Understanding Financing

Real estate is expensive and most buyers can’t afford to pay cash for their purchase.

They use financing. It makes good business sense and goes back to the core concept of investing: leverage.

Financing allows the borrower to use other people’s money to make their own money.

Your credit

Good credit is extremely important for investors. Credit history affects not only an investor’s ability to obtain loans, but also the interest rates they will receive on those loans.

Most lenders, as well Freddie Mac and Fannie Mae, use the FICO credit scoring system. Individuals can have scores between 375 and 900. The higher the score, the more credit-worthy a borrower will appear.

Most institutional lenders will not grant loans to those who score below 620. However, there are sub-prime lenders who will make loans to higher risk individuals – for a much higher interest rate.

Methods of financing

There are three primary instruments of financing: mortgages, trust deeds and land contracts.

Mortgage: a two-party instrument in which the borrower (mortgagor) gives a promissory note and a mortgage to the lender (mortgagee). The mortgagee is usually a lending institution, but can also be the seller financing the buyer of a property. The mortgage is then recorded with the county recorder, which serves as notice of the mortgagee’s interest in the mortgagor’s property. Once the mortgage is paid in full, the mortgagee records a satisfaction of the mortgage. This terminates the mortgagee’s interest in the property. If, however, the mortgagor defaults on payments, the mortgagee can foreclose to force payment or regain their interest in the property.

Trust Deed: used in place of a mortgage in order to avoid the long redemption period given to mortgagors who are in default. More than half the states use trust deeds, and California is one of them. A trust deed differs from a mortgage in that it involves three parties: a borrower (trustor) who makes payments on a note to a lender (beneficiary). For greater security, the trustor gives title (the trust deed) to a neutral third party (trustee) to hold. Like mortgages, trust deeds are recorded to demonstrate the beneficiary’s interest in the property. Once the trustor has paid the beneficiary in full, the beneficiary orders the trustee to transfer title back to the trustor. If the trustor defaults, foreclosure is much quicker than with mortgages. After a short period of notice, the trustee has a sale and the trustor loses their interest in the property.

Land Contract: (aka Contract of Sale or Contract for Deed) a two-party instrument where the seller (vendor) retains title and the buyer (vendee) receives possession only. When the vendor is paid in full, the vendee receives the deed. A land contract is normally used when the seller is financing the buyer and the buyer is putting a minimal down payment on the property. These contracts give the seller the best form of security because they retain title, making foreclosure easy. To protect their interest in the property, vendees should obtain title insurance and have the contract recorded.

Priority of loans

The priority of financing instruments is determined by the date and time of recording. For instance, a mortgage recorded after another one on the same property will become a second mortgage (also called a secondary or junior lien). Since creditors can enforce a lien through foreclosure, the interests of secondary lien holders can be wiped out by the primary mortgage holder. To protect their interest in the property, junior lien holders can usually step in to make payments, thus stopping the foreclosure and giving them ownership of the property.

Primary financing
First mortgages and trust deeds are known as primary financing. Sources of primary financing include mortgage companies, banks, insurance companies, and mortgage brokers. Mortgage companies are the largest source of primary financing. Not to be confused, mortgage brokers are not lenders. They act as middlemen bringing together borrowers and lenders. Generally, an investor will spend less money in fees and lower interest rates by going directly to a bank or mortgage company rather than finding a lender through a brokerage.

Secondary financing
Second mortgages and trust deeds fall under the category of secondary financing. The interest rates on these loans are higher because the lender is taking a greater risk. In a purchase money loan, the seller carries the loan; otherwise, a buyer can get loans from institutional and non-institutional sources. Mortgage brokers are very active in the secondary loan market.

Qualifying for a loan (myfico.com)
Each lender has qualifying criteria new loan applicants must meet. Generally, lenders are interested in the borrower’s credit, their collateral for the loan and their capacity to make the payments. These factors determine the borrower’s credit risk. Credit is typically measured by a FICO score, which is based on a consumer’s credit and payment history. Lenders then measure a borrower’s capacity to pay back the loan using two ratios: front-end and back-end.

Due to these qualification factors, it is important to delay large expenditures involving installment payments (car, furniture, etc) prior to applying for a home loan.

