An article series on navigating the private lending world
Many real estate investors miss out on the tools available to help customize a rental loan and meet their investing objectives. Make sure you’re not one of them.
The fundamentals of a long-term rental loan are similar to those of a conforming consumer mortgage. Most investment borrowers can receive a fixed rate for a set number of months, along with a monthly payment obligation.
But let’s dive beyond the fundamentals to examine how you can tailor the loan to fit your plans. The following discusses investing strategies and features available to optimize your loan.
Loan-to-Value
When deciding on your loan amount, the lender has guidelines for the maximum loan to value (LTV) for your particular property type and borrower profile. In today’s private lending world, that is generally 80% LTV for purchases and no cash out refinances and 75%-80% for cash out refinances. Sometimes, investors consider the balance between keeping their capital in the property versus the amount of positive cash flow they will receive monthly.
Example: $200,000 property
Consider a loan of $150,000 at 5.25% with a monthly principal and interest payment of $828.00,or a loan of $120,000 at 4.75% with a monthly principal and interest payment of $626.00.
Here’s your decision to make: Do you lock in $202 per month in improved cash flow for 30 years or take the additional $30,000 in a cash out?
Here’s the break-even calculation: $30,000 / $202 = 148.5 months to recoup the $30,000 through lower monthly payments.
Adjustable Rate (ARM) versus Fixed Rate Mortgages (FRM)
Most rental loan lenders offer an adjustable rate product along with a 30-year fixed rate option. In the current low-rate environment, it’s crucial to know when you should consider an adjustable-rate mortgage instead of a fixed-rate loan. Here are some considerations:
- Short- to medium-term hold. When you will hold the property for a few years, it makes sense to take the slightly lower interest rate offered by the ARM products.
- You plan to refinance again. If you’re confident you’ll refinance again soon, an ARM loan may be best. For example, if your credit score is lower than you’d like and you’re not getting the best rate, an ARM gives you time to improve your score and refinance in the future. Another instance would be if you plan on making improvements to the property. This could allow you to lock in long-term financing once the improvements are complete and the property’s value increases.
- Rate difference is significant. Currently, the rate difference is about 0.25% between a 30-year fixed rate and a 5/1 adjustable-rate mortgage (ARM). A 5/1 ARM is fixed for the first five years, then it adjusts once per year thereafter. With our current historically low rates, most investors are opting to lock in the rate for 30 years unless they plan to sell or refinance in the next five years.
Rate and Fee Options
Private lenders generally offer a base rate, which may or may not come with an origination fee. These origination fees generally range from 0%-2% before a borrower has the ability to pay more or less to adjust the rate higher or lower.
For example, assume the borrower pays additional to buy down the rate from 5.375% to 4.875% for a loan of $150,000. The total cost to buy-down the rate is 1.375% of the loan amount or $2,062.50. The payment difference is $56 per month. The calculation for the breakeven is as follows:
$2,062.50 (Cost of Buydown) / $56 (Monthly Payment Improvement) = 36.83 months or about three years to break even. Borrowers will need to consider their hold period for the property to determine whether the buydown of the rate makes sense.
Longer vs. Shorter Prepayment Penalties
Your holding period is an important consideration when determining a prepayment penalty period a borrower is comfortable with. A prepayment penalty is calculated based on a percentage of the outstanding loan balance.
Prepayment penalties generally range from three to five years. A borrower’s selection can improve or worsen the interest rate or fees for a rental loan. The most quoted prepayment penalties are 5% for five years and the five-year step-down prepay penalty. The step-down prepayment, or “54321,” is a penalty that starts at 5% for the first year, and then declines by 1% each subsequent year until it expires at the beginning the sixth year of the loan.
Most lenders offer options to shorten, extend, or change the prepayment penalty period to fit your investment strategy. This allows you to pay a higher rate or fee to shorten the prepay penalty period to as little as one year. Investors can consider this option as opposed to a short-term bridge loan for properties they plan to sell in the next one to three years. In many cases, the rates for a long-term loan, with the shortening of the prepayment penalty, is superior to the standard bridge loan.
Additionally, several lenders offer seven-year prepayment penalty options. These options can reduce the rate or fees for a loan and make sense if you plan on a very long-term hold.
Interest Only or Amortizing Loan
“Interest only” means the monthly payment is only the interest accrued for the loan. Lenders frequently offer either a five- or 10-year interest-only phase followed by a shortened amortized period.
Investors with a short-term hold horizon can consider this option. Since there isn’t a large principal paydown created in the first five years of a 30-year amortizing loan, this strategy can maximize cash flows and capture property appreciation during the hold period.
Many borrowers with a long-term hold horizon select the amortizing loan structure, with the intent to let their renters’ monthly rent payments pay down the loan balance for them.
Single or Portfolio Rental Loan
When a borrower has multiple rental properties, they may need to determine whether it’s better to finance them all as single-property loans or group them into a blanket portfolio loan.
Lenders offering blanket or portfolio loans generally provide release provisions for paying off a single rental property from the pool. This allows a property to be released from the loan obligation. Typically, lenders are requiring 120% of that property’s associated loan amount, within the pool, to discharge it from the group.
Example: Property Value: $100,000
Property Associated Loan Amount: 70% LTV = $70,000
Cost Required to Release (120% x $70,000) = $84,000
Therefore, an extra $14,000 is deducted from the property sale proceeds, which the lender will use to reduce the principal balance of the existing loan. Importantly, this isn’t a prepayment penalty since the additional funds are used to pay down the current loan.
An alternative option is to use individual loans on each property. Lenders may have an underwriting fee of $500 to $1,500 per property. If you have five or fewer properties to finance, it could make sense to pursue individual loans and work to negotiate a discounted underwriting fee.
When designing a rental loan, it is important to investigate your loan options and better support your investment strategies. Be careful to connect with a trusted broker or lender that has these possibilities available. A great finance partner can help you save time and money—and increase your profitability.
Damon Riehl is the founder and CEO of Investment Property Loan Exchange. He has more than 35 years of lending experience in a broad array of asset classes, including commercial and residential mortgage, small business, and construction lending.
Riehl held top leadership positions as head of commercial lending for Ocwen Mortgage, head of unsecured lending for Citibank, global mortgage leader for GE Capital, and head of construction products at Fannie Mae. He is a member of the Harvard Joint Centers for Housing Studies.
Riehl has built six de novo lending platforms and used that knowledge to build and grow Investment Property Loan Exchange and the FinTech platform LoanBidz.com.
