Financing plays an important role in the whole flipping process. It can significantly impact the profit margin and the amount of time it takes you to flip the home. Here are several popular options in financing and funding a flip;
Using personal finances and a traditional mortgage
Using only personal finances
Obtaining a rehab/construction loan
Personal Financing with a Traditional Mortgage
Although a popular option, personally I don’t see this as a preferable one for first time home Ivestors. The way this works is simple. You find the house; you go to a mortgage broker, bank or lender and ask them to finance the house for you. The remaining costs of repairing and rebuilding the house are all out of pocket.
Let’s say the property you found is listed for $100,000. As long as the house is in livable condition, lenders will offer traditional financing for the property based on their guidelines. Now for financing this house you may need an additional down payment of 5% or 20% and etc. This all depends on how comfortable the lending institution is with your credit, income and mortgage history. You’d have to talk to your mortgage broker, loan officer or personal banker for more details on the down payment.
Once the bank approves the loan, double check to make sure there is no prepayment penalty for selling the home once you’ve completed the rehabilitation process.
Back to our example, we’ll say the bank required a 10% down payment from you to buy the home. Additionally, you’ve talked to your contractor and he’s told you that the costs of repair are going to be about another $30,000. So far, you’ve had to come up with about $40,000 out of pocket in expenses. Of course these aren’t the only things you’ll need to be spending money on. You will still have carrying costs and monthly mortgage payments for the house, insurance, utility and property tax payments as well. And of course, let’s not forget all of the unexpected items that seem to happen all the time.
Many people assume that this is the only real way to finance and work on a house flipping project. The problem becomes worst when hopeful investors tap into their personal and emergency savings accounts to fund their project.
On the plus side, by putting money into the project from personal finances, you save time and money. You don’t have to go back and forth with a bank to get a draw for a specific project and you only pay interest on the money you borrowed for the property. Construction and rehab loans typically have much higher interest rates which again, tap into your profit margin.
Personally, I only recommend moving forward with this type of financing after several properties have been flipped and a comfortable cushion has been made.
Using Only Personal Finances
The way this works is simple. You pay for everything from your own funds and put all of your own money on the line. This is good because you avoid closing costs, mortgage payments and most importantly you will be one of the top considerations for a seller when they have multiple offers. Someone that offers to close with cash has a much higher chance of getting the deal than a second offer willing to pay more, but has to wait for his financing to come through.
On the downside, you’re putting all of your money on the line and tying it up in the property. You have to wait to sell or refinance the property to get your money back out of it and continue with other projects. We’ll talk about refinancing a flip in a different article.
Some big time investors choose to go this way but many of them refrain. These investors would much prefer to make a little less in profits, but have the ability to spread their money into multiple projects at the same time.
Construction and Rehabilitation Loans
An investors favorite, rehab and construction loans are a popular method of financing investment projects. An initial down payment is usually required by the banking institution for purchasing the home. The amount is determined by the bank based on the sales price, future appraised value (when the project is completed), comparable houses in the neighborhood, and the sworn construction statement that has been given to you by your contractor.
The lender finances the property, and allots you a certain amount of funds in the form of a rehabilitation loan. To draw money from this loan, the bank might request the contractor to fill out a draw request schedule on the sworn construction statement and split the payments into a minimum of three parts. Remember, different banks have different guidelines so this is a general scenario. This ensures you and the bank of having a completed phase in the project done before any money is transferred to the contractor. On the down side, the contractor will have to cover all fees until each phase of the project has been completed.
Your monthly payments will be based on the total money borrowed at the current time. For example, you’ve borrowed $100,000 for the land and have drawn $10,000 from the rehab loan to pay the contractors. So your payment would be based on a total loan amount of $110,000. Depending on your lender, these monthly payments can be deducted from the total money you’re borrowing from the bank so you don’t have to immediately pay it out of pocket.
These loans allow you to put a much smaller amount of money from your personal finances into the property and avoid tying it all up into the same project. On the downside you will be making payments month to month on the loan, closing costs and won’t have as much flexibility in making changes (which is sometimes a good thing). Also, you might notice delays in receiving funds from draw requests.
As a branch manager for a mortgage company, to obtain these kinds of loans I personally recommend finding a good local bank or federal credit union. They are much more familiar and aware of the local circumstances that surround a neighborhood. Once you establish a relationship with these smaller local banks, obtaining financing, draws and etc becomes much quicker. Not to mention it can lead to a sudden growth of business from all the relationships you’ll establish. Loan officers and mortgage companies do have access to some rehab lenders, but the fact that they are not local makes the financing procedure sometimes tedious and extremely difficult to obtain