Summary: There are a variety of financing options available to real estate investors. In this post, we cover the two most common ways to finance your next purchase and highlight the key differences between residential vs commercial loans. In a future post, we will cover alternative or more unconventional sources of funding.
So you’ve decided to become a real estate investor. You have some money in the bank, but not enough to purchase the property you want outright.
Besides, you understand the power of leverage. You know part of the advantage of real estate over the stock market is the ability to make money on someone else’s money (usually the bank’s). Plus you also understand that your cash-on-cash return will be much larger if you buy using a loan rather than paying the full price out of pocket.
So you want to borrow some money to buy. But where do you begin?
In this post we cover the the two most basic financing options for your real estate investment properties: residential and commercial loans.
Since this could be considered a dry topic by some (though not by us!), we’ll make it more interesting by ending with with a head-to-head comparison of the two financing options. Let’s get into residential vs commercial loans!
Residential loans for investment properties
A residential loan is a basic loan, similar to the one you get on your primary residence. The main differences are that you have to put more money (usually 25% for a loan on an investment property vs. as low as 3% for a FHA loan on a primary residence) and your interest rate will be higher.
Like a loan for a primary residence, you can get a residential loan for up to 30 years.
There are options for shorter term loans (e.g., 15 year loans). We always advise getting a 30-year loan so you keep your options open and maintain flexibility. You can always pay off a 30 year mortgage in 15 years or less—the choice is yours. In contrast, with a 15 year mortgage, you have no choice but to pay it off in 15 years. We consider it a form of “forced savings.”
You can even do something a little more fancy called mortgage recasting along the way. The key is that you have the flexibility to also pay it down over 30 years if something unexpected gets in your way—whether it be a downturn with increased vacancy or even a personal situation, like losing your job. You want to have the maximum cashflow per month possible so you aren’t ever in a situation where you’re paying out of pocket to keep the property afloat.
More on Residential loans
As it is when you are purchasing your primary residence, whether you qualify for a personal loan is based on you and your finances. The bank will want all the same documents when you apply. Get ready to give them pay stubs, a letter from your employer, last year’s tax returns and other financial documents. The process is much more arduous compared to what it was prior to 2008. Back then, loans were given out to people with no income verification (the infamous “ninja loans”).
The one tip to make this whole process easier, though, is to choose an investor-focused lender. A lender who is familiar with giving loans for rental properties will be your partner in finding ways to get your loan approved. They also may offer assurances about the odds of your loan getting called if you transfer it to a LLC. Finally, they should also be pulling as much information as they can access themselves (without you needing to go through the work to provide it) and collecting all that paperwork so the next time you go to get another loan with them, they will need far fewer documents from you.
The commercial loan
You can use commercial loans for any type of rental property. You could even use a commercial loan for a single family home if you wanted.
However, most investors use residential loans for smaller properties. This is a classic residential vs commercial loans issue.
The main reason is that commercial loans are more expensive. They usually come with higher interest rates and a shorter loan term (e.g., amortized over 20 years instead of 30 years), which raises your monthly mortgage payments significantly.
It’s important to point out that residential loans are only available for properties with one (a single family home) to four dwelling units. For anything 5 units and above, you have to use a commercial loan.
So in what scenarios would you decide to buy a smaller, one to four unit property, using a commercial loan? I can think of a couple.
Commercial Loan Scenarios
First, you might consider using a commercial loan if you want to buy a property in the name of an LLC instead of your name. With residential loans, there are risks to quitclaiming your property into an LLC. For example, quitclaiming might trigger a due on sale clause. This means that the bank could call your loan and make you pay the entire balance of the loan. Another problem with quitclaiming is that your title insurance doesn’t necessarily transfer to the LLC. So if there is a problem with title, your title insurance might not cover the cost to fix this issue. With a commercial loan, everything is already in the name of the LLC, so you don’t have to go through the quitclaim process or worry about the due on sale clause or losing title insurance.
More on Commercial Loans
Another reason someone may choose a commercial loan is if he/she doesn’t have the W-2 income or history to be able to qualify for a residential loan. Usually, banks want to see a couple of years history of W-2 income before they want to lend to you. Maybe you’re a resident who doesn’t have much income or maybe you’re self-employed and not paying yourself a salary, just dividends. Because commercial loans are based on the performance of the property not so much your finances, it may be easier in some cases to qualify for a commercial loan.
Finally, there is a limit to the number of residential loans you can take out. For individuals, it is a maximum of 10 residential loans. For married couples, if you purchase all properties in one spouse’s name and quitclaim the property to the spouse who is purchasing the property, you can get a maximum of 20 residential loans (10 each). Once you go above this number (10 or 20), you have to go commercial.
Residential vs Commercial Loans–a Head-to-Head Comparison
So how do these two financing options stack up? Here is a head-to-head comparison of residential vs commercial loans.
1) Source: You can source residential loans from pretty much any major bank or national mortgage lender. In contrast, commercial loans tend to be from local banks. So if you are buying something in Oklahoma City, you’ll want to develop a relationship with a local bank in that city.
2) Interest rate: Residential loans tend to have lower interest rates than commercial loans. This isn’t always the case, especially when the loan is amortized over a shorter term (see #3).
3) Amortization period: This is the length of the loan. Most residential loans are for 30 years. In contrast, commercial loans are often amortized over shorter periods. With a shorter term loan, it’s less risk for the lender and they get higher payments every month. For you, this means your costs go up. It may be harder to get a property to cashflow when you use a commercial loan.
More Important Comparison Points
4) Fixed vs. Variable: Residential loans typically have a fixed interest rate over 30 years. You lock in a rate and regardless of what happens to interest rates, your interest rate and payment stays exactly the same. Commercial loans on the other hand tend to have variable rates. This means that your interest rate is tied to some standard index and goes up and down along with the index. As with a shorter amortization period, this lowers the risk for the lender because if the interest rates skyrocket, so will your mortgage payment.
5) Down payment: With residential loans, you will put down 25%. You may be required to put down more with commercial loans. Especially if you don’t have a banking relationship with the lender (what is called a “seasoned relationship”). This is why it’s important to start building relationships with local banks as soon as possible.
6) Qualifications: As mentioned above, with residential loans, whether or not you qualify largely depends on you and your income. With commercial loans, it’s much more about the property and how much income it generates. The more income a property generates, the less important your income becomes.
This concludes our comparison of the two most common financing options for your next rental purchase. We’ll cover the more unconventional sources of funding in a future post.
How are you financing your purchases? Which do you prefer, commercial or residential financing?
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