Finding the funds to buy property outside of the traditional bank loan requires creative financing in real estate.
You have several options in real estate investing. You can become a landlord for your property or flip houses for a profit. You can also get involved with real estate investment trusts (REITs), real estate limited partnerships (RELPs), real estate investment groups (REIGs) or real estate mutual funds. Each can provide consistent cash flow and equity to leverage.
That said, there are barriers to getting started. Fixed-rate mortgages typically require a down payment of around 15% with a credit score of 680 for a one-unit investment property. It can also be hard to get lenders due to the risk. With these challenges, potential buyers and investors might need to consider creative financing in real estate.
What is creative financing in real estate?
Creative financing in real estate refers to unconventional ways to finance or purchase a property. Typically, property purchases require cash payments , financing from a traditional mortgage loan or a combination of both. Creative real estate financing is an alternative if you are interested in buying or investing in real estate but don’t meet the usual qualifications.
Most people seek out creative financing for one or more of the following reasons:
• Low credit score
• Lack of employment history or they are paid on commission
• Lack of capital
“Most home buyers need to have two years of employment history to be considered for a bank-funded loan," said Monica Roff, an Ohio-based real estate agent for RE/MAX. Even with 25% down, it can be difficult to secure a loan without proof of consistent income.
Creative financing can appeal to prospective home buyers because they usually don’t have to use a lot of their own money. In some cases, creative financing might even help avoid high interest rates.
A common type of creative financing is DIVVY, a rent-to-own company that helps prospective home buyers when there is no credit or employment history. “After talking with the client, going over finances and performing inspections on the intended property, they use cash to purchase the home," Roff said. “After purchasing the home, the buyer pays DIVVY a monthly fee, part of which is set aside for the buyer’s down payment. Once the buyer has enough for the down payment, they can buy the home.”
12 types of creative financing in real estate
1. Owner financing
Owner financing involves convincing property sellers to finance the property with you directly. Also known as seller financing, purchase-money mortgage or bond-for-title, the seller replaces a bank lender and provides the buyer with either a full or partial loan.
This type of financing is usually not based on the buyer’s credit or income and isn’t always reported on their credit report. The buyer usually takes over the property after paying a considerable down payment, with the mortgage coming later. This type of creative house financing is appealing because it can be faster and easier, bringing down or eliminating transactional costs such as closing and real estate agent fees.
2. Cash-out refinance
You can also pay off your existing mortgage and get a larger one. With a cash-out refinance, you can withdraw part of your home’s equity in cash. This is a great option if you need a significant amount of money at once, but you should know how much you need before getting started.
Remember that cash-out refinancing means owing more because your total debt load increases. You’ll also need to pay closing costs again.
3. Personal loan
If you can’t put your house up as collateral, but you have great credit, a personal loan might be a great creative financing option. Personal loan lenders usually check your credit, income, debt, employment status and more. It could be difficult to use a personal loan toward the down payment of a traditional house, but it could finance repairs or other costs. It could also finance a tiny house or mobile home.
Personal loans often range from $10,000 for an unsecured personal loan and $30,000 for a secured loan. Personal loans usually have higher interest rates and shorter repayment periods than mortgages. They can also affect your credit score.
This is a loan that serves to “bridge” the time a seller has between selling an existing property and buying a new one. Referred to as a caveat or swing loan, this type of creative financing is a short-term loan that provides cash flow relief during the transition. The borrower uses their current home’s equity as the down payment for the new house.
Some perks of this real estate financing include faster loan processing and quicker access to the funds. On the other hand, they typically have short payment periods, high origination fees, and high interest rates.
5. Lease-to-purchase option
The lease-to-purchase option involves the buyer or investor working with the property owner to own the property when the lease agreement ends. This is a good path if you don’t have the credit or down payment for a traditional loan. You’ll usually pay above-market rent since part of it goes toward your down payment.
Lease-to-purchase is different from other creative financing options because you will still need to meet the usual requirements later. That’s why buyers who take this route often try to improve their credit profile to qualify for a great deal when it’s time to purchase. You should also be ready to shop around until you find the best landlord for your situation.
6. Hard money loan
These are asset-based loans from private investors or companies, not banks or other traditional institutions. Hard money loans are short-term and great for fast approval and quick access to funds. The lenders of these loans also focus more on funding profitable deals and are willing to take the risk if you can convince them to support your goals.
