Taking a Look at Mortgage Options

Although you can find thousands of different types of mortgages (thanks to all the various bells and whistles available), only two major categories of mortgages exist: fixed interest rate and adjustable rate. Technically speaking, some mortgages combine elements of both — they may remain fixed for a number of years and then have a variable interest rate after that. This section discusses these major loan types, what features they typically have, and how you can intelligently compare them with each other and select the one that best fits with your investment property purchases.

Fixed-rate mortgages

Fixed-rate mortgages, which are typically for a 15- or 30-year term for single-family properties, condos, and one- to four-unit apartments, have interest rates that remain constant over the life of the loan. Because the interest rate stays the same, your monthly mortgage payment stays the same.

Examining the pros and cons

For purposes of making future estimates of your property’s cash flow, fixed-rate mortgages offer you certainty and some peace of mind because you know precisely the size of your mortgage payment next month, next year, and ten years from now. (Of course, the other costs of owning investment property — such as property taxes, insurance, maintenance, and so on — still escalate over the years.) But this piece of mind comes at a price:

You generally pay a premium, in the form of a higher interest rate, compared with loans that have an adjustable interest rate over time. If you’re buying a property and planning to improve it and sell it within five to ten years, you may be throwing money away by taking out a fixed-rate loan to lock in an interest rate for decades.
If, like most investment property buyers, you’re facing a tough time generating a healthy positive cash flow in the early years of owning a particular investment property, a fixed-rate mortgage is going to make it even more financially challenging. An adjustable-rate mortgage, by contrast, can lower your property’s carrying costs in those early years. (We discuss adjustable-rate mortgages in the next section.)
Fixed-rate loans carry the risk that if interest rates fall significantly after you obtain your mortgage and you’re unable to refinance, you’re stuck with a relatively higher-cost mortgage. For example, you may be unable to refinance if you lose your job, your employment income declines, the value of your property decreases, or the property’s rental income slides. Also remember that even if you’re able to refinance, you’ll probably have to spend significant time and money to get it done.

Making a point of comparing fixed rates

In addition to the ongoing, constant interest rate charged on a fixed-rate mortgage, lenders also typically levy an upfront fee, called points, which can be considered prepaid interest. Points are generally a percentage of the amount borrowed. To illustrate, 1.5 points are equal to 1.5 percent of the loan amount. So, for example, on a $200,000 mortgage, 1.5 points translate into $3,000 upfront (also known as prepaid) interest. Points can add significantly to the cost of borrowing money, particularly if you don’t plan to keep the loan for long.

Generally speaking, the more points you pay on a given loan, the lower the ongoing interest rate the lender charges on that loan. That’s why you can’t compare various lenders’ fixed-rate loans to one another unless you know the exact points on each specific mortgage, in addition to that loan’s ongoing interest rate.

The following are two approaches to dealing with points, given your financial situation and investment goals:

Minimize the points: When you’re running low on cash to close on a mortgage, or if you don’t plan to hold the loan or property for long, you probably want to keep your points (and other loan fees discussed in the next section) to a minimum. You may want to take a higher interest rate on your mortgage.
Pay more points: If you’re more concerned with keeping your ongoing costs low, plan to hold the property for many years, and aren’t cash constrained to close on the loan now, consider paying more points to lower your interest rate. This is known as buying down the loan rate and can be an excellent strategy to lower your overall costs of borrowing and increase the property’s cash flow and equity buildup.

To make an easier apples-to-apples comparison of mortgages from different lenders, get interest rate quotes at the same point level. For example, ask each lender for the interest rate on a particular fixed-rate mortgage for which you pay one point or two points, for example. You may also compare the annual percentage rate (APR), which is a summary loan cost measure that includes all of a loan’s fees and costs. However, please remember that the APR assumes that you hold the mortgage for its entire term — such as 15 or 30 years. If you end up keeping the loan for a shorter time period, either because you refinance or pay off the mortgage early, the APR isn’t valid and accurate (unless you recalculate based on the changed term and payoff).

