How to Fund Real Estate Investments – Part 1

So you’ve found the perfect investment property, now what?! This is where a lot of investors or aspiring investors get stuck. “I want to invest in real estate, but I don’t have any money” or ” I don’t have good credit” or “I don’t know how to deal with all that bank paperwork” are among the popular responses when the question about getting started comes up.

As you may have noticed in the title of this post, I am making this a multi-part post because funding real estate deals can be broken into two categories: traditional vs creative. In this post, I will address the traditional way which is what most of us are used to. Traditional or conventional is when you have money for the down payment and go to a bank to borrow money. In the second post, I will address my favorite way of funding real estate which is via creative financing strategies.

I am going to open up by saying that I HATEEE dealing with traditional lenders. I really do and I know I am not alone. It gives me a lot anxiety, but after a few good rounds of financing, I’ve gotten better at the process and I’ve learned to anticipate the underwriters requests or how to address the requests.

As new real estate investor, you will most likely get either a conventional or FHA loan under your personal name. These are two two loan types that I am focusing on today. If you already own a home, the process is going to be very similar with a few exceptions.

The loan that you choose will likely depend on your investment strategy: a) House Hacking, b) Live-In-Flip or c) Turn-Key Rentals or d) Short-Term rentals. Note that I am purposely excluding Flips because they don’t normally qualify for conventional lending.

FHA Loans

FHA loans is the favorite loan product for investors looking to house-hack. This is because you can finance a property with 1-4 units with only 3.5% down. Basically, you can get a $200,000 fourplex for under $10k. A lot of people don’t know this. Personally, I have not used an FHA loan myself, but I have gotten one for my dad.

So, what is an FHA loan? An FHA mortgage is a mortgage insured by the Federal Housing Administration (FHA). The FHA was stablished in 1930s to make home ownership more affordable and attainable. These loans let you put as little as 3.5% and have lower credit requirements than conventional loans.

To qualify for an FHA loan:

1. You need 580 credit score to qualify for the lower 3.5% down-payment or 500 credit score to qualify for 10% down payment.
2. The property must be your primary and either a single-family home or a multi-family property with no more than 4 units.
3. Your monthly debt payments need to be less than 43% of your gross income (DTI), but can go as high as 57%. How high they can go on DTI will be dependent on overall credit profile. However, this is lender specific and some lenders have lower thresholds.
4. Your income and financial information need to be verifiable (this is where the nightmare happens)

We will discuss No. 4 in detail later on. The documentation requirements for FHA and conventional are pretty similar.

Conventional Loans

Conventional loans are loans that are not backed by the federal government unlike FHA loans previously discussed. Due to the of lack of federal backing, conventional loans have higher standards. The down payment for conventional loans can be as low as 3% for first time buyers, but generally 5%-20% is most common.

To qualify for a conventional loan:

1. Generally will need a 620 credit score, but this may vary from lender to lender.
2. To qualify for the lower down payments, the property must be your single-family primary residence. On average, you can get 5-10% on primary residence and 20-25% on investment properties. Unlike FHA, you will have a hard time finding a lender that will give you a low down-payment in a multi-unit property. They exists, but you will have to do a lot research and will no likely go below 10%-15%.
   • When we were looking to house hack, our lender would allow 10% for two-unit (aka duplex) multi-family and 15% for 3-4 units. Spoiler alert- We didn’t end-up house hacking.
3. Your monthly debt payments need to be less than 43% of your gross income (DTI), but can go as high as 65%. However, this is lender specific and some lenders have lower thresholds (or higher). How high they can go on DTI will be dependent on overall credit profile. Personally, I have had lenders lend to me with 50% DTI.

Let’s Talk DTI. What is it and how is it calculated?

DTI stands for Debt-to-Income ratio. If you have been reading or talked to lenders, you may have heard the term DTI thrown around quite a bit. This is a measure that lenders used to see if you can afford to get into more debt. A lower DTI tells lender that you have income available to pay for your debts, where a higher DTI tells lenders that you have a lot of debt obligations. The higher the riskier for them. Understanding how this is calculated will help you get a better understanding of your lending profile.

DTI= (Sum of Monthly Debt Payments)/Gross Income.

For example, let’s say you make $5,000 gross income per month and you have a car payment of $300, student loan payments of $150, a mortgage payment of $1,000.

DTI = (150 + 300 +1,000)/5,000 = 29%.

Now, there is also something called Front-End DTI. As if this wasn’t already confusing, right? The front-end DTI will take only your housing monthly payments. The difference between front-end and back-end is that the back-end will include all of your debt payments, not just housing.

When it comes to front-end DTI, lenders usually prefer to be between 28-31%.

How do you get your Monthly Payments to calculate DTI?

