Your Borrowing Strategy in Foreclosure Investing
Plan your borrowing strategy before contacting your bank or financial institution
Funny Thing in Finance: Lenders like to give money to those who don't need it. You don't simply get it if you desperately need it. Moral of the story: Arrange financing when you don't need it. You look like a person with long-term plans!
Why do you need financing?
You need financing for two purposes:
- To buy foreclosure property
- To fix foreclosure property
You may get a regular home mortgage loan to buy foreclosure property and get a second mortgage loan for foreclosure repair. Your lender may want to cover both.
You start with estimating foreclosure fixerupper repair costs. For HUD-owned properties, HUD informs buyers in its announcements of the allowance it designated for fixing up the property.
Good News! You are buying a fixer-upper or foreclosure property and paying a price well below the market price. If you plan to sell the property after you fix it up, then you will be able to obtain financing at the market value. This leaves you a nice portion of the loan that you can use as working capital to build up your business.
Your borrowing strategy in buying pre-foreclosures and foreclosure homes
- If you will flip it, minimize your loan closing costs and points at the expense of a higher interest rate. You will not pay interest too long anyway!
- If you will hold the foreclosure property (let's say, for at least five years), obtain the lowest interest rate loan at the expense of higher loan closing costs and points. So, you will base your plan on whether you hold or flip foreclosure property.
You can amortize such tax-deductible expenses over the years. The lifetime cost of the loan is more important than one-time costs.
Some differences in lending
- Institutional lenders have higher borrowing or loan closing costs than private lenders.
- Qualification procedures of institutional lenders are tougher than private lenders.
- Interest rates of institutional lenders may be lower to compensate for the above disadvantages.
Obtain financing directly from lenders rather than mortgage brokers. There are institutions that deal with mortgage banking and banks also extending mortgage loans.
Mortgage brokers, on the other hand, find one of these lenders for you, probably costing you a little bit extra for their intermediary services. If you do not have much time to shop around for the lowest-cost mortgage loan, then mortgage brokers can find you a low-cost lender and justify their markup.
How much do you need to buy a foreclosure property?
First, calculate how much you can afford. Here's some help in figuring it out:
You need cash for the following:
- Down payment
- Cost of materials that you need to fix up the home
- Fees that you need to pay for a handyman or professional, if you need one.
- Closing costs
- Mortgage payments if you decide to keep the property to live in or lease out
- Insurance and annual property taxes
- Of course, you don't need the whole amount at the beginning.
Types of mortgage lending
Federal Housing Administration (FHA) & Department of Veterans Affairs (VA) Mortgages: These government agencies do not directly deal with you. They provide insurance and guarantees for loans extended by HUD-approved lenders. However, you need to qualify for their mortgage loan programs to get a low down payment. HUD/FHA and VA own many fixer-upper foreclosures. You can get loans from lenders insured or guaranteed by them for your fixer-upper purchases. FHA loans have maximum mortgage limits.
For a listing of HUD-approved lenders in your state:
U.S. Department of Housing and Urban Development (HUD)
Conventional mortgage: lender provides funds without government agency backing
- Adjustable/Variable Rate Mortgage (ARM): Interest rate is indexed to one of the well-known interest rates (prime rate or LIBOR) with or without a margin. There are annual and lifetime caps on the maximum interest rate.
- Graduated Payment Mortgage: Lower monthly installments in the beginning, increasing monthly payments later on.
- Assumption: You will be able to afford to pay higher monthly payments as a result of your increased income in the future. Some of these loans are called "balloon" loans.
- Blanket Mortgage: Your loan covers more than one property. Your equity in these properties also serves as collateral.
- Shared Appreciation Mortgage: Lender applies lower interest but shares its portion of appreciation in the value of the property it finances. Only private lenders can do this.
Conventional lending/borrowing
You need to know what lenders are looking for so that you can improve such factors to qualify better. Here are some major criteria:
- Your overall annual income and its source
- Your employment history
- How long you have been at your current job
- Your monthly installments on credit cards, car loans, and any other regular monthly payments.
- Collateral that you provide (real estate property in our case)
The starting point in conventional lending is your PITI (Principal, Interest, Taxes and Insurance). In general, your monthly PITI should not exceed 28 percent of your monthly gross income to qualify for a mortgage loan. This is almost industry standard in real estate financing. They give you an extra 6 percent for other monthly payments, making it 34 percent for all your monthly payments including PITI.
Lenders and their underwriters look at debt coverage ratio (DCR) to assess your payment capacity.
NOI (Net Operating Income)
DCR = ----------------------------------
Debt service
Debt service = Repayment of principal amount and interest
In general, DRC must be higher than 1.3.
How do you compare different loan terms?
Take into account the following costs:
Interest rate (APR = Annual Percentage Rate)
- Fixed
- Variable: Margin + Annual and life-time caps (Type of index)
- Points to be paid (from 1 to 4 points. One point is one percent of the loan)
- Maturity (15 to 30 years)
- Loan-to-value ratio ((related to percentage of down payment)
- Loan initiation fee
- Pre-payment penalty
- Appraisal fee
- Assumable? Non-assumable?
Your loan application file
Your lender will give you a loan application form and a few other forms to fill out. Create a positive image by preparing the following in advance:
- Your business plan (your budget and profit expectation in home purchase, foreclosure investing, or fixer-upper business).
- Your short resume.
- Photographs, specifications and sales literature of the property that you want to purchase. If you are applying for a line of credit, then, include characteristics of the property that you are interested in.
- Copy of your credit report, if you already have one.
- Two years of IRS Form 1040.