Adjustable-rate mortgages (ARMs)

Adjustable-rate mortgages (ARMs) carry an interest rate that varies over time. An ARM starts with a particular interest rate, usually a good deal lower than the going rate on comparable length (15- or 30-year) fixed-rate mortgages, and then you pay different rates for every year, possibly even every month, during a 30-year mortgage. Because the interest rate on an ARM changes over time, so too does the size of the loan’s monthly payment. ARMs are often attractive for a number of reasons:

You can start paying your mortgage with a relatively low initial interest rate compared with fixed-rate loans. Given the economics of a typical investment property purchase, ARMs better enable an investor to achieve a positive cash flow in the early years of property ownership.
Should interest rates decline, you can realize most, if not all, of the benefits of lower rates without the cost and hassle of refinancing. With a fixed-rate mortgage, the only way to benefit from an overall decline in the market level of interest rates is to refinance.

ARMs come with many more features and options than do fixed-rate mortgages, including caps, indexes, margins, and adjustment periods. The following sections help you to understand these important ARM features.

Start rate

The start rate on an ARM is the interest rate the mortgage begins with. Don’t be fooled though: You don’t pay this often tantalizingly low rate for too long. That is why it’s often called a teaser rate. The start rate on most ARMs is set artificially low to entice you. In other words, even if the market level of interest rates doesn’t change, your ARM is destined to increase as soon as the terms of the loan allow (more on this topic in a minute). An increase of one or two percentage points is common. The formula for determining the future interest rates on an ARM and rate caps is far more important in determining what a mortgage is going to cost you in the long run.

Future interest rate

The first important thing to ask a mortgage lender or broker about an ARM you’re contemplating is the formula for determining the future interest rate on your loan. ARMs are based on the following formula:

Future Interest Rate = Index + Margin

The index is a designated measure of the market interest rate that the lender chooses to calculate the specific interest rate for your loan. Indexes are generally (but not always) widely quoted in the financial press. The margin is the amount added to the index to determine the interest rate that you pay on your mortgage.

For example, suppose that the loan you’re considering uses a one-year Treasury bill index, which say is at about 2 percent, and the loan you’re considering has a margin of 2.75 percent (also often referred to as 275 basis points; 100 basis points equals 1 percent). Thus, the following formula would drive the rate of this mortgage:

One-Year Treasury Bill Rate (2 percent) + Margin (2.75 percent)

Do the math and you get 4.75 percent. This figure is known as the fully indexed rate (the rate the loan has after the initial rate expires and if the index stays constant). If this loan starts out at just 2 percent, you know that if the one-year Treasury bill index remains at the same level, your loan can increase to 4.75 percent. If this index rises one percent to 3 percent during the period that you’re covered by the ARM’s start rate, that means the loan’s fully indexed rate goes to 5.75 percent (3.00 + 2.75), which is nearly three percent higher than the loan’s start rate.

Compare the fully indexed rate on an ARM you’re considering to the current rate for a comparable term fixed-rate loan. You may see that the fixed-rate loan is at about the same interest rate, which may lead you to reconsider your choice of an ARM that carries the risk of rising to a higher future level.

Understanding ARM indexes

The different indexes used on ARMs vary mainly in how rapidly they respond to changes in interest rates. If you select an adjustable-rate mortgage tied to one of the faster-moving indexes, you take on more of a risk that the next adjustment may reflect interest rate increases. When you take on more of the risk that rates may increase, lenders cut you breaks in other ways, such as through lower caps (the maximum rate increase possible over a given time period; see “Future interest rate adjustments” later in the chapter), lower margins or lower points.

Should you want the security of an ARM tied to a slower-moving index, you pay for that security in one form or another, such as a higher start rate, caps, margin, or points. You may also pay in other, less-obvious ways. A slower-moving index, such as the 11th District Cost of Funds Index (COFI, discussed later), lags behind general changes in market interest rates, so it continues to rise after interest rates peak and goes down slower after rates have turned down. The following list covers some of these indexes.

