Flipping Fairfield Series: Vol. 2 "Financial Health & Loan Options"
This post is going to deal with things that most of us shy away from talking about, yet it’s an absolute must to examine when determining if we can take the leap into flipping properties: our financial health and the qualifications needed to purchase a flip. Along with answering the “Can we financially afford to start this type of a project” question, I hope to highlight where your money will most likely be going (or at least inform you about where our’s has gone/goes) once you’ve taken on this initial part of the investment.
*Full disclosure before we start this conversation- our relative had a significant amount of capital set aside and she knew that we had been interested in this venture for some time. One day, she approached us with the idea that we use the money to expand the business by adding on an “arm” dedicated to flipping and she has since become an investor- without her, none of this would have been possible at this stage in our lives.
With that said, whether you have one, many or no investors , you must have good credit! You may also need a large chunk of capital (that capital could be in the form of cash or stocks and bonds that can be quickly sold for cash). And though you don’t necessarily need to present an “all cash offer” to the sellers, like so many of those home improvement shows lead us to believe (and you don’t even need to have your own cash to make the improvements), you should at least have the ability to access cash when necessary. Below, I will further explain the different types of loans and mortgages available, but first you need to qualify for these loans. And that’s where that good credit comes into the picture. We have to remember that every penny spent is profit lost and if you go the route of obtaining a mortgage, but you can only qualify for one with a very high interest rate, or one where you have to pay many “points,” then your monthly costs are going to be higher. With any investment property with a mortgage, you will already be paying a higher than typical interest rate (assuming you do everything on the up and up- which you should if you don’t want things to bite you in the ass later). Therefore, before you get into flipping, or any sort of real estate investment, fix whatever you have to fix to bring that score up!
After considering your credit rating, the next thing to do is examine your overall financial ability to take on another home- this is much easier to do if you have an investor with cash or a nice nest egg that you're sitting on, but just remember that banks will need to see that you can make monthly payments on top of your current living expenses. This goes for loans that you may have to take out after the initial property purchase is made. Put it all on the table and budget in every little thing down to your monthly grocery costs and only add on a property if you can comfortably make all your ends meet times 2.
To acquire the flip, you have a couple loan options (remember, I am only referencing what we’ve learned while flipping in CT, so options in your own state may vary). You can apply for a typical mortgage, but in order to keep everything legal, you must disclose that this is a second property- and more specifically, an investment property-one that you will never use for yourself- this is important so that you can get the correct insurance coverage for the contractors and other professionals who will be working on site (I will go over liability, another major consideration, in a future post). Above, I’ve briefly mentioned that there is an interest difference in doing it this way, but let me break it down further… When applying for a mortgage that covers an investment property expect to pay at least one full percentage point higher than the going rates. If the current interest rates are 4.25% then your investment property’s mortgage will be 5.25%. Now, that may not seem like an awful lot, but when you do the calculations, it could be the difference of $200-$300 a month and you may have to hold the property up to a year-that’s an extra $2,400-$3,600 in interest. Now, this is why I initially said to get your credit and finances in order! If you don’t have a good rating and your personal finances are out of whack, then expect the banks to charge you an even higher initial interest rate. And when you add a full percent on top of an already high rate, you’ve already spent so much money on owning the property, that you may not see a return on your investment! But, if everything is in good shape, this is a pretty straightforward way to go about owning that next property. In this scenario, if you have an investor, they have a couple options as well. They can be considered a lender by the banks and therefore would not be on the mortgage or on the deed. Or the investor could apply for the mortgage with you and own a part of the property- this all depends on how involved the investor wants to be and how much risk they are willing to take on (again, liability will be in a future post).
A second type of loan that you could apply for is called a Construction Loan, or more specifically a Renovation Construction Loan. We looked into this because others in the industry had made it seem like an intriguing choice, but after speaking to a lender in great detail about what this type of loan involved, we decided it really wasn’t that attractive to us (but that’s because we had a lump sum in the bank and our own timelines and plans with trusted crews). With this type of loan, the banks become more involved in the construction planning and project management side of the process. They require you to have all the written bids (for everything!) before the home is owned- smart!- but instead of paying out a lump sum for the home at closing, the bank will pay installments directly to the contractors/tradesmen at specific times during construction. They will also have someone perform routine inspections to determine if the project is moving along at the projected pace (since I haven’t used this type of loan, I can’t be perfectly sure, but I imagine that if the project is not moving along according to the projected timeline then the bank will withhold payments). The upside of this type of loan is that you don’t have to pay any principal until all phases of the project are complete. Therefore you’ll only be paying interest, and those payments don’t begin until construction begins. Also, with a construction loan, the lender will be sure that you have a contingency in place for unassumed costs that may arise during any stage of the renovation.
Sounds intriguing right!? Well, there are some drawbacks…Number one, these loans aren’t that easy to qualify for and once you do, the interest rates are actually much higher than your typical mortgage rates (even after the 1% additional cost that I discussed above). Anyone with a current mortgage probably notices that most of your monthly payment initially goes towards paying the interest, not the principle, so if your plan is to get in and out in a year or less, then paying down principle isn’t your objective anyways. And if your interest rate is higher then so are those overall monthly payments. Additionally, you still need to go through all the same steps to qualify for this type of loan that you’d need in order to qualify for a typical mortgage- plus expect to put at least 20% or more down (we always choose to put 20% down by the way, even though it’s not necessary in our case).
So, the upside to a construction loan is that every penny is accounted for and that you can feel pretty confident knowing that what you initially planned to pay for the renovation is what you will pay for-it also helps to guarantee that the timeline is adhered to. But, what if, for the sake of saving money, you end up going with a regular mortgage, and feel confident in your own project management skills, yet you know that towards the middle or end of the project you’ll need to access more cash than what you currently have? Well, you can always ask your investor, but chances are they will have set aside an amount that you can draw from and that’s it!
The next thing to consider then would be a home equity line of credit. In this circumstance, a bank will determine the value of your property (by this point, you’ve hopefully improved it enough to already increase the value) and will lend you a set amount based on what they believe the home is worth. If you cannot do this for your investment property, consider taking one out on your 1st home. The great thing about home equity lines of credit is that you can set terms so that you can hold that line of credit, but you aren’t charged for any of it until you use an amount. For example, if we were given 100k of credit, and don’t use it for 6 months, we pay back nothing in those 6 months. If we use, 20k of that 100k, we only start paying interest and principle on that 20k etc. It’s very much like a credit card.
As you can see there are options out there, but not quite as many as you’d think. And therefore, if you plan to make this a business, just be sure you’re absolutely positive this is the right move for you. In my opinion, what we’ve talked about today is the most tedious part of home ownership, and you will be doing this every single time you look to buy a new property!
Have I bombarded you with enough information? I was going to get into the breakdown of closing costs and construction fees, but to save you from absolute boredom, I think it’s best to wait until the next post!
I welcome all comments and questions- and if I there are any tips or techniques that I haven’t thought of, send them my way! I will happily amend the blog to get as much information out there!
As always- Love and Creativity,