What we learned about lending for real estate – Part 1 of 3
This is part 1 out of 3 of a longer article, “What we learned about lending for real estate”. We explore some often used loan products for financing real estate purchases. For this part, we’ll talk about Conforming Loans, FHA, VA, and other residential lending programs.
This is a quick overview of lending options that we use to finance our real estate purchases. I often get asked what loans are available for financing real estate buys, so I thought to write it up for posterity. But also as a reminder for myself, since there is plenty of detail that is easy to gloss over.
The text is relevant for the lending landscape in the USA only. Other countries have their own rules and unique opportunities, but I know nothing about those. I am therefore sticking to the USA and the loans available to you for real estate dealings in the States. I also intend to describe the landscape in broad strokes, and give plenty of links that you can use for your own research. It is hard to make a complete overview of all financial products available out there in what is intended to be a relatively easy to read blog post, so I am focusing on loan programs that are most popular with real estate investors.
The exposition mostly follows the sequence of loan programs that we were exposed to. As a result, I am writing in more detail about the loans I know well, and in less detail about those that I am not familiar with. I also specifically do not talk about any revolving credit lines, such as the home equity line of credit (a.k.a. HELOC) or other forms of equity lines of credit secured by real estate.
This means, even though this text gives you ideas of what questions to ask of your lender, the onus is still on you to figure out a loan that best fits your needs as a borrower and an investor. Being nimble in your plans and creative in your approach can open financing doors.
For most homeowners in the USA, the only loan product for real estate they encounter will be the conforming loan. A conforming loan is a government-backed loan program designed to offer as many working people as possible an opportunity to finance their home—their primary residence. This loan program has a tormented history, and a scrutinized present, that are both out of scope of this article: we will discuss the loan program as it is now from the perspective of a real estate investor who sees real estate financing as a tool that enables creating value through real estate. I will leave untangling its problematic corners to someone with more political savvy.
While conforming loans are usually discussed in terms of personal residence purchases, they are also interesting for real estate investors since conforming loan programs support purchases of 2nd homes—which could then be also rented out part of the year—as well as investment properties.
The conforming loans conform to the limits set out by the Federal Housing Finance Agency (FHFA), hence the name. For us, it is of practical importance to know that there is an upper limit to the loan amount that can be made under this program. The limits vary over time, so the best way to know what the limits are is to look them up online. While the ideal would have been to have uniform loan limits for all localities in the USA, the local market variations have forced the existence of several different limits:
- The “regular” loan limits
- The limits for “high cost” counties – those living in the San Francisco Bay Area will recognize themselves
- The limits for 2 and more units.
The rules for obtaining such loans are set forth by the Federal National Mortgage Agency (FNMA, colloquially known as “Fannie Mae”) and Federal Home Loan Mortgage Corporation (FHLMC, colloquially known as “Freddie Mac”). FNMA publishes the Selling Guide which lists all rules that a conforming loan must fulfill. This includes rules for lenders, borrowers, property and services related to the property. So, for example, to understand what property can qualify as a 2nd home, you could look it up there.
Despite the fact that conforming loans are usually used to finance single-family homes (and primary residences), there are other property types that can be financed this way too. Under similar conditions, it is allowed to finance a property between 1 and 4 units with a conforming loan. It is also possible to finance a primary residence (personal home), a 2nd home as well as an investment property. However, it is not possible to finance a non-residential property, or a property with 5 or more residential units. It is also not possible to finance property which does not have residential use as its primary use. For example, it is not possible to finance farmland.
The lenders who originate (write) conforming loans rarely do so to keep the loan note themselves. They write a conforming loan with the intention to re-sell the loan to a government agency such as FNMA. This is why they must ensure (sometimes at great tedium to the borrower) that all terms in the Selling Guide are upheld.
Because conforming loans are guaranteed by the US government institutions, they present lower risk to the lender compared to other loan products. Therefore such loans usually command the lowest rates out of the full spectrum of loan products. Up to very recently, loan rates as low as 2.5% were possible on 30-year fixed loans. Those times are now gone, maybe forever. Time will tell.