Treasury bills (T-bills) are IOUs that the U.S. government issues. Most ARMs are tied to the interest rate on 6-month or 12-month T-bills (also referred to as the one-year constant maturity Treasury index). This is a relatively rapidly moving index. Some investment property mortgages are tied to the rate on ten-year Treasury Notes. Being a somewhat longer-term bond, a ten-year index doesn’t generally move as rapidly as the shorter-term indexes.
Certificates of deposit (CDs) are interest-bearing bank deposits that lock the depositor in at a set interest rate for a specific period of time. ARMs are usually tied to the average interest rate that banks are paying on six-month CDs. Like T-bills, CDs tend to respond quickly to changes in the market’s level of interest rates.
London Interbank Offered Rate Index (LIBOR) is an average of the rate of interest that major international banks charge each other to borrow large sums of U.S. dollars, which is commonly referred to by real estate lenders as an index for their adjustable loans. LIBOR tends to move and adjust quite rapidly to changes in interest rates and is at times even more volatile than the U.S. Treasury or CD index rates.
Eleventh District Cost of Funds Index (COFI) is a relatively slow-moving index. Adjustable-rate mortgages tied to the 11th District Cost of Funds Index tend to start out at a higher interest rate. A slower-moving index has the advantage of moving up less quickly when rates are on the rise. On the other hand, you have to be patient to benefit from falling interest rates.
In a relatively low-interest rate environment, fewer lenders tend to offer COFI loans. This illustrates the point that lenders don’t always offer the same choice of indexes. Rather, each lender offers one or typically no more than two indexes, and borrowers should specifically look at the index as part of their overall decision on choosing a lender.

Future interest rate adjustments

After the initial interest rate ends, the interest rate on an ARM fluctuates based on the loan formula. Typically, ARM interest rates change every 6 or 12 months, but some adjust every month. In advance of each adjustment, the lender sends you a notice telling you your new rate. Be sure to check these notices because on rare occasions, lenders make mistakes.

Almost all ARMs come with a rate cap, which limits the maximum rate change (up or down) allowed at each adjustment. This limit is usually referred to as the adjustment cap. On most loans that adjust every six months, the adjustment cap is 1 percent; the interest rate charged on the mortgage can move up or down no more than one percentage point in an adjustment period.

Loans that adjust more than once per year usually limit the maximum rate change that’s allowed over the entire year as well — known as the annual rate cap. On the vast majority of such loans, 2 percent is the annual rate cap. Likewise, almost all ARMs come with lifetime caps, which represent the highest rate allowed over the entire life of the loan. Lifetime caps of 5 to 6 percent higher than the initial start rate are common for adjustables.

Many ARMs also have a rate floor that is the minimum interest rate that will apply to the loan. Often the rate floor is equal to the start rate, which means that your loan can adjust up or down over the life of the loan, but never lower than the start rate. Robert has an ARM loan that adjusts annually up or down based on the COFI index. During the low interest rate years, this loan has actually adjusted down, but it can go no lower than the rate floor, which was specified in the loan documents.

Taking an ARM without rate caps is like heading out for a weeklong outdoor trek without appropriate rain gear and clothing for varying temperatures. When you consider an adjustable-rate mortgage, you must identify the maximum payment that you can handle. If you can’t handle the payment that comes with a 10 or 11 percent interest rate, for example, don’t look at ARMs that may go that high. As you crunch the numbers to see what your property’s cash flow looks like under different circumstances (see Chapter 12), consider calculating how your mortgage payment changes based on various higher interest rates.

Avoiding negative amortization ARMs

As you make mortgage payments over time, the loan balance you still owe is gradually reduced or amortized. Negative amortization (when your loan balance increases) is the reverse of this process. It occurs when the monthly loan payments are less than the amount of interest that is accruing during that time. Some ARMs allow negative amortization. How can your outstanding loan balance grow when you continue to make mortgage payments? This phenomenon occurs when your mortgage payment is less than it really should be.

Some loans cap the increase of your monthly payment amount but don’t cap the interest rate. Thus, the size of your mortgage payment may not reflect all the interest that you currently owe on your loan. So, rather than paying the interest that you owe and paying off some of your loan balance (or principal) every month, you end up paying off some, but not all, of the interest that you owe. Thus, lenders add the extra, unpaid interest that you still owe to your outstanding debt.

