Prosper Newsletter: October 2007 > Real Estate

You understand that the following information is educational in nature and is not intended to be legal, accounting, or tax advice. You are responsible for your own financial decisions and should consult your own legal, accounting, and tax advisors before making your financial decisions.

Financing 101

Some people are in a position where they can pay cash for an investment property. Even if you are in a position that you can pay cash, it is probably not the best idea.

For example, assume that you have $500,000 cash. Depending on the market where you are, you may be able to purchase anything from a commercial property to a modest home. If you pay cash for the property, you will be able to purchase one property and make whatever income it generates. On the other hand, if you use the $500,000 as down payments on a series of properties, you could conceivably purchase 20 similar properties (if the down payment was 5 percent) and have the income from all of the properties.

Much of the income that you will receive as a real estate investor is not limited to the rent that you collect; in fact, many times you earn more from appreciation of the properties. That is one reason it is usually more beneficial for you to use leverage and control more than one property.

Leverage

The principle behind leverage is that you use a little bit of your money to control a lot of property. Sometimes it is even possible to use other people's money entirely and not tie up any of your own money in the investment. When you don't have any of your money tied up in the investments, it is known as infinite leverage.

When you borrow money to purchase real estate, the only money that typically comes out of your own pocket is the down payment. It is becoming more and more common for residential loans to have down payments under 5%. What this means is that you can control $200,000 worth of real estate for less than $10,000 in many cases.

The reason this is important for you as an investor is that you will receive the appreciation or you can make a percentage profit on the entire property even though you have only paid for a small fraction. The concept of leverage is the reason that real estate investors use financing.

Borrowing Money

Consider some general guidelines that pertain to you as you seek to borrow money. Let's look at some of the individuals and groups that are involved in borrowing money:

Banks—in the past you would hear a lot about savings and loans, but you don't hear that term much anymore. Credit unions are similar to the old savings and loan companies, but we will discuss them here as well.

The general idea of a bank is that the bank will make money available to people once the people agree to pay back over a period of time not only the money that they received, but also interest on that money. The interest typically is substantial. The banks make their money on the interest. Banks are not the only place that you can get a loan, but it is usually the place that most people think of first.

The person at the bank or credit union that is determining whether or not you qualify for a loan is generally known as a loan officer. The loan officer's job is to determine that you will pay the money back to the bank as agreed.

Remember, when applying for a loan, that the loan officer wants to find people to loan money to because that is how the bank makes money. Many times, we feel intimidated by loan officers because they pry into our lives and look at things that many of us would rather that no one else see. That said, there are some loan officers that have lost track of what their purpose is and do become deliberately intimidating.

The loan officer will gather information about you. In the United States there is a system to simplify the loan officer's job. The credit system gives a number score that determines whether or not you are a worthy applicant for a loan. Meaning someone that the bank can count on to pay the loan back as agreed. This system is known as a FICO score. FICO stands for fair Isaac credit organization, named after the inventor of one of the systems. The scores given range from 350 to 850. Average scores range from 650 to 750.

The credit score is unique to the United States. It is a convenience for people because it allows the lender to quickly determine whether or not they can safely give a loan. This being said, it is important for you to remember that it is not a perfect system. People who know what to do to get higher scores often are able to manipulate the system. These people are more able to obtain financing, regardless of whether they are more credit-worthy. Loan officers, especially when looking at residential loans, pay particular attention to credit scores.

Mortgage Brokers—in addition to loan officers working at banks there are also mortgage brokers or mortgage companies. Mortgage brokers are much like insurance salesmen in that they will look at a variety of different lenders and programs to sell you. Mortgage brokers are also called independent agents.

When you approach a mortgage broker for a loan they sometimes look at hundreds of different lenders and programs to see who is making the kind of loan that would work best for you in your situation. The broker is looking for a loan that has requirements that you are best able to meet and is for the kind of project that you are doing. Because they look at such a wide array of different loans, they may be able to come up with a better loan than a bank or a credit union that can only provide loans produced internally.

Some people may ask why, if the mortgage officer is going to a bank to get the loan, you can't just go to that bank. You can, if you know what bank has the program that works best for you. There are many advertisements from companies on the Internet that say that they will have banks "compete" for your business. These companies are basically no more than Internet mortgage brokers.

The difference between these Internet companies and typical mortgage brokers is that the Internet companies will let a lot of different lenders know about you and the loan that you are looking for. Many of these lenders will then contact you. Once you receive the loan information from the lenders, you will have to sort through the different loans available to find the one that works best for you.

Wholesalers—a wholesaler is a lender that may start out lending his or her own money, but usually once the loan is established and you have closed on the property, the wholesaler sells your mortgage to another bank or lending institution. Sometimes wholesalers are small private banks, or a few people that have pooled their money together. Because wholesalers do not hold onto the loans for a long period of time, they can usually begin with a relatively small amount of money.

