Recently, I stumbled upon a report by Statistica that surprised me: Did you know that the global real estate market is expected to reach a staggering value of $637.7 trillion by the close of 2024?
Even more surprising, Statistica predicts that this value will only keep escalating at a compound annual rate of 3.41%, rising to an all-time high of $729.4 trillion by the end of 2028.
Take a look:
What does that mean? More and more people are turning to real estate for long-term investment.
However, that doesn’t mean it’s a risk-free landscape. In fact, considering the heavy investment involved, venturing into real estate can be a risky proposition for inexperienced individuals.
That’s why before you plunge into the landscape, it’s crucial to first acquaint yourself with the lowdown of real estate financing. Otherwise, a single misstep could be all you need to seal your eternal financial doom.
But worry not — that’s where this guide comes in. Herein, we’ll provide you with knowledge of what real estate financing involves, available financing options, how to choose the best one for you, and so much more.
Let’s dive right in!
What Is Real Estate Financing?
Real estate financing simply refers to the process used to secure funds for acquiring real estate properties. It usually involves borrowing money from lenders or using one’s own resources to purchase, develop, or renovate properties.
Just before I continue, let me make it clear. There are two types of real estate properties:
- Commercial real estate
- Residential real estate
Commercial real estate properties are those intended for business activities. Think of retail spaces, office spaces, and warehouses.
Residential real estate properties, on the other hand, are intended for residential purposes. Think of single-family homes and condos.
Regardless of the type you want to go for, real estate properties are money-intensive, which is where the essence of real estate financing comes in.
Real estate financing offers aspiring home buyers various methods of acquiring properties they’d otherwise not be able to afford with their own finances.
But that’s not all it does.
It also offers individuals and businesses an avenue to leverage their assets and generate income through rental properties or property sales.
Property tech, which refers to the use of technology in the real estate industry, is also increasingly becoming an important aspect of real estate financing. Technologies such as online mortgage applications, property management software, and real estate investment platforms are revolutionizing the way real estate financing is conducted.
Essential Financing Terms And Jargon
We have the basics knocked out. Let’s now familiarize ourselves with some common terms and jargon you’re likely to encounter in this field and as you journey on with us:
- Lender: This refers to a person, whether an institution or individual, who provides real estate funds to a borrower, usually the buyer of the property.
- Borrower: This is the person or entity receiving the loan from the lender and is responsible for paying it back together with the agreed interest.
- Principal: This refers to the original amount of money borrowed from a lender.
- Interest: This is simply the cost of borrowing money. Think of it as the difference between the money to be paid back and the actual borrowed amount, and is usually expressed as a percentage of the loan amount.
- Down payment: This is the initial payment made by the borrower when purchasing a property. It’s typically expressed as a percentage of the total purchase price.
- Collateral: This is the asset used as security against a loan. Unlike in other fields, when it comes to real estate, collateral is often the property being purchased. This means that in the occurrence that the borrower is unable to pay the loan as per the agreement, the lender can sell the property to recover some of their money.
- Points: These are fees paid to the lender by the homebuyer for processing the loan. One point is equal to 1% of the total loan amount. For example, for a US$100,000 mortgage, a point will be valued at US$1,000.
- Amortization: It’s simply the process of paying off a loan through regular payments over time.
- Equity: The difference between a property’s market value and any outstanding loans or mortgages on it. It represents the amount of ownership an individual or entity has on a property.
Understanding these terms and jargon will help you navigate through the world of real estate financing with ease.
Real Estate Financing Options
Now that we have a basic understanding of what real estate financing is and have familiarized ourselves with some of the commonly used terminologies in this field, it’s time to focus on our nitty-gritty: What real estate financing options do you have?