Negative amortization is similar to paying only the minimum payment that your credit card bill requires. You continue to rack up finance charges (in this case, greater interest) on the unpaid balance as long as you only make the artificially low payment. Taking a mortgage with negative amortization defeats the whole purpose of borrowing an amount that fits your overall financial goals.

Avoid ARMs with negative amortization. The only way to know whether a loan includes negative amortization is to ask explicitly. Some lenders and mortgage brokers aren’t forthcoming about telling you. If you have trouble finding lenders that will deal with your financial situation, make sure that you’re especially careful — you find negative amortization more frequently on loans that lenders consider risky, which should be taken as a sign that maybe you’re overreaching for a property that isn’t an ideal investment. You’re likely only to be considering such a mortgage because your cash flow won’t allow you to have a fully amortized loan. Therefore you would need to achieve significant appreciation in the property to cover this negative cash flow plus your desired rate of return in order for this investment to make sense.

Reviewing Other Common Fees

Whether the loan is fixed or adjustable, mortgage lenders typically assess other upfront fees and charges. The lender must disclose these ancillary fees. You may have to search carefully to find them in the paperwork, so make sure that you do because they can significantly add up to quite a bundle with some lenders. Here’s our take on the typical extra charges you’re likely to encounter and what’s reasonable and what’s not:

Application fee: Most lenders charge several hundred dollars to work with you to complete your paperwork and see it through their loan evaluation process. Should your loan be rejected, or if it’s approved and you decide not to take it, the lender needs to cover its costs. Some lenders credit or return this fee to you upon closing with their loan, but you need to verify it up-front in writing.
Credit report charge: Most lenders charge you for the cost of obtaining your credit report, which tells the lender whether you’ve filed bankruptcy in the last seven years, plus repaid other loans, including consumer debt (such as credit cards, auto loans, and so on), on time. A credit report also allows the lender to verify your employment and personal residence and business addresses. Your credit report should cost about $50 for each individual or entity that will be a borrower.
Appraisal fee: The property for which you borrow money needs to be valued. If you default on your mortgage, a lender doesn’t want to get stuck with a property that’s worth less than you owe. The cost for standard form appraisal typically ranges from several hundred dollars for most residential properties of one to four units to as much as $1,000 or more for larger investment properties. (On particularly large properties, this fee can be more significant — on a 30,000-square-foot office building, an appraisal may run around $5,000; on a 300-plus-unit apartment building, it is more in the $10,000 range.) You may be able to save some money if the property has been appraised recently and you contact the appraiser and he’s willing and able to provide you with an updated appraisal.
Environmental assessment or phase I: Virtually all lenders making loans on residential properties with five or more units or, especially, commercial property, require a qualified engineering company to perform a site assessment and overview of the entire area in which the property is located to identify possible environmental issues. This type of report is commonly referred to as a phase I environmental report, and the cost directly correlates to the location, type of property, size, and even the prior use of the property and the surrounding area. Phase I reports can run from $300 to as much as tens of thousands of dollars. (We include more details in Chapter 14.)
Third-party physical inspection: Depending on the property being financed, lenders often require third-party inspections by competent professionals. For example, an inspection report from a licensed pest control firm documenting the property condition and specifically the presence of termites and/or wood-destroying organisms is required in virtually all transactions, including single-family homes and commercial properties. Again, the cost of these reports varies depending on the property. (More details to come in Chapter 14.)

Request a detailing of other fees and charges in writing from all lenders that you’re seriously considering. You need to know the total of all lender fees so that you can accurately compare different lenders’ loans and determine how much closing on your loan will cost you. For residential and commercial income properties, the lender usually asks for a deposit that the lender uses to cover the types of fees and charges outlined here.

To reduce the possibility of wasting your time and money applying for a mortgage that you may not qualify for, ask the lender for any reasons it may not approve you. Disclose any problems on your credit report or with the property. Don’t expect the lender to provide you with a list of credit or property problems that may conceivably put the kibosh on a mortgage.