House flippers often use this option because the process requires things to move fast, from accessing the funds to renovating the house. Some downsides of hard money loans are short repayment terms and high interest rates. You can also expect a lower LTV ratio than a conventional loan—around 50% to 75% as opposed to the regular 80%.
7. Private money loan
Another common type of creative financing is a private money loan or private financing. Private money loans involve the buyer’s family member, friend or a connection with an investor who can finance the purchase. Because this is more personal and less about the business aspect, both parties can be more flexible when negotiating loan terms.
Some perks of this option are that the buyer usually pays lower fees and can expect to receive the funds quickly. One drawback is that it might be difficult to get someone to invest in you if you don’t have a history of successful ventures or no history at all. These private loans can also come at a higher interest rate, according to Roff.
Crowdfunding platforms have become common in the world of financial goal-setting. Crowdfunding allows you to make a case to the public for whatever you need funds for and encourage people to support it. GoFundMe, for example, is commonly used to crowdfund for medical bills, travel costs or burials. However, a captivating message behind your project may be all you need to raise funds for your down payment. Hatch My House and Feather The Nest are common platforms for real estate buyers and investors.
9. Home equity loan or line of credit
One of the most popular ways to cover the down payment of an investment property is with a home equity loan or line of credit. A home equity line of credit (HELOC) is a line of credit tied to a home that you can borrow against repeatedly for large expenses. It is considered creative real estate financing because you use your home’s equity to finance a new down payment.
It’s common to borrow up to 85% of your home’s equity, which means its value minus the amount still owed. Bank of America recommends going above the minimum monthly payment and making additional payments toward the principal to save on interest and decrease your overall debt faster.
10. Self-directed IRA
This is another way to be creative as you finance your real estate. If you’ve been in the workforce for a while and have significant funds in your IRA that you’d rather use to invest in real estate, you can create a self-directed IRA. Some perks are that it diversifies your investment portfolio and includes additional tax benefits. If you don’t have an IRA, you can open one. However, this method can be tricky and may require a professional to help.
11. FHA loan
The US Federal Housing Administration (FHA) is the largest insurer of mortgages in the world. FHA loans are essentially insured by the government, and obtained through an FHA-approved lender. It’s one of the most common ways to get a mortgage for first-time home buyers and helps buyers who don’t meet the typical requirements. Buyers can get low down payments and qualify with credit scores as low as 580. The minimum down payment on this type of loan is 3.5% against the purchase price, or $3,500 for every $100,000.
Other eligibility factors include having a verifiable income and employment status, not being delinquent on federal taxes or federal student loans, and not owning another FHA-financed home. Two main downsides of an FHA loan could include the additional cost of a mortgage insurance premium (MIP) and higher interest rates compared to traditional loans.
This is a common method for expanding real estate portfolios. Cross-collateralization is the process of using more than one property to secure an investment loan. You can use the equity of property such as a vehicle, land or another house as a down payment. The lender can also increase the loan size. This could be a better option than cash-out refinancing because the buyer saves on interest payments.
Another benefit of cross-collateralization: you can remove loans from your credit report when you use multiple properties. (Traditional lenders restrict the number of financed properties a buyer or investor can have.) This option is great for buyers with multiple assets, allowing them to move forward with a deal without providing funds. One important note about cross-collateralization: The assets put up for collateral won’t always be treated as they usually would. For example, you might not be able to trade in your paid-off vehicle because it’s tied to another loan. Also, a borrower needs to be careful not to default on their loan because the lender could potentially seize the collateral used to secure the loan.
Creative financing vs. a traditional mortgage
Traditional mortgages typically work best for people who can comfortably meet all the requirements to invest in properties. This means having the right assets, credit score, income, debt-to-income ratio (DTI) and even the type of property. Traditional mortgages typically involve paying about a 10-20% down payment with various loan lengths and terms.
They require about a 620 credit score and no more than 36% when it comes to the debt-to-income ratio. While flexible on loan terms, they are generally strict with eligibility. Another indication that a traditional mortgage is right for you is if you aren’t in a hurry to sell, because this is your primary residence and only home.
Creative financing is best for those who don’t meet the usual requirements for a mortgage, have little equity and/or really want or need to sell their home. It could also be ideal for those who don’t want the terms of a traditional mortgage and want a better deal on their investment purchase. This may be a great option for seasoned investors, like house flippers, who make quick turnarounds or are taking on more than one property project.
While creative financing has many upsides for the right person; it could also be a lengthier process to secure and come at a higher cost, such as a higher interest rate or a rent-to-own situation where the buyer pays more on a monthly basis.