Ideally, you would have a budget with your monthly payments and have this readily available. However, usually what I do is get the information directly from the credit bureau. Experian.com has a free account option that lets you monitor you credit regularly. What better than getting it straight from the source, right? Using their credit report, I get the monthly payment amount for all of my debt account with balances as shown in the credit bureau report. This is exactly what your lender will do on their end. They will count your monthly credit card payments as well. If you are carrying a small balance or something, better to pay it off.

What is counted as gross income?

If you are salaried, gross income is easy to calculate. They will use your current salary divided by 12 and that’s what they will use to calculate DTI. However, what if you are not salaried?

If you are an hourly full-time employee, the lender will use your current hourly rate to come up with annualized wages using 40 hours per week and 52 weeks. Calculated as follows: Hourly x 2080 hours (40 hours x 52 weeks) divided by 12. For example, if you make $20/hr then ($20 x 2080 hours=41,600) divided by 12 would be $3,466 per month.

If you are an hourly part-time employee, they will use paystubs to come up with an average number of hours worked per week. Then calculate same as above (Number of hours worked x 2,080 hours).

What if you are self-employed or 1099? Get’s a little bit tricky because lenders want to see 2 years of consistent income as a self-employed individual or contractor. This also applies for commissions, etc. Sometimes employer pay commissions on 1099 and that won’t get counted unless you have the two years (it happened to my dad). Of course, lenders can make exceptions given specific programs or based on a great credit profile.

Documents you will need to provide for application:

• Application: Each bank has their own application format, but most information is the same. Basic information such as name, address, rent/mortgage amount, salary, etc. You may also be asked to sign disclosures and other consent forms.
  • Income Verification: If you are taking a loan under your personal name or with you as the guarantor, you will be asked to supply proof of income. This is usually verified with Paystubs and tax returns. If you are self-employed, most lenders will be looking for two years of income reported in Schedule C for the same type of business. With Self-Employment income, they will usually average out the two years. There are some programs out there for self-employed individuals called bank statements loans which are a bit more expensive, but useful for anyone that hasn’t met the two year period as self-employed. Lenders like easy, so paystubs is their preference.
    • Rental income is normally verified with leases, but you may be asked to provide proof of rent payment collections. For rent collections, I would normally provide the business bank statement. Even if you don’t have an LLC, you should still have a separate bank account for your rentals. If you don’t, shame on you. JK 😉
  • Debt Listing: Most lenders will use your credit report to obtain this, but some others may ask you to list all of your debts and all of their monthly payments. It helps if you use something Mint or Personal Capital to track your accounts. You can also use the Experian.com credit report mentioned above.
  • Real Estate Owned: If you own one or more properties, they will ask for the addresses, the rental income (if applicable) and the mortgage information (monthly payment and whether it is escrowed).
    • If you are using a conventional lender (Fannie Mae type product), they will likely ask you to submit your latest mortgage statement (for each property). If you have multiple properties, this is a pain.
    • If you need to use any of the rental income to offset your DTI, they will likely also as for leases. Depending on the lender, they might not count month-to-month leases so keep that in mind.
  • Cash Sourcing: This is an area where we have personally messed up several times. Lenders will ask for two or three months worth of bank statements showing where the down payment funds are coming from and to verify that you did not borrow the funds. You want to make sure that you don’t have large deposits that cannot be explained because underwriters will be asking a lot of questions and requesting support. For example, in one of our recent closings, we sold a car and were using those funds as down payment so underwriters needed to see the bill of sale to confirm the source of the funds. Do not deposit any borrowed funds to the same account that you are using for your down payment.
    • Side Note: After my first cash sourcing nightmare, I ended up opening several personal bank accounts: Income Account, Bill Account and Household Account. The “Income Account” is for just for any personal income like payroll direct deposit or bonuses so there isn’t much activity beside intra bank transfers. The household account is used for all other deposits and transactions including personal loans and business transfers. Ryan and I jokingly call them the clean money and dirty money account :). In all seriousness, loan underwriters will get confused if you have too many zelle transfers or large outgoing transactions. At one point, I had to explain a large refund.
  • Personal Financial Statements: Not usually requested for Fannie Mae/Freddie Mac loans, but if you are working with a community bank and for a loan on an business name, then you’ll likely be asked to complete a Personal Financial Statement (PFS). Each bank has a different format, but overall is the same information requested. This is also known as your Net Worth Statement which includes a list of all Assets (everything you own) minus list of all liabilities (everything you owe). Banks are usually looking for a positive net worth, but doesn’t mean they won’t let you if you have a negative. This is where an app like Mint or Personal Capital come in handy as well.

I hope this helps. Please feel free to reach out to me via Instagram @beyondjustnumbers or leave a comment below.

Bonus

Want to find small community banks? Go the small bank directory —> ICBA.ORG

Don’t know what to ask? Here are some questions I ask lenders when shopping around —> Lender Questions