No-point mortgages aren’t no-brainers

Some property buyers are attracted to no-point or zero-cost mortgages (which also sometimes have no other loan fees or costs either). Remember that if a loan has no points, it’s sure to have a higher interest rate. That’s not to say that no-point loans are better or worse than comparable loans from other lenders, but don’t get duped into a loan because of a no-points sales pitch. The lenders who heavily promote these types of loans rarely have the best mortgage terms.

Consider a no-point/no-fee mortgage if you can’t afford more out-of-pocket expenditures now or if you think that you’ll only keep the loan a few years. But if you’re that cash constrained, you may want to consider whether you can truly afford to buy investment property (see Chapter 1). This same advice applies to the no-document or stated income loans that are currently out of favor due to their poor track record of having a very high default rate.

Making Some Mortgage Decisions

You can’t (or at least shouldn’t) spend months deciding which mortgage may be right for your situation. So, in this section, we help you zero in on which type is best for you.

Choosing between fixed and adjustable

Choosing between a fixed-rate or adjustable-rate loan is an important decision in the real estate investment process. Consider the advantages and disadvantages of each mortgage type and decide what’s best for your situation prior to going out to refinance or purchase real estate. This section covers the key factors to consider.

Your ability and desire to accept financial risk

How much risk can you handle in regard to the size of your property’s monthly mortgage payment? If you can take the financial risks that come with an ARM, you have a better chance of saving money and maximizing your property’s cash flow with an adjustable-rate rather than a fixed-rate loan. Your interest rate starts lower and stays lower with an ARM, if the overall level of interest rates stays unchanged. Even if rates go up, they’ll likely come back down over the life of your loan. If you can stick with your ARM for better and for worse, you should come out ahead in the long run.

ARMs make more sense if you borrow less than you’re qualified for. If your income (and applicable investment property cash flow) significantly exceeds your spending, you may feel less anxiety about the fluctuating interest rate on an ARM. If you do choose an adjustable loan, you may feel more financially secure if you have a hefty financial cushion (at least six months’ to as much as a year’s worth of expenses reserved) that you can access if rates go up.

Some people take ARMs when they can’t really afford them. When rates rise, property owners who can’t afford higher payments face a financial crisis. If you don’t have emergency savings that you can tap into to make the higher payments, how can you afford the monthly payments and the other expenses of your property?

If you can’t afford the highest-allowed payment on an ARM, don’t take one. You shouldn’t take the chance that the rate may not rise that high — it can, and you can lose the property.

Ask your lender to calculate the highest possible monthly payment that your loan allows. The number the lender comes up with is the payment that you face if the interest rate on your loan goes to the highest level allowed, or the lifetime cap. (For more on caps, see the “Future interest rate adjustments” section earlier in the chapter.)

Don’t take an adjustable mortgage because the lower initial interest rate allows you to afford the property that you want to buy (unless you’re absolutely certain that your income and property cash flow will enable you to meet future payment increases). Try setting your sights on a property that you can afford to buy with a fixed-rate mortgage.

Length of time you expect to keep the mortgage

Saving interest on most ARMs is usually a certainty in the first two or three years. An adjustable-rate mortgage starts at a lower interest rate than a fixed one. But, if rates rise, you can end up repaying the savings that you achieve in the early years of the mortgage.

If you aren’t going to keep your mortgage for more than five to seven years, you pay more interest to carry a fixed-rate mortgage. A mortgage lender takes extra risk in committing to a fixed-interest rate for 15 to 30 years. Lenders don’t know what may happen in the intervening years, so they charge you a premium in case interest rates move significantly higher in future years.

You may also consider a hybrid loan, which combines features of fixed- and adjustable-rate mortgages. For example, the initial rate may hold constant for three, five, seven, or ten years and then adjust once a year or every six months thereafter. Such loans may make sense for you if you foresee a high probability of keeping your loan seven to ten years or less but want some stability in your future monthly payments. The longer the initial rate stays locked in, the higher the interest rate. Don’t confuse these loans with the often-unadvisable balloon mortgage (which we discuss in the “Mortgages That Should Make You Think Twice” section later in the chapter).

