How you finance your next real estate transaction will depend on how much cash you have available, your credit capability, and your long-term goals.
If you have cash for the necessary downpayment and closing costs, then you can use traditional financing methods (mortgages). If not, then you have to be more creative.
Your credit capability is based on your credit score and your financing ratios.
Your credit score is determined by independent credit bureaus and is calculated by looking at how much credit you have, how long you have had the credit, and how good you are at making your payments on a regular basis.
A minimum allowable credit score varies but is usually around 600. An excellent credit score is 800 and up. The better the credit score, the more financing options are available. A lender is more willing to entertain creative options when financing a property for someone with an excellent credit score.
Your financing ratios are calculated by comparing how much debt (mortgages, taxes, credit cards, etc.) you are carrying divided by how much income (employment, rent, interest, etc.) you receive.
There are two main ratios. The gross debt service (GDS) is used to calculate the debt-income ratio for just your housing costs (mortgage interest). The total debt service (TDS) is used to calculate the debt-income ratio for all debt including any personal loans and credit cards. Another term used is debt-to-income (DTI) ratio.
The standard maximum allowable GDS is 32 percent, and the standard maximum allowable TDS is 40 percent, but many lenders will allow a maximum that is slightly higher.
Conventional Financing
Conventional financing usually requires a significant downpayment from the investor. Most financial institutions will provide financing of up to 80 percent of the purchase price of an investment property. This means the purchaser must provide the other 20 percent.
Also note that additional cash is required to cover closing costs, which include items such as legal fees, title fees, and land transfer tax. Depending on the jurisdiction, you can estimate an additional 1 percent to 2 percent of the purchase price for closing costs.
Seller Financing, Vendor Take-Back
There are several different kinds of seller financing, but one of the most popular forms is vendor take-back (VTB). A VTB is where the current owner (vendor) agrees to “loan” the purchaser a portion of the purchase price.
It’s called a “vendor take-back” because the vendor is taking back a portion of his or her payment in the form of a loan to the purchaser. This loan is usually secured by a mortgage registered on the title of the property being sold.
Some lending institutions, serving as the primary source of funding, have limitations on how much of the purchase price is financed through other sources. Some require a minimum of 10 percent of the purchase price to be directly from the investor’s cash.
For example, let’s say an investor is looking at purchasing a property for $300,000, and the vendor has agreed to hold back a loan of $30,000, the investor must still contribute $30,000 to complete the purchase if his or her primary source of funding is such a lending institution.
Joint Venture
Another common way for investors to purchase an investment property is by entering into a joint-venture agreement with another partner.
The joint venture could be set up so that the partner provides the downpayment and the closing costs while the investor handles all other aspects such as finding the property, finding the tenants, and undertaking all of the property management.
This is a very popular arrangement in real estate investment circles, especially for busy professionals who have the capital to invest but not the time to deal with the operational aspects of real estate investing. The joint-venture agreement outlines what each partner would be contributing to the overall venture.
So there you have a few ways of financing your real estate investment. But like most things in real estate investing, many possible variations can occur in these scenarios, such as different seller-financing options, different ways of borrowing the downpayment, and various other forms of financing.
Jim Pellerin has been investing in real estate for over 25 years. He is the author of “7 Steps to Real Estate Riches.” Check out his blog at www.jimpellerin.com.