Whatever the loan rates do in the short run, another remarkable feature of conforming loans is that their interest rate is typically fixed for the entire lifetime of the loan once the rate is locked in the loan process. This means, once the loan rate is “locked” (which happens once the underwriting of the loan is complete), a borrower will enjoy a known and predictable—in this case fixed—loan payment for as long as 15 or 30 years. The fact that the loan payments are fixed, and that the US dollar is typically losing value as time goes on makes such a loan a very easy inflation hedge for any homeowner, and is one of the major wealth creation vehicles in recent US history. This is a unique property of the loans in the USA, and the government set lending guidelines are the de facto benchmark for all other lenders. In other parts of the world, adjustable rate mortgage loans are the norm: with such loans, the interest rates are adjusted on a periodic basis as some percentage point above a certain well known index, such as the “London Interbank Borrowing Rate”, or LIBOR, in Europe.
Another important feature of conforming loans is that they are written on the merits of the borrower, not on the merits of the property that is being bought. As long as your credit score and financial situation can support a home purchase, you should be able to qualify for a loan, even if the property itself is not economically viable. FNMA publishes a set of underwriting criteria, which define the loan terms that can be offered to people of various means and various credit scores.
After the credit crunch of 2008 and the ensuing crash of the securities market, the lenders have become increasingly wary of writing loans for properties where the borrower has little “skin in the game” – i.e. downpayment. Downpayment is the cash the borrower needs to contribute towards the closing of the property, and a set minimum for conforming loans is 20%. This means, you will need the ability to put down $20,000 of seasoned funds for a $100,000 purchase. Funds are “seasoned” if they spent some time on your account, typically two months, which gives enough time for it to become obvious that these funds are something you own, but have not gone into debt to get.. Some funds are by default considered seasoned too, such as proceeds from stock sales, regardless of when they were made.
Conventional loans must come without a prepayment penalty. This means, if you decide to pay the loan off early, the lenders must allow you to do so, and must not charge you any additional fees or penalties for the option to do so. The more we go into the realm of commercial lending, the less this useful loan feature comes about.
Conventional loans are usually fully amortized. This means that the loan term and maturity match: once the loan matures, the borrower is expected to have paid the loan off in full.
Some limitations apply, however. The FNMA regulation prescribes that an individual may have a maximum of 10 loans in their own name. So, after you have taken out 10 loans, this borrowing avenue becomes closed to you. It is also not possible to take out a conforming loan in the name of a company. Conforming loans may have multiple borrowers, but they must always be natural persons, which is something that is not always compatible with an investor’s business plan. This is something to keep in mind when dealing with conventional loans. Also, conventional loans rely on strict underwriting rules and protracted appraisal process, making their timelines at odds with the quick close requirements of the investing world. The interest rates will also differ depending on the purpose of the property that is being bought. A loan for a 2nd home would typically be at a rate 0.5% higher than a loan for a primary home. A loan for an investment property would be at a rate 0.5% higher than a loan for a 2nd home.
FHA, VA, and other residential lending programs
This, however, is not the full spectrum of residential lending available to every person. For those unable to afford the 20% down payment, the Fair Housing Administration has a loan program that allows one to buy a house for as low as 3% of down payment. This is commonly known as the “FHA loan”. While it was originally intended for first-time home buyers, it is actually available to anyone. The low down payment will require taking out a private mortgage insurance, which would be an additional out-of-pocket cost for the borrower. Some additional conditions apply for the properties seen for an FHA loan. For example, some types of deferred maintenance are not financeable. There is a limit of one active FHA loan per person; but people have been known to take out multiple FHA loans one after the other–not concurrently–over their investment career, using them as powerful levers in wealth building. One strategy that commonly goes hand-in-hand with an FHA loan is “house hacking”. As it is allowed to buy up to 4-unit property with an FHA loan just as with the conforming loan, some borrowers would decide to buy multi unit buildings, living in one of the units and renting the others. This sometimes allows them to even come out ahead of the loan repayment game, as the rents collected on other units either considerably help loan repayment, or even exceed the required monthly payment amounts.
There is a range of other more specialized loan programs that I have had less experience with and am unable to write in reasonable detail. The US administration of Veterans Affairs (VA) offers specialized loans for veterans and immediate family members, allowing even 0% downpayment. This option is open to US military veterans who have spent a certain minimum number of days in deployment. Individual states have comparable programs for military personnel. California has the CalVet program, which while technically different from a regular loan, from the borrower’s perspective behaves very similarly to a regular loan. CalVet is also open to current and former military personnel who have seen deployment for a certain minimum time, is aware of degrees of disability, but is constrained that it only may be applied to properties that are physically located in California.
Check out the other parts of this series in our blog: