Investing in Real Estate Profitably:  Financing Options for Purchase of Rental Houses, Part 1.

by Jeanette Joy Fisher and Robert S. Kramarz

This is not an article about tricks for 100% (no money down) financing.  Even if you do take advantage of various no money down strategies from time to time, these strategies are not generally applicable when you begin investing systematically in multiple rental homes with the goal of making significant rental income.

This is because some of these strategies require a degree of deceit and careful timing, others require difficult-to-find pricing or seller situations, and others require sophisticated legal instruments and training, or a combination of all of the above. These complex strategies are good for selling mentoring programs, books and training courses.

However, none of these methods are practical, in our opinion, as a consistent practice for profitable and stress-free ethical investing. For a consistent winning program of investing, you want to be able to act quickly, repeatedly, openly and consistently, which will enable you to build up a portfolio of rental properties in a relatively short period of time.

It is therefore much more profitable and sensible in our opinion to play it safe and keep it simple. This means to focus on obtaining good investments from the point of view of future rental income and appreciation, and pay whatever down payment the banks require.

Simple as that.  If you do this, you will be able to build up a portfolio of properties quickly.

You can still get very good loan deals by shopping around for financing, or by using an independent loan broker. Make sure your loan broker shops around on your behalf.  Standard bank financing at good interest rates generally needs only a 5% to 10% down payment for investment property, which is not very much in the big picture.

Unless you are going to flip a property quickly, you probably want to maintain positive cash flow for most of the time you own a rental property. This is true even if you eventually plan to sell the property at a profit. After all, you never know how long you may have to hold the property before its value appreciates significantly, particularly if you have to survive the inevitable down turn in property values which can last a year or more. The only way to ensure you can comfortably hold the property as long as you need is to have positive cash flow each month.

To this end, consider the advantages of paying a full 20% to 25% down payment.  This will allow you to qualify for the lowest interest rate programs. Lower interest rates mean lower monthly payments, which mean positive cash flow. In fact, with a 20% to 25% down, you may qualify for so-called "payment option loans" with minimum payment rates as low as 1%. With these loans, the minimum payment stays low for the first 5 years, with a payment increase cap each year of just 1.075 times the previous year’s monthly payment. At these levels, you will almost assuredly achieve a very good positive cash flow.

With such minimum payment loans, you still have to pay the current adjustable rate (usually around 4.5% today). However, most of the interest is deferred. At the end of 5 years, the deferred interest is added onto the loan balance. This will probably be much less than the property has appreciated. Therefore, it is a small price to pay for the positive cash flow gained during the first 5 years.

Another option readily available today is "interest only" payments. The "payment option loans" described above usually include an interest-only option. That is, each month you have the option of paying either the minimum payment described above or an interest-only payment. Other loans do not have the minimum payment option and have only an interest-only payment option. In any case, when you make an interest-only payment, you are paying only the interest for the month, and not paying down the principle. This reduces your monthly payment allowing positive cash flow in most cases, but of course you do not build up any equity in the property.

As a general rule in most states, most loans are available with interest-only options nowadays. Sometimes you have to pay a small fee at closing for this option (typically .125% to .250%) and sometimes there is no charge.  If there is no charge, you may find that the interest rate is a little higher. You just have to shop and compare loans to get the best deal, as stated earlier, or make sure your independent loan broker is shopping for you.

Here is a comparison of three monthly payments plans

1) A typical minimum payment (in a payment option loan)

2) An interest-only payment (in a payment option loan or any interest-only loan)

3) A fully-amortized payment (in which you are paying down the principle a little each month.)

For a $200,000 loan, a 1% minimum payment is $643 per month.  By comparison, a typical 4.5% interest-only adjustable rate loan produces a monthly payment of $750.  Lastly, a fully amortized 4.5% payment is $1013.

You can see that the minimum payment and the interest-only options are low and fairly close but the fully amortized loan can make a significant dent in your cash flow.

Beware that the minimum payment in a payment option loan and the interest-only option in any loan program lasts (generally) for only 5 years. However, there are interest-only loans where the interest only option lasts 10 years. The latter is preferable if your intention is to hold the property for more than 5 years without refinancing.

Beware also that, in order to get the low interest-only rate I have used in the example above (about 4.5%), you would need to accept an adjustable rate mortgage (ARM) program where the rates adjust annually or even more often.  If interest rates jump significantly in the next two years, you could get stuck with a relatively high payment.

We are recommending for most borrowers who plan to hold properties for more than a year or two to either:

1) Obtain a "payment option loan" as described earlier with minimum payments that last a full 5 years, or

2) Obtain an adjustable rate mortgage (ARM) loan with an initial fixed interest period of 5 years. This will cost 1% to 2% more in rate, but the insurance is absolutely worth it, in our opinion, at this time in the real estate cycle.

This article has reviewed some modern strategies for minimizing your loan payments when purchasing investment rental homes. There is much more to say on this topic. So keep an eye out for additional articles by the same authors on this and related topics.