Selecting short-term or long-term

Most mortgage lenders offer you the option of 15-year or 30-year mortgages. You can also find 10-year, 20-year, and 40-year options, but they’re unusual. Some lenders are even allowing you to select customized or other length amortization terms that allow you to personalize the number of years of your mortgage. Personalizing your mortgage may make sense if you have a specific goal in mind such as completing your mortgage payments before tackling college tuition bills or a retirement date. So how do you decide whether a shorter- or longer-term mortgage is best for your investment property purchase?

To afford the monthly payments and have a positive cash flow, many investment property buyers need to spread their mortgage loan payments over a longer period of time, and a 30-year mortgage is the way to do it. A 15-year mortgage has higher monthly payments because you pay it off quicker. At a fixed-rate mortgage interest rate of 7 percent, for example, a 15-year mortgage comes with payments that are about 35 percent higher than those for a 30-year mortgage.

Locking yourself into higher monthly payments with a 15-year mortgage may actually put you at greater financial risk. If your finances worsen or your property declines in value, odds are you’ll have trouble qualifying for a refinance. You may be able to refinance your way out of the predicament, but you can’t count on it.

Don’t consider a 15-year mortgage unless you’re sure that you can afford the higher payments that come with it. Even if you can afford these higher payments, taking the 15-year option isn’t necessarily better. You may be able to find better uses for the money. If you can earn a higher rate of return investing your extra cash versus paying the interest on your mortgage, for instance, you may come out ahead investing your money rather than paying down your mortgage faster. Some real estate investors, including Robert, are attracted to 15-year mortgages to get their loans paid off by or even before retirement age.

If you decide on a 30-year mortgage, you still maintain the flexibility to pay the mortgage off faster if you choose to. You can choose to make larger-than-necessary payments and create your own 15-year mortgage. However, you can fall back to making only the payments required on your 30-year schedule when the need arises. The only situation in which you can’t pay off your 30-year mortgage faster is if the loan has a prepayment penalty (a penalty for paying off your loan before you’re supposed to), which we dislike. Normally, prepayment penalties don’t apply if you pay off a loan because you sell the property, but when you refinance a loan with prepayment penalties, you typically have to pay the penalty.

Typically the interest rate will be lower for a 15-year loan than a 30-year loan, but if they’re the same or very close, then you gain the flexibility with a 30-year loan with no prepayment penalty at zero cost. You can then adjust your payments over the life of the loan to customize your loan to exactly the term you desire. (Robert did so years ago when he decided that he and his wife should pay off their primary residence mortgage in full within nine years because their oldest daughter was scheduled to graduate high school and had upcoming costly college tuition payments.)

Getting a Seller-Financed Loan

Not every seller needs or even wants to receive all cash as payment for his property, so you may be able to finance part or even all of an investment property purchase thanks to the property seller’s financing. The use of seller financing is the cornerstone of most no-money-down strategies.

Seller financing is a transaction in which the seller accepts anything less than all cash at closing. One form of an all-cash transaction to the seller is the buyer literally paying all cash, but typically it’s a transaction in which the buyer uses a conventional loan (money to purchase the property from a lender other than the seller) so that the seller effectively receives all cash at closing.

Some sellers are financially well off enough that they don’t need all of the sales proceeds immediately for their next purchase or are buying a property for less money — or maybe not buying a replacement property at all — and prefer to receive payments over time. They may be looking for the payments to replace their income in retirement or they may prefer to receive the funds over time so they can reduce their taxable income.

Any seller with equity can offer seller financing, but usually private individuals are the best sources. The best candidates for seller financing are sellers with significant equity or, best of all, folks who own their property free-and-clear (without any debt on the property at all). Many seniors have owned their properties for years and may be more willing to extend a loan.

Sometimes sellers offer this option, but in other cases, you need to pop the question. We can think of two good reasons to ask for the seller to help finance an investment property purchase:

Better terms: Mortgage lenders, which are typically banks or large monolithic financial institutions, aren’t the most flexible businesses in the world. You may well be able to obtain a lower interest rate, lower or waived fees, and more flexible repayment conditions from a property seller. There are also many expenses with conventional loans that a property seller may not require: loan points, origination fees, and an appraisal. Some sellers may not even require a loan application or credit report, but they’d be wise to go through due diligence (including a personal financial statement) on the buyer.
Loan approval: Perhaps you’ve had prior financial problems that have caused mortgage lenders to routinely deny your mortgage application. Some property sellers may be more flexible, especially in a slow real estate market or with a property that’s challenging to sell. A seller can also make a decision in a few days, whereas a conventional lender often takes weeks.