Well, there are several of them:
- Cash financing
- Self-Directed IRA Accounts
- Mortgage
- Seller Financing
- Peer to Peer Lending
- Private money lenders
- Hard money Lenders
- Crowdfunding
Whether you’re buying property abroad or you’re buying property locally, you’ll need to provide many documents, along with your proof of funds before the real estate agent (or private seller) even considers your options. That’s why having the real estate financing sorted out is key. So, let’s take a deeper examination of each of these financing options:
1. Cash Financing
This real estate financing option is the most straightforward and involves paying for the property in full, upfront. This means no mortgage loans, no monthly payments, and no interest to worry about.
Cash financing has for many years been a reserve for the select few whose pockets are deep enough. That’s because real estate acquisition involves an enormous amount of money that not many people can fork out without getting a cushion from a loan or spreading the amount over a given period of time.
However, in their recent report, Redfin News revealed something interesting: 1 out of 3 home buyers is now opting for an all-cash payment when acquiring a real estate property. This came as a surprise, especially considering the upsurging cost of property ownership.
The reason for this? Well, there are actually two!
One is the steep rates of property ownership. The increasing cost of property ownership means that some of the would-be buyers are being priced out of the market.
Two, mortgage rates are on the rise. Coupled with the increasing cost of property acquisition, this sidelines even more aspiring property buyers. For the remaining prospects, now the affluent individuals, it only makes more sense for them to pay for the property purchase in all-cash to avoid these high interest rates.
Greg McBride, The Chief Finance Analyst at Bankrate, commenting on this trend, puts it aptly:
“With mortgage rates at 7.5 percent or more, financing isn’t nearly as compelling as when rates were 2.5 percent.”
2. Self-Directed IRA Accounts
Next up, we have self-directed IRA accounts (SDIRA). It is a type of retirement account that allows the investor to put their money in various alternative investments, usually prohibited in conventional IRAs.
Unlike the regular IRAs that exclusively allow you to invest in bonds or stocks, with SDIRA, an individual can invest in almost anything that is investible, and this encompasses real estate.
When using this option, you aren’t borrowing money but you’re instead directing your retirement savings towards the purchase of property.
One significant advantage of using SDIRA to acquire real estate property is that the returns on investment are tax-deferred or, in some cases, tax-free. This means you won’t have to pay taxes
on the rental income or any capital gains you make from the property.
That sounds appealing, right?
But before you opt for it, know it comes with a set of strict rules and regulations that you must follow. As such, it’s highly recommended that you consult a certified financial advisor before choosing it.
3. Mortgage Loans
A mortgage is a type of loan that is borrowed from a lender (usually a financial institution) to help finance the purchase of a property. With mortgages, the lender holds the title of the property until the borrower pays the loan back in full.
This method of real estate financing remains one of the most commonly used in the United States and the world at large.
In fact, a report published by Statistica shows that mortgages are the single largest component of household debts, accounting for over a third of the total debt held by households.
Take a look:
The same report showed that it comes second, only after credit card bills, as the most common source of debt among Americans.
However, with the post-pandemic upsurge in mortgage interest rates, the percentage of people opting for this financing option is only declining.
However, it’s worth mentioning that different types of mortgage loans are available based on one’s financial status and goals.
- Conventional Mortgage Loans
- FVA Loans
- VA Loans
- USDA loans
Conventional Mortgage Loans
When the word Mortgage is mentioned, this is the type of loan that comes into the minds of most people. A conventional mortgage loan is a type of loan issued by a bank or any other financial institution to an individual for the purchase of a property.
This type of loan requires the borrower to have a good credit score (minimum of 680), documentation of income, and other requirements not needed when acquiring money from other financing options.
The interest rates and percentage of down payment needed for these loans differ depending on the lender. However, in most cases, the latter is between 15% and 25% of the property value.
FVA Loans
The second type of mortgage loan is the Federal Housing Administration (FVA) loan. This type of loan, unlike the conventional one, is insured by the Federal Housing Administration.
In other words, in the event that the borrower defaults it — that is, fails to pay back the loan — the lender gets compensation from FHA for their loss. But, of course, this cover comes with some price to bear, as the borrowers are expected to pay mortgage insurance premiums (MIPs).
