Wednesday, March 12, 2008

Financing Part 2 - Insitutional Financing

Traditional Mortgage Instruments

Let’s begin by looking at the traditional mortgage marketplace. No investor would turn their back on conventional financing, particularly when the mortgage marketplace is good. The problem is, right now, it’s not, which is why I’ll be spending so much time on upcoming posts about alternative financing. Still, it only makes sense for investors to know as much as possible about traditional mortgages, particularly when it’s so tough to obtain conventional money. The more you know, the better off you’ll be when seeking out conventional money.

Traditional mortgages can be broken down into 2 categories:

Government-backed loans underwritten by either the Federal Housing Administration (the FHA) or by the Veteran’s Administration (the VA) and conventional mortgages that are, in essence underwritten by investors.

What’s important to note about FHA loans is that the organization opened it’s doors up more for second home/vacation home purchases over the last decade, and even developed more programs accessible by investors. It’s somewhat the same with VA – programs available for purchases other than one’s primary home are now available.

Conventional lending over the last ten years went absolutely crazy. Qualifications all but diminished, interest rates fell to a low of around 4%, and money was creatively offered by even the biggest lenders. As short as two years ago, it was common to see investor money for 100 to even as high as 125% of the purchase price being offered. But as quickly as those lenient doors opened, they closed within these last two years. Common terms for investor financing today is 10% down, with several months of reserves – and that’s if you are a good credit risk! I will note, however, that the credit markets are easing a bit and some more creative terms are beginning to pop up. I’ve recently seen multiple lenders offering a product based on 70% of the appraisal value as opposed to 70% of purchase price. Thus, if you can buy low enough (or are dealing with a rehab project) you can get virtually the entire thing financed.

To be effective with conventional lending, it’s important to understand and know how to work with first and second mortgages. Most people think that if they want to finance a property with 100% financing, they need a loan for 100% of the purchase price. In reality, the more likely scenario would be a first mortgage for, say, 80% of the purchase price, and a second mortgage for 20% of the purchase price. This is called a blended loan, and the rationale behind them is that in a case of default, the holder of the first mortgage is in a more secure position since the house is worth more than the loan balance. The holder of the second mortgage is in more jeopardy because their loan represent that top 20% that could get wiped out in a foreclosure auction with a low-ball price. That’s why the second mortgage has a much higher interest rate than the first – because it’s riskier.

It’s also important to note two additional things. First, is that the lower the first mortgage balance is to the property’s value, the more likely you will get qualified. In other words, an your chances of getting financed for a 70% first mortgage are higher than for a 90% first mortgage. If you had the 30% in cash to put down, most banks would be willing to talk with you regardless of a lot of negative financial factors you might have. If you don’t have the cash, that’s where the second loan comes in, and the qualification really takes place more on that loan. The next item is that a blended loan will help you avoid the payment of mortgage insurance, which is generally required on a first mortgage with a balance of higher than 80% of the properties value. That’s really an unnecessary expense to your monthly payment and you should look at ways to avoid it.

At any rate, being able to talk coherently and deal in combinations of loans is your route to securing traditional financing for higher loan amounts. You can think in terms of many combinations – here’s just one example: a 70/25/5, which means a combination of a 70% first loan, a 25% second loan, and 5% down.

It’s important to note that blended loans – at least those where both loans were offered by the same lender have virtually disappeared in this credit crunch, but I have faith they will return in short order.

Another piece of the traditional lending puzzle is that of home equity lines of credit and home equity loans. The difference between the two is fairly simple. Home equity lines of credit are much like credit cards. You are extended an open line of credit. You pull from that line as you need it. As you pay down your balance, the payment amount drops and your available balance goes up accordingly. With a home equity loan, it’s a fixed loan, you are loaned the money, and you have a fixed period of time to pay it back, generally with fixed payments.

Both home equity lines and loans are good options because they are relatively easy to qualify for, and in most cases can be had with little to no lender fees. Whereas a mortgage for $70,000 might cost you $1500 in appraisals, title insurance, underwriting and other “junk” fees, a $70,000 line of credit may cost you a mere $300 in underwriting.

The downside to both is that they require an equity cushion in the property – normally you will have difficulty getting a home equity line or loan for more than 90% of the property’s value if it’s a residence, and it’s common right now to see 80% for an investment property. It’s also important to note that they will be at higher interest rates than standard mortgages. Figure a full 1-3% in interest rates over the cost of a regular mortgage in most cases.

One of the great benefits of a home equity line for an investment purchase, is that when you pay down the loan and open up your available credit, that’s money you can access for another purchase.

And, both lines and loans are good ways to pull your own equity out of a property for purchases or other investment needs. One of the really amazing things about holding property over the long haul is that you don't have to sell a property to get cash from it. With sufficient equity, you can refinance and pull out cash and keep the property too! It's a clear case of having your cake and eating it too. Plus, money borrowed in this way is not taxable. If you sell a property, you pay hefty taxes on the profits. If you refinance, it's tax-free money!

Until next time....

Contact me at william@thecoasttocoastinvestor.com if you have any questions you'd like answered.

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