Assuming an existing loan
When purchasing a property with an existing loan against it, an investor can either refinance by paying off the old loan and replacing it with a new one, or you can “assume” or take the property “subject to” the existing loan. If there is nothing in the original loan prohibiting assumption (i.e. due-on-sale clause), you can take over the loan payments and assume the liability of non-payment.

On the other hand, taking the property subject to means the buyer recognizes the existing loan and knows he must keep up the payments in order to hold on to the property. However, if the property is foreclosed for non-payment, the buyer is not liable for a deficiency judgment because he never agreed to be personally obligated to pay on the existing loan.

Assuming a loan is considered a good option when the buyer doesn’t qualify for a traditional loan or when the interest rate on the existing loan is more attractive than the current rate.

Due-on-sale clause
This clause gives the lender the right to accelerate payments on a loan if the property is transferred to another owner. This usually works against a buyer trying finance their purchase through assumption of a prior loan.

Loan types

• Amortized loans: pay off interest and principal equally over the term of the loan. Payment amounts remain the same throughout the loan period.
• Unamortized (or partially amortized) loans: have a series of equal payments commencing with a much larger final payment (know as a “balloon”). Unless the buyer refinances, they will be required to make the significantly larger payment or face foreclosure.
• Hard money loan: lender actually supplies cash to the buyer.
• Purchase money/soft money loan: seller finances the buyer.

Loan terms

30-year loan: the long amortization period means a lower loan payment; however, the added interest will mean the buyer ends up paying significantly more in the long run.

15-year loan: higher payments than with a 30-year loan, but less will be paid in the long run because less interest will accrue.

ARM (adjustable rate mortgage): has an interest rate that can be raised or lowered over the term of the loan. Generally, the initial rate is below market and guaranteed for a period of time (1 year, 5 years). At the end of that period, the rate changes to reflect the terms of the agreement. This interest rate is usually tied to the prime rate, Treasury rate, etc. An ARM can be good for buyers who can’t qualify for a fixed rate mortgage, but they must be aware of the possibility of a stiff increase in payments if they don’t refinance before the initially low rate period ends.

Rollover loan (short term fixed rate): generally for 5 or 7 years with payments based on a long-term amortization schedule. After the initial fixed rate term, the loan converts to an adjustable rate. Lenders often make these loans appealing with low rates and reduced costs. If the buyer doesn’t plan to hold onto the property for an extended period of time, then this type of loan is a good option.

Government loans
The Federal Housing Administration (FHA) makes government-insured loans available for primary residence purchases with very low down payments. They have a maximum amount, which varies by location.

The Veterans Administration has a program that guarantees loans made to veterans (VA loans). Qualified applicants can use the loan to purchase a home they will occupy, farm or business. The VA does not require a down payment for loans under $240,000 and is a good option for those who qualify.

Conforming & non-conforming loans
Conventional loans are those made by institutional lenders - not the government. A conventional loan that meets the Fannie May and Freddie Mac purchase standards is easy to resell, therefore, lenders will usually give these loans a lower interest rate than loans considered “non-conforming.” Presently, conforming loans for single-family homes can be made up to $322,700. Loans over this amount are considered “jumbo” or “non-conforming.”

Private mortgage insurance
Lenders are seeking to protect their assets and limit risk; therefore, if a buyer’s loan to value (LTV) ratio is greater than 80%, the borrower will required to private mortgage insurance (PMI). This insurance is considered interest and is not a tax-deductible expense. PMI varies based on the down payment and size of the loan.

Participation loans
Participation loans give the lender an equity position in the property in exchange for granting the loan. This creates a limited partnership between the buyer and lender. Some investors use these loans to finance 100% of a property so they can build equity for themselves without using their own money. A shared appreciation mortgage (SAM) is a type of participation loan.

Evaluating loan alternatives
Consider the following factors when shopping for a loan:

• Interest rate
• Loan period
• Fixed or adjustable rate
• If adjustable, consider the terms
• Amortized or balloon payment
• Possibility of negative amortization
• Prepayment penalty
• Loan costs (points, appraisal fees, other fees)

Refinancing
Savvy investors use property refinancing to get money out of an asset. They use this money to invest in another property offering a higher rate of return – it’s known as “trading on your equity.”

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