Unlike the conventional type, this FHA mortgage also doesn’t need a very stringent credit score (580 minimum). The down payment requirement is also too low, sometimes as little as 3% of the property value.
This mortgage loan is perfect for aspiring property owners who don’t meet the credit score or down payment requirements (or both) required when in a conventional mortgage.
VA Loans
The third type of mortgage, the Veteran Affairs (VA) loan, offers very convenient terms in terms of interest rates and the down payment needed. In fact, in some cases, you won’t even need to make any down payment when getting this type of mortgage loan.
But here comes the caveat: It’s only meant for active military personnel and veterans who aspire to become homeowners. The loans are usually provided by The US Department of Veterans Affairs and are backed by the federal government, making them very secure.
USDA Loans
For individuals who want to invest in rural properties, getting a loan to finance their property purchase can be a real hassle. But if you don’t want to go through all this turmoil, you can opt for the United States Department of Agriculture (USDA) loans.
A USDA loan, also known as a rural development (RD) loan, is a type of government-backed mortgage specifically tailored for those buying property in rural areas. Similar to VA loans, you don’t need to make any down payment here, and you can even get a modest fixed interest rate if you’re a low-income earner.
But get this: This loan doesn’t finance just any property. To qualify, the targeted property must be classified as “rural” as per their standards and show that your income doesn’t exceed certain levels.
4. Seller Financing
This option is also known as owner financing. It involves an agreement between the buyer and the seller, whereby the former directly pays money in the form of installments to the latter instead of getting a loan from a bank or other financial institution.
In this case, the seller of the property acts as the lender in the place of a bank or another financial institution, essentially eliminating the need to involve an intermediary.
Since no third party is involved, the terms and conditions of the agreement, such as interest rates, payment period, and down payments, are usually negotiated between the two main parties: the buyer and the seller.
Unlike with traditional financing methods where the lender is an impersonal entity, this option allows for a more personalized approach to real estate financing.
Speaking of the benefits of this approach, the Corporate Finance Institute team says, “Both the seller and buyer can save money when it comes to closing costs, including lawyer costs, taxes and stamp duties, interest expenses, etc.”
Think of it much like a lease-purchase agreement whereby the buyer agrees with the original property owner (seller) to make regular payments on the property until the installments sum up to the total value of the property.
5. Peer-to-Peer Lending
Peer-to-peer lending (P2P lending) is a form of real estate financing that involves borrowing money from individuals instead of getting it from a bank or another traditional financial institution. In this case, the borrower makes an online request for loans and investors (lenders) are free to fund parts or all of the loan.
Although it’s a relatively new concept, P2P lending has gained immense popularity in the recent years.
Statistically speaking, the P2P lending market value is expected to cross the $370 billion mark by 2025 and $522.42 billion by 2030, at a CAGR rate of 11.2% over this period, at least as per Industry Arc.
This significant growth is mostly due to the increasing transparency in P2P lending brought about by the incorporation of technological tools such as blockchains and smart contracts.
Another advantage of P2P lending is that the interest rates are usually more competitive compared to traditional financing methods.
6. Private Money Lenders
Private money lenders are simply individuals or companies that loan out their capital to different investors, including those in the real estate, with the aim of making a profit from them through the interest earned from the amount loaned out.
Similar to seller financing and peer-to-peer lending, private money lenders interact with the borrower (or the buyer) directly to agree on the terms of payment, etc. and are not affiliated with the bank or any other financial institution.
The terms of these loans are usually agreed upfront between the loaner and the loanee and the repayment period is usually between 6 to 12 months, although it can also stretch up to 60 months depending on what the parties agree.
One advantage of this financing option is that it is typically faster and less stringent than traditional financing methods. On the flip side, interest rates are usually high, making it ideal only for short-term loans.