Some wholesalers have become quite large and have become widespread through the marketplace. Even larger banks will sometimes act as wholesalers. They start out giving you a loan and then six months later you get a notice in the mail stating that someone else is now carrying the note and you should send your payments elsewhere.

When your loan is sold from one organization to another, legally it must be sold with all of the terms you had still intact. In other words, when your note is sold, the new company cannot change the terms. The thing that can be changed is whom you are making payments to. When you receive a notice informing you of a change in where you are making payments, you will know that your note was sold to someone else.

At times individual investors purchase notes as their way of investing in real estate. When an individual investor purchases a note, he gets it at a discount. The idea behind the discount is the time-value of money. Meaning that instead of getting the full amount over the course of years, the lender gets slightly less money right now and can put the money to use making more money.

It is ironic that when individuals purchase a note, it is usually at a discount, but when a bank purchases the note; generally it is at a premium. In other words you may have a mortgage for $150,000 and the note may be sold to a bank at $155,000. The reason that banks pay the premium is that they are convinced that your payments are going to come in at regular intervals. The banks know that if you pay your loan off over the 30 years, the way many mortgages are set up, that they will not get $150,000, but closer to $400,000 from the loan.

Fannie Mae and Freddie Mac are examples of establishments that were created by the federal government and purchase loans from wholesalers. You may ask why the government is involved in purchasing mortgages. The idea was to encourage home ownership in the United States. The Veterans Administration will also carry loans on properties.

Some other government institutions, with a different purpose, are FHA and HUD. These are not all of the institutions, but serve as examples.

FHA does not make loans; FHA guarantees loans. Twenty or thirty years ago, people expected to make 25% down payments. Many people saved their entire lives to save enough money to make a down payment for their own home, and some never were able to save enough. Since the government is interested in you owning a home, as evidenced by tax breaks for owning a home, the government created the FHA to guarantee the loans because many banks feared lending for homes with a small down payment. The FHA is an insurance policy set up by the government designed to lower down payments.

Since it was not fair for the taxpayer to be responsible to pay off the loans when people defaulted, the FHA includes a premium in the monthly payment of any FHA guaranteed loan. This is an odd type of insurance since the person paying the premium is not the person who is protected by the policy.

Usually, if you purchase a home with a small down payment, your monthly payment will include a premium to either FHA or private mortgage insurance (PMI). This secures the loan for the bank.

HUD comes into play when a loan goes into default. HUD is the government agency responsible for selling properties that have been foreclosed on-when the government has had to pay the bank. This is not the only thing that HUD does, but it is one of the main functions.

Loan Servicing Agencies—many times loan servicing agencies are confused with banks. Loan servicing agencies take on the role of collecting payments and keeping books on mortgages-for a fee. The loan servicing agencies are the ones that charge a late fee when you don't make your payment on time. Sometimes the bank sends your note to these organizations and it appears as though your note has been sold.

In addition to the interest and principle payments included in your mortgage payment, many payments include an escrow account in which you pay a little extra each month that is saved up to pay for taxes and insurance. There is no federal law that says that you have to pay your property taxes month by month. Some lenders do require it though. Escrow is an easy way to assure that you have the money set aside to pay for the property taxes.

Factors That Affect Interest Rates

Loan Type—loan types include owner-occupied loans, second-home loans and non-owner-occupied loans. Banks feel safer loaning money on homes where the owner is going to live. Statistically, there is less occurrence of default where the owner is living in the house. People owning investment properties are more likely to default on the investment property and keep the home they are living in.

Because of this, banks typically give a lower interest rate when the property will be owner occupied. There are many things that people manipulate in the lending industry. One way some people manipulate the system is to call the property their second home. Banks usually will only consider the idea of a second home if the properties are more than 20 miles apart.

Many people buy a property as their second home without any intention of living in the property, just to get a better interest rate. While this is not honest, some banks tend to look for plausible excuses to get the loan through.

Non-owner-occupied loans do not typically have the same benefits. FHA guarantees and other programs are limited in non-owner occupancies because they are used to encourage owner occupancy.

Loan To Value—Loan to value looks at the amount of down payment you are making as well as the percentage of the value of the home you are borrowing. The typical cutoff, where you do not have to pay mortgage insurance, is when you pay a 20% down payment.

Another situation where loan to value comes into play is that banks will often set a limit on the loan to value that they will lend you based on your credit score, amount of savings that you have, equity in other properties, and other factors. The better you score in these factors, the more that you will be able to borrow.

