passive income. Whether you're a seasoned investor or just starting out, understanding your financing choices is essential, as you'll need to ensure that your earnings are outpacing the interest you'll have to pay.

Below, we guide you through your choices in financing your real estate purchases. Doing this right—and many don't—can make the difference between a profitable venture and a boondoggle of ever-deepening losses. Let's get you started on doing this right.

• Conventional bank loans for investment properties typically require a higher down payment (30% or more) and also require minimum credit scores, income, and assets.
• Buying properties and renovating them to resell for a profit is called flipping in real estate jargon.
• Hard money loans are short-term, high-interest loans based on the property's after-repair value, often used for flipping properties.
• Private money loans come from individuals, such as friends or family, and require careful consideration of terms and the potential for default.
• Home equity loans allow you to borrow against your home's equity to finance investment properties.

Investing in real estate has long been a popular strategy for building wealth and generating passive income. An investment property is a real estate asset purchased with the intention of earning a return through rental income, capital appreciation, or both. This can include residential properties like single-family homes, multiunit buildings, and condominiums, as well as commercial properties such as office buildings, retail spaces, and warehouses.

Investing in real estate offers many advantages that make it worthwhile for investors looking to build wealth and generate income. One of the primary reasons is the potential for appreciation, as property values typically increase over time, providing significant capital gains upon sale. Below are the changes in median home values in the U.S. since the mid-1960s, with the compound annual growth rate going back a decade, 25 years, and the last 60 years:

Real estate also allows for using leverage, enabling investors to amplify their potential returns by borrowing funds to buy properties. It also diversifies a portfolio while reducing risk because it doesn't correlate directly with price changes in other assets. You also have more direct control over your real estate assets, allowing you to be more strategic about attaining profitability. In addition, real estate serves as a tangible asset and a hedge against inflation, preserving purchasing power as property values and rental incomes rise.

1. For those looking to benefit from real estate investing, there are many strategies to consider. Some popular approaches include rental properties, house flipping, and crowdfunding platforms. Since your financing is going to be determined in part by the strategy and rationale for investing in real estate. vestment portfolio, reducing risk.

Investment property financing is more complex and diverse than ever before. While conventional mortgages remain popular for doing so, you have access to a wide range of alternative financing options, from hard money loans and private money lenders to crowdfunding platforms and syndicates. Let's take you through the main options for financing your property investments.

You’re likely familiar with conventional financing if you have a primary residence. A standard mortgage conforms to guidelines set by Fannie Mae or Freddie Mac. Unlike Federal Home Administration, U.S. Department of Veterans Affairs, or U.S. Department of Agriculture loans, it’s not backed by the federal government.23

With conventional financing, the typical expectation for a down payment is 20% of the home's price, though many lenders will accept less depending on your credit and income. However, lenders often require 30% of the sale price as a down payment with an investment property.

With a conventional loan, your credit score and credit history will determine both your ability to get approved and the interest rate. Lenders also review your income and assets. You'll need to show you can afford any debts (including a home mortgage) and the monthly loan payments on an investment property.

Future rental income isn’t factored into debt-to-income calculations, and most lenders expect you to have at least six months of cash set aside to cover your loan without income from the property. Here are the major types of more conventional bank loans:

• Adjustable-rate mortgages: These loans start with a lower fixed rate of interest for an initial period and adjust periodically based on market conditions, which can result in fluctuating monthly payments.
• Fixed-rate mortgages: These have a set interest rate and monthly payment throughout the life of the loan, providing stability and predictability for long-term financial planning.
  
• Jumbo Loans: These loans exceed the loan limits set by the Federal Housing Finance Agency and are typically used for buying high-value properties. They have stricter credit requirements and higher interest rates. 

One of the primary advantages of conventional loans is their lower interest rates compared with alternative financing options like hard money loans. This makes them more affordable over the long term. In addition, conventional loans offer longer repayment periods, typically ranging from 15 to 30 years. This could result in lower monthly payments and a more manageable cash flow.

These loans often come with strict qualification requirements, including higher credit scores, lower debt-to-income ratios, and considerable documentation. This can make it hard for some to qualify. Another challenge is the requirement for larger down payments, often 30% or more, which can be a barrier for investors without deep cash reserves.4

The approval and underwriting process for conventional loans can be lengthy, potentially delaying the purchase of a property.

A U.S. Federal Reserve review of recent data on homeownership and wealth found an inverse relationship between net worth and the percentage of portfolios given over to real estate. As of the fourth quarter of 2023, the bottom 50% of households held just over 50% of their assets in real estate, while the top 1% and 0.1%, respectively, dedicated 13.1% and 9% of their portfolios to property.

A hard money loan is typically short-term. It's most suited to flipping an investment property rather than buying and holding, renting, or developing it.

You can use a hard money loan to buy a property and then immediately pay it off with a conventional loan, private money loan, or home equity loan. However, starting with other options is more convenient and cost-effective if you aren't flipping the property involved.

The home’s estimated after-repair value is used to gauge whether you can afford to repay the loan. It’s also possible to get loan funding in a matter of days, rather than waiting weeks or months for a conventional mortgage closing.