Be careful when considering a property where a seller is offering financing as part of the deal; this act may be a sign of a hard-to-sell property. Investigate how long the property has been on the market and what specific flaws and problems it may have.

Some of the reasons why sellers may offer their own financing include

They’re attracted to the potential returns of being a mortgage lender. This reason shouldn’t concern the buyer as long as the terms of the seller financing are reasonable and avoid the issues raised elsewhere in the chapter about balloon payment, and negative amortization or interest-only loans.
The seller has significant equity. This situation creates another win-win opportunity for both the buyer and seller to use seller financing.
The current financing has prepayment issues. This road can be a problem for the buyer; if the underlying financing has a due-on-sale clause and the lender becomes aware of the sale, it can demand the full payment of the outstanding loan balance on short notice. The seller is responsible for any prepayment penalties for their current financing when they pay it off.
They’re seeking a price that exceeds the normal conventional loan parameters, or the property doesn’t qualify for a conventional loan for some reason. Examples of qualification issues include a cracked slab, environmental issues (including drug manufacturing like methamphetamine), improvements done without permits, and so on. This scenario is risky for the buyer and may be an indication that they’re over-reaching or pursuing a property that’s not a good investment.

Be sure that your seller financing agreement is nonrecourse (as discussed later in the chapter) and doesn’t contain a due-on-sale clause prohibiting you from selling the property without paying off the loan in full. If the seller requires a due-on-sale clause, you have to pay off the full balance owed to the seller when you sell the property. Most sellers wisely ask for the due-on-sale clause so that the property can’t be sold to another owner.

Mortgages That Should Make You Think Twice

You may come across other loans such as balloon loans and interest-only mortgages. We also want you to know the potential risks associated with recourse loans and loan guarantees. The following section presents our thoughts on these options.

Balloon loans

One type of loan that is sometimes confused with a hybrid loan is a balloon loan. Balloon loans start off just like traditional fixed-rate mortgages. You make level payments based on a long-term payment schedule, over 15 or 30 years, for example. But at a predetermined time, usually three to ten years after the loan’s inception, the remaining loan balance becomes fully due.

Balloon loans may save you money because they have a lower interest rate than a longer-term fixed-rate mortgage. Sometimes, balloon loans may be the only option for the buyer (or so the buyer thinks). Buyers are more commonly backed into these loans during periods of high interest rates. When a buyer can’t afford the payments on a conventional mortgage and really wants a particular property, a seller may offer a balloon loan.

Balloon loans are dangerous for the simple reason that your financial situation can change, and you may not be able to refinance when your balloon loan is due. What if you lose your job or your income drops? What if the value of your property drops and the appraisal comes in too low to qualify you for a new loan? What if interest rates rise and you can’t qualify at the higher rate on a new loan? We recommend balloon loans only when the following conditions apply:

Such a loan is your sole financing option.
You’ve really done your homework to exhaust other financing options.
You’re certain that you can refinance when the balloon comes due.

If you take a balloon loan, get one with as much time as possible, preferably seven to ten years, before it becomes due.

Interest-only loans

In the early years of such mortgages, your monthly mortgage payment is used only to pay interest that is owed. Although this helps to keep your payments relatively low (because no money is going toward repaying principal), the downside is that you’re not making any headway to pay down your loan balance.

Usually, after a preset time period, such as five or seven years, your mortgage payment jumps substantially so that you can begin to pay down or amortize your loan balance. Our experience and observation has been that many people don’t really understand or investigate how this increased payment affects them, which is why we’ve long advised against taking these types of loans.