Size of Loan—banks would usually rather make a few large loans than a bunch of smaller loans because the bookkeeping is easier and there are fewer loans that they have to spend the time to do the due diligence on. Therefore, the cost to set up the loan is less.

But, if you are getting a residential loan (not a commercial loan) and you spend a lot of money, you might pay a higher interest rate. This is due to the fact that banks feel that they are taking a bigger risk in lending the money. Banks set their own limits, so it may be worthwhile to shop around if you don't feel that you are getting the best deal.

Debt-to-Income Ratio—the debt-to-income ratio is used to determine the interest rate and also whether or not you will even get the loan. The debt-to-ratio is determined by taking total of all the minimum payments that you are required to make on all of the loans that you have-including credit cards, cars, properties, etc., and comparing it to your gross income.

Banks do not want your total payments to total more than 40 to 50 percent of your income. Usually you can spend about 50 percent of your income on debt and still qualify for a loan. An option that many banks have come up with is a no-doc loan. When you apply for a no-doc loan, banks tend to assume the worst and charge a higher interest rate.

Credit Score—credit scores will also determine the interest rate that you will pay.

Events in Your Credit History—two people with identical credit scores may not be offered the same loan or interest rate. One may have had a bankruptcy two or three years ago, and the other may have had a couple of late payments in the last six months. The person with the bankruptcy may have a harder time finding a loan. A foreclosure would make it much harder to get a loan than even a bankruptcy.

Documentation—full documentation means that you give the bank all of the information that the bank usually likes to have. This documentation includes income, work history, debts, credit, etc. There are also limited documentation loans where you only show some of the documentation, but omit other parts. The interest would usually be somewhere between the full documentation and no documentation loans.

There are also stated income loans that are usually used by business owners who are able to deduct most of their expenses before they pay taxes. The bank usually obtains the income information from the tax returns.

Type of Property—banks look at the type of property you are trying to purchase. The two main types are commercial and residential loans. Commercial loans include apartment buildings and buildings with five or more units. The idea of a commercial loan is that you are borrowing to purchase a business. An apartment building is a business in a way. The interest rate and qualifications for a commercial loan are generally different and are usually more stringent.

Fixed or Variable Rate—variable rates often start at a low interest rate; many times the interest goes up over the term of the loan. Many times the interest rate goes much higher than it would have been to get a fixed rate.

There are a number of parameters to be aware of when looking at a variable interest rate. The first parameter you should look at is the amount of time that you will be locked into the initial interest rate. Typically, there will be two numbers associated with the variable rate loan. The first number is the amount of time you are locked into the initial interest rate. The second number is how often the rate will change. For example, if you have a 5-6 loan, you will be locked in for five years and the loan will be adjusted every six months.

Interest—only loans are another type of variable rate loans. When you get an interest-only loan, you do not pay on the principle, you only pay the interest. Sometimes you pay the interest for the first few years, and then you start paying on the principle.

Power Option Loans—this is just one of many names for this type of loan. This loan offers you choices on how much to pay each month. For example, option one may be to make a payment that would pay off the loan in 15 years. Option two may be the amount it would take to pay off the loan in 30 years. The third option might be interest only. The fourth option might be a minimum payment where you don't even pay all the interest.

Can you invest in real estate with no money? The answer is no. Contrary to what you may have heard, when investing in real estate you need money, or at least access to money. There is no such thing as buying real estate without money. Yet, the good news is it doesn't have to be your own money, and this is why real estate is such an attractive business investment. So, as an investor you need to make sure you have access to good sources of capital, regardless if you are a novice or seasoned investor. Having sources of capital will also make working with real estate agents easier. It will give them more incentive and motivation to help you find deals.

That said, start with a mortgage broker (as opposed to your local bank). A mortgage broker is going to be more investor-friendly, and will have access to a much broader range of investment loan products. Yet, don't stop there! You also want to have relationships with hard money lenders. These lenders provide short-term financing, primarily for rehab projects. They work significantly different than traditional lenders in terms of how they value projects, and how they determine lending limits. You will find them much more flexible than traditional lenders. Lastly, you should always be forging relationships with other investors and other private parties that may be interested in investing in your projects, or partnering with you on your deals. Real estate investment clubs are a great place to meet these people.

The last thing you want to do is spend value time and energy looking for deals only to have the deals fall apart because of a lack of capital and funding.

---

Prosper welcomes your feedback. Do you have a suggestion for a topic you would like us to address in the next edition of the monthly newsletter, or an idea for a great elective class webinar? Send us an email at newsletter@prosperlearning.com

HOME | PARTNERS | PRODUCTS | TESTIMONIALS | SUCCESS CENTER | ABOUT US | CONTACT | SITE MAP | PRIVACY POLICY | CAREERS