The upside of using a hard money loan to finance a house flip is that it may be easier to qualify than a conventional loan. While lenders still consider things like credit and income, the primary focus is on the property’s profitability. This makes them accessible to those who might not qualify for traditional financing because of poor credit or other financial issues. These loans are usually supplied by private lenders. They can be secured much faster than conventional loans, making them better for time-sensitive investments such as property flips or short-term projects.

The biggest drawback of using a fix-and-flip hard money loan is that it won’t come cheap. Interest rates can be as high as 18% or more, depending on the lender, and your time frame for repayment can be short—often less than a year. Origination fees and closing costs may also be higher than conventional financing, chipping away at returns.

Private money loans are those from one individual to another. Friends and family of the investor are the source of most private money loans. If you don't have friends or family in a position to loan you money for an investment property, another place to look is local real estate investment networking events.

Actual loan terms and interest rates on private money loans can vary significantly, from extremely favorable to predatory, depending on the relationship between you and the lender. These loans are typically secured by some sort of legal contract that allows the lender to foreclose on the property if you default on payments. If you are new to real estate investing, consider carefully how your relationship with the person lending you private money may sour if you default before you get started.

The approval process for private money loans is often quicker and less stringent, making it easier to secure financing, even if you have less-than-perfect credit.

A significant drawback is that these loans often have higher interest rates and fees than traditional bank loans, reflecting the increased risk private lenders take. In addition, because the loans are not regulated by traditional financial institutions, there may be less oversight and protection for you. Finally, if you're borrowing from friends or family, the deal and its personal repercussions could be significant, which even the best investment prospects might not be worth.

The fourth way to secure an investment property is by drawing on your home equity. You can do this through a home equity loan, home equity line of credit (HELOC), or cash-out refinance. In most cases, it’s possible to borrow up to 80% of the home’s equity value to put toward the purchase, rehabilitation, and repair of an investment property.

A cash-out refinance would come with a fixed rate but would extend the life of your existing mortgage. A longer loan term could mean paying more interest for your primary residence. That would have to be weighed against the anticipated returns of the investment property.

One of the primary benefits is the ability to access significant funds by borrowing against the equity of your primary residence. This can give you the necessary capital for down payments or even the full purchase of investment properties. In addition, interest rates on home equity loans and HELOCs are often lower than those on other types, given they are backed by your home.

One major drawback is that these loans put your primary home at risk; failure to repay the loan could result in foreclosure. In addition, the amount of equity available to borrow against may limit the funds accessible through these loans. Another potential problem is that interest rates on HELOCs can be variable, leading to fluctuating monthly payments that can complicate financial planning.

Commercial loans are a major source of financing for those wanting to buy multiunit residential properties, commercial properties, or mixed-use developments. These loans differ significantly from residential mortgages and have specific rules, benefits, and challenges.

Commercial loans are used to finance properties intended for business purposes, such as office buildings, retail spaces, warehouses, apartment complexes, and mixed-use properties. They are not intended for single-family homes or owner-occupied residences. Unlike residential mortgages, commercial loans often have shorter terms, typically ranging from five to 20 years, with amortization periods that can extend beyond the loan term. This loan may also have a balloon payment (a lump sum) due at the end of the term.

Commercial loans are well-suited for financing large-scale real estate projects like multiunit apartment buildings or mixed-use developments. These loans often have higher borrowing limits, allowing investors to buy more expensive properties. In addition, commercial loans may offer longer repayment terms, which can result in lower monthly payments and improved cash flow. Interest rates on commercial loans can also be competitive, especially if you have strong credit and a solid business plan.

One of the main disadvantages of commercial loans is their more rigorous qualifications. To qualify, you typically need extensive documentation, including detailed financial statements and business plans. In addition, commercial loans often require larger down payments, which can be a significant financial commitment.

The approval process can also be long, potentially boxing you out of some property deals. Lastly, commercial loans may have higher interest rates and fees than residential ones, reflecting the increased risk associated with commercial real estate investments.

An investment property is any real estate that you buy to make a profit, rather than to use it as a residence for you or your family.

Each lender and type of financing will have varying requirements. Private lenders may simply require a relationship with the borrower. Hard money lenders may only require a hot real estate market and a good estimated after-repair value. Home equity loans, HELOCs, and conventional loan lenders will have the strictest requirements on income and credit scores.

Home equity loans and HELOCs are similar products but have important differences. A home equity loan is a good choice if you intend to buy a single property and need an exact dollar amount for purchase, repairs, and rehab.

Alternatively, suppose you plan on quickly buying and selling multiple properties. In that case, a HELOC is more convenient because you'll have revolving access to cash as you draw from and pay down your credit line with each purchase and sale, rather than taking out and paying off multiple home equity loans.

Investing in a rental property or tackling a house-flipping project is risky, but it has the potential for a big payoff. Finding the money to take advantage of real estate prospects doesn’t have to be an obstacle that stops your venture if you know where to look. As you compare different borrowing options, keep in mind the short- and long-term costs and how each can affect an investment’s bottom line.

While real estate investing can be challenging with market fluctuations and property management responsibilities, if you stay informed, adaptable, and strategic in your approach, you can be well-positioned to capitalize on the prospects that come along.9 As with any investment, it's crucial to do thorough research, seek professional advice, and maintain a long-term perspective so you're never taking on more than your risk tolerance and investment goals dictate.