The main attraction that we see for interest-only mortgages for investment property purchases is that the low initial payments help you achieve more positive cash flow early on. Our concern, however, is seeing some property buyers attracted to interest-only loans to afford purchasing high-cost property that is difficult to realize positive cash flow from.

If the only way for you to invest in an income property is to use an interest-only loan, perhaps you shouldn’t invest. Investing in rental real estate is risky, and you can lose your entire investment if the market turns and you don’t have the staying power to ride through the real estate cycles. The margin of safety that you have with a decent down payment and an amortizing loan (where each payment reduces your loan balance) can be very positive if your rental property hits a rough patch.

If you consider an interest-only mortgage, be sure that you understand upfront exactly how high your payment will be after the loan moves out of the interest-only payment phase. And be sure that you’ve surveyed the mortgage marketplace and understand how the terms and conditions of interest-only loans stack up versus other types of mortgages.

Recourse financing

The goal of most real estate investors is to accumulate wealth over time while not taking any unreasonable risks. That’s why we discourage using interest-only loans or loans with balloon payments. But there is another factor to explore before agreeing to any loan: Is the loan nonrecourse or recourse?

Nonrecourse financing: In the event you fail to fulfill the terms of your loan, this type of loan limits the lender to only foreclosing on the underlying property. Foreclosure is the full and complete satisfaction of the loan, and the lender can’t seek a deficiency judgment or go after your other assets. Agreeing only to loans with nonrecourse financing is extremely important because you increase your overall net worth through real estate investing. You don’t want one bad investment to jeopardize your successful properties or, even worse, the equity in your primary residence or a business.
Recourse loans: These loans lower the lender’s risk because they offer additional protection. The lender has the legal right to seek a deficiency judgment against you personally or pursue other assets to cover any shortfall should the property value not fully cover the lender’s outstanding debt balance. Remember that after a loan is in default, the interest penalties and legal fees can add up quickly. If you’re already in default on the loan for your rental property, the last challenge you need is to have a lender looking to take your home or other viable rental properties to satisfy their deficiency judgment.

As long as you’re not too aggressive and don’t overleverage your rental properties, real estate investing can be relatively safe, and the chances are you won’t be faced with losing your property by defaulting on your loan. But there are limits to your ability to control all of the diverse factors that can affect your property. For example, your cash flow will definitely suffer if the major employer in your area suddenly leaves.

Nonrecourse financing has more stringent qualification standards, such as higher debt coverage ratios, and generally results in a lower loan amount. But just as with borrowers who utilize interest-only loans so that they can borrow as much money as possible, the closer you live to the edge, the more likely you’ll regret it.

Many of the loans you consider will be nonrecourse, but if you’re seeking financing for an unstabilized property (a property whose cash flow is uncertain due to vacancy or unusually high expenses) or a property requiring major renovation, you may find that lenders are willing to provide the funds you need only with a full recourse loan.

Typically you’re evaluating different loan proposals with either full recourse or full nonrecourse financing. But lenders can also offer a partial recourse loan. A partial recourse loan allows the lender to seek a deficiency judgment up to a certain limit if you default. Again, there may be great real estate investment options where such a loan makes sense, but be very careful before agreeing to such terms, and include the consequences to your overall financial status in a worst-case scenario in your overall analysis.

No matter what type of loan you use, we strongly recommend that you only use nonrecourse financing. You’ll sleep better at night!

Loan guarantees

Another way that lenders reduce their risk of a loan defaulting is requiring a loan guarantee. A loan guarantee is a promise by the guarantor (the person or entity subject to the loan guarantee and legally responsible for repayment of any shortfall) to assume the debt obligation of the borrower if the borrower defaults on the loan. Investment real estate is often purchased in the name of a legal entity that may not have other assets than the real property subject to the loan. In these instances, a personal loan guarantee will be required from an individual, which is usually the person that is the owner or one of the owners of the legal entity that owns the real property.

Particularly if the loan is nonrecourse, the lender will want a loan guarantee to be included. The loan guarantee can be limited or unlimited, which controls if the guarantor is responsible for some or all of the debt. You may have seen or heard about guarantors for leases, such as a parent serving as the guarantor of their child’s college apartment.

Financing Your Property Purchases