7. Hard Money Lenders
Hard money lenders are private companies or individuals that offer loans to borrowers, usually with a repayment period of 6 to 18 months. The loan is called “hard” because it is backed by a physical asset, in this case, real estate.
In most cases, this option is used by real estate investors who want to renovate their homes for resale but don’t have a good credit score to qualify for loans from traditional financing institutions.
One pros of this option is that the procedure involved is significantly shorter than that of traditional financing methods. In some cases, it can be as short as ten days, which is a third or even a fifth of the time it takes banks.
But on the dark side, the interest rates involved are usually very high. Our quick research shows that this interest can range between 10% and 18% of the loaned amount, which really is a big chunk of money.
8. Crowdfunding
Crowdfunding is a relatively new approach in real estate. It involves raising money from a pool of people (crowd) instead of from a single institution.
This financing method is quickly gaining popularity. Vantage Market Research predicts a CAGR of 45.9% between (2023 and 2030), and this might dramatically boost its valuation from a meager $11.5 billion reported in 2022 to an impressive $161.8 billion by 2030.
The idea behind crowdfunding is that most investors may be willing to invest a small amount, so it opens this platform to them, allowing real estate buyers to benefit from investors they’d otherwise not have.
One of the main advantages of using this financing method is that it lets individuals who are inexperienced in real estate investment put their money into different types of properties while minimizing risk. Plus, the minimum can be as low as US$1,000, accommodating even small-scale investors.
9. Home Equity Loan
Homeowners who have built up equity in their personal residence can consider taking out a home equity loan to finance their real estate purchase or other expenses, such as repair or renovation. This includes financing energy-efficient upgrades, such as solar energy for homeowners, which can reduce long-term utility costs and increase property value.
Formally known as a Home Equity Line of Credit (HELOC) loan, this home loan allows you to use your home equity as collateral for acquiring the loan. Unlike most other loans, borrowers of these loans enjoy low interest rates depending on the prime rate, and they can even be tax deductible, especially if they meet IRS guidelines.
To determine the amount of money you qualify to borrow, several factors come into play, for instance, the Loan-To-Value (LTV) ratio. In most cases, you can only receive 80 to 90% of the home’s appraised value. Other factors include your credit score, payment history, and many others.
The repayment period runs to between 5 to 15 years, and the loan is ideal for those who want to finance renovations before putting the house up on the market. However, one drawback you have to keep in mind is that in case real estate value reduces, then you end up incurring loss.
Which Real Estate Investment Financing Option Should You Choose?
With all these financing options, it’s easy to find yourself facing the conundrum of settling on one. So, which of these financing options is best for you?
Well, just so you know, we don’t have a specific correct answer to that question. When it comes to choosing a financing option, each of the options discussed can come in as the most appropriate depending on the overall context of the situation.
To make the best choice, asses these six essential factors:
- Your credit score
- The property value
- Long-term financial goals
- Property Location
- Interest rates
- Down payment requirement
As long as you pay due diligence to each of these factors when making a financing decision, you should single out an option or even several of them that are most suitable.
And, of course, if you find the decision too complex for you, you don’t have to go through the process alone. Get the service of a financial expert instead. They will help you understand how different financing methods work and even recommend the ideal one based on your situation.
Conclusion
In conclusion, despite the fact that properties are becoming more expensive, you don’t have to abandon your dream to purchase a home or become a real estate investor.
We’ve got several financing options that you can use to make your dream come true. From mortgages and cash financing to home equity loans and crowdfunding, there are just way too many ways you can use to obtain finances to actualize your dream.
But of course, each real estate financing strategy is different. Even so, as long as you factor in the elements highlighted in this article, you should find it easy to pick the method that works best for your case. And remember, you can always leverage professional help to make the best decision. The good thing about using a licensed professional is that they always stay up to date with what’s happening in the dynamic landscape so that they can advise accordingly.
So, whether you want to invest in real estate or just buy a residential property, go ahead and make your dream of owning one a reality! Keep exploring financing options until you find the one that’s perfect for you.