When it comes to financing your real estate purchase, you have plenty of options. Many investors pay cash for their investments. This is an attractive option to sellers because the closing process is expedited and the risk of loan denial by a bank is eliminated. In return, cash buyers often receive a lower purchase price. If you don’t have a bundle of cash readily available to purchase real estate, have no fear! There are a multitude of financing options available today. We’ll cover fixed rate and adjustable rate mortgages and explain the different mortgage types, including conventional, FHA, and VA mortgages. Finally, we’ll differentiate between conforming and non-conforming loan types.
The main difference between fixed rate and adjustable rate mortgages is the interest rate. Interest is the price you pay for borrowing money, and the interest rate on your loan can significantly impact your return on investment. This should be intuitive; the more money you pay to the bank, the less money you get to keep as profit. With a fixed rate mortgage, you have the same interest rate for the entire life of the loan. This is beneficial for planning and budgeting because you can be assured that you’re “locked in” to pay the same amount of interest every month. There are no surprises with a fixed rate mortgage. Fixed rate mortgages are typically offered on a 15-year or 30-year basis.
On the flip side, interest rates change periodically with an adjustable rate mortgage, or ARM. For instance, a 5/1 ARM has a stable interest rate for the first five years, after which it adjusts every one year. This can make financial planning for the real estate investor difficult. Let’s take, for example, an investor who pays $300 in mortgage interest each month and earns a healthy $400 monthly profit on a rental property. After five years of a stable interest rate (and stable interest payment of $300 per month), the investor’s adjustable rate mortgage has an interest rate adjustment. Now the mortgage interest payment jumps up to $375 per month, and the monthly profit subsequently drops to $325 per month. It’s common for adjustable rate mortgages to have a very low introductory interest rate which can be attractive to short-term investors. Once the adjustments kick in, however, they are commonly tied to a national mortgage index. Investors may prefer to use an adjustable rate mortgage to take advantage of low interest rate periods and take a chance that they won’t experience high interest rate periods. It’s a gamble, but it depends on the investor’s individual attitude towards risk.
Once you decide between a fixed rate or adjustable rate mortgage, you’ll choose the mortgage type, including conventional, FHA, or VA. The differences between these mortgage types have to do with whether the loan is insured. Conventional mortgages are not insured or guaranteed by the government. The minimum down payment requirement for a conventional mortgage is 5% for a primary residence and 20% for an investment mortgage. VA loans are part of a program offered by the U.S. Department of Veterans Affairs to military service members and their families. One huge benefit of VA loans is that there is no minimum down payment requirement! However, real estate investors cannot use VA loans to purchase investment properties, as the program requires the borrower to use the property as a primary residence.
FHA mortgages are insured by the Federal Housing Administration. The minimum down payment requirement for an FHA loan is 3.5% which makes it an attractive alternative for many personal home buyers. FHA loans have two main disadvantages for the real estate investor to consider. The first is that FHA loans are primarily restricted to buyers who intend to occupy the property they are purchasing. The second is that FHA loans require the borrower to pay for private mortgage insurance, or PMI. The price of the PMI is determined based on the borrower’s credit score, and it adds another monthly cost for the real estate investor to account for. One workaround to the FHA loan residency requirement is for the real estate investor to live in the property for some time and rent it out later. This is ideal for people who are just getting started in real estate investment and still need a place to live for the time being. As you can tell, these are all valuable considerations for the prudent real estate investor.
Another concept related to mortgages is based on the size of the loan in question. As a real estate investor, you will often make purchases of varying size. For example, one year you may purchase a single-family home as a rental property, and the next you may purchase an apartment building with 12 units. These two investments will carry two very different price tags. Depending on the size of the mortgage loan you need, you’ll fall into either the conforming loan or the jumbo or commercial loan category. Conforming loans meet the underwriting guidelines that have been established by the government. Non-conforming loans may also be granted, but they are typically accompanied by adverse factors like prohibitively high interest rates. Jumbo loans exceed the size limits established by the government, and for this reason the lender considers the borrower to be high-risk. To compensate for the higher risk that the lender takes on, it may require higher down payments, higher credit scores, and higher interest rates.
There is no shortage of factors that will impact a real estate investor’s investment – and mortgages are just one area of contemplation. If you’re not able to purchase an investment using all cash, then a mortgage is a necessary evil. Mortgage payments are a huge factor that impacts the overall profitability of a real estate investment, so make sure you choose the mortgage type that suits your investment goals. Be sure to work with a reputable mortgage broker that can help you understand the intricacies of choosing which mortgage is right for you.
Charles Carillo is the founder and managing partner of Harborside Partners. He has invested in over $25 million worth of real estate, in several states, and has extensive knowledge in renovating and repositioning multifamily and commercial real estate. Charles holds a BS from the Connecticut State University.