Financing Real Estate Investments For Dummies

Ralph R. Roberts

Real estate professional and coauthor of

Foreclosure Investing For Dummies

Chip Cummings

Real estate financing expert and author

• Evaluate potential lenders

• Maximize your cash flow

• Finance through private lenders

• Tap into government programs

Learn to:

Financing Real Estate

Investments

Making Everything Easier!

™

Open the book and find:

• Real-world advice on financing

without tying up all your capital

• How to get prequalified or

preapproved for a loan

• Questions to ask your lender

upfront

• Ways to avoid common beginner

blunders

• How to protect your personal

assets from investment risks

• Bargain-hunting hints for

low-cost loans

• Strategies for surviving a credit

crunch

• Ten pre-closing steps you must

take

Ralph R. Roberts is an internationally acclaimed real

estate agent, speaker, investor, and consultant. Chip

Cummings is a real estate lending expert, a Certified

Mortgage Consultant with more than 25 years of

experience, and a seasoned real estate investor. Roberts

and Cummings coauthored Mortgage Myths: 77 Secrets

That Will Save You Thousands on Home Financing.

$21.99 US / $25.99 CN / £15.99 UK

ISBN 978-0-470-42233-5

Business/Real Estate

Go to dummies.com

for more!

Want to be a smart, successful real estate investor?

This no-nonsense guide contains everything

you must know to make the right choices about

financing your investments — from the various

options available and the impact on cash flow to

the tax implications and risk factors involved. You

also get tried-and-true tips for surviving a down

market and using current investments to finance

future ones.

• A crash course in real estate financing —

understand standard terms and concepts, learn the

various sources of investment capital, and gather

all essential facts and figures

• Weigh your options — decide which type of

ancing is best for your circumstances and

incorporate it into your real estate investing plan

• Finance residential properties — evaluate

idential loan programs, navigate the loan

application and processing, and handle the closing

• Invest in commercial properties — know the

ferent property types, choose the one that meets

your investment goals, and discover unique sources

for financing

• Tap into unconventional sources — discover the

s and cons of “hard money,” capitalize on seller

financing, partner to share risk and equity, and

invest on the cheap with no-money-down deals

Your practical guide to

scoring cash to fuel your

real estate investments

Financing Real Estate Investments

Roberts

Cummings

Spine: .576 in

02_422335-ftoc.qxp 3/11/09 11:50 AM Page viii

Financing Real Estate

Investments

FOR

DUMmIES

‰

by Ralph R.Roberts and

Chip Cummings with Joe Kraynak

01_422335-ffirs.qxp 3/11/09 11:49 AM Page i

Financing Real Estate Investments For Dummies

Published by

Wiley Publishing, Inc.

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Published simultaneously in Canada

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01_422335-ffirs.qxp 3/11/09 11:49 AM Page ii

About the Authors

Ralph R. Roberts, CRS, GRI, is a seasoned professional in all areas

of real estate, including buying and selling homes, investing in real

estate, and building and managing real estate agent teams. He has

been profiled by the Associated Press, CNN, and

Time magazine,

and has done hundreds of radio interviews. He has authored and

coauthored several successful titles, including

Flipping Houses For

Dummies, Foreclosure Investing For Dummies, Foreclosure Self-Defense

For Dummies, Mortgage Myths: 77 Secrets That Will Save You Thousands

on Home Financing, and Foreclosure Myths: 77 Secrets to Saving

Thousands on Distressed Properties!

(John Wiley & Sons); Protect

Yourself Against Real Estate and Mortgage Fraud: Preserving the

American Dream of Homeownership

(Kaplan); and REAL WEALTH by

Investing in REAL ESTATE

(Prentice Hall).

To find out more about Ralph Roberts and what he can offer you

and your organization as a speaker and coach, visit

AboutRalph.com.

For details on how to protect yourself and your home from real

estate and mortgage fraud, check out Ralph’s blog at

Flipping

Frenzy.com

. And don’t miss the latest addition to Ralph’s family of

Web sites and blogs,

GetFlipping.com, where Ralph offers addi-

tional information and tips on the art of flipping houses and invest-

ing in foreclosures and pre-foreclosures. You can contact Ralph by

emailing him at

RalphRoberts@RalphRoberts.com or calling

586-751-0000.

Chip Cummings, CMC, is a recognized expert in the areas of real

estate lending and e-Marketing, and is a Certified Mortgage

Consultant with more than 25 years in the mortgage industry and

more than a billion dollars in sales volume.

Chip has written hundreds of articles and appeared numerous times

on radio, television, and in various magazines including

Entrepreneur,

Mortgage Originator, Real Estate Banker/Broker, and The Mortgage

Press

. He is an experienced professional in all areas of real estate

financing, including residential and commercial mortgages, govern-

ment lending, regulatory and compliance issues. He is past president

of the MMBA (Michigan Mortgage Brokers Association), and is a

licensed mortgage broker and lender in Michigan.

As an international speaker, he has addressed groups and organiza-

tions of all types, and trains thousands of mortgage professionals

from around the country every year. Chip is a certified national

trainer for continuing education in more than 40 states, and has

served as an expert witness in state and federal courts. He is also

the author of

ABC’s of FHA Lending and Stop Selling and Start

Listening! – Marketing Strategies That Create Top Producers

(Northwind), Mortgage Myths: 77 Secrets That Will Save You

Thousands on Home Financing

, Foreclosure Myths: 77 Secrets to

Saving Thousands on Distressed Properties!

and Cashing In on Pre-

foreclosures and Short Sales

(John Wiley & Sons).

01_422335-ffirs.qxp 3/11/09 11:49 AM Page iii

Chip lives in Rockford, Michigan with his wife Lisa and three chil-

dren, Katelyn, CJ, and Joe.

To learn more about Chip Cummings, his many successful products

or how he can help your organization as a speaker or business con-

sultant, visit

www.ChipCummings.com. To receive a complimen-

tary subscription to his multimedia e-newsletter and online events,

check out

www.eCoachingClub.com. You can also reach Chip by

emailing him at

info@ChipCummings.com or by calling

616-977-7900.

Joe Kraynak (joekraynak.com) is a freelance author who has

written and coauthored numerous books on topics ranging from

slam poetry to computer basics. Joe teamed up with Dr. Candida

Fink to write his first book in the

For Dummies series, Bipolar

Disorder For Dummies,

where he showcased his talent for translat-

ing the complexities of a topic into plain-spoken practical advice.

He then teamed up with Roberts to write the ultimate guide to flip-

ping houses —

Flipping Houses For Dummies and delivered encore

performances in

Foreclosure Investing For Dummies, Advanced

Selling For Dummies

, and Foreclosure Self-Defense For Dummies. In

Financing Real Estate Investments For Dummies, Joe assists Chip and

Ralph in delivering the ultimate guide to scoring some cash to fuel

your investments in real estate.

01_422335-ffirs.qxp 3/11/09 11:49 AM Page iv

Dedication

From Ralph: To real estate investors and professionals who are

dedicated to supporting and promoting the American dream of

homeownership.

From Chip: To my assistant Debbie Forth who has managed to keep

me organized for the last 14 years, and to my wife Lisa who puts up

with all the crazy hours and remains my #1 fan.

Authors’ Acknowledgments

Thanks to acquisitions editor Lindsay Lefevere, who chose us to

author this book and guided us through the tough part of getting

started and to our agent, Neil Salkind of StudioB (

www.StudioB.com),

who ironed out all the preliminary details to make this book possible.

Chad Sievers, our project editor, deserves a loud cheer for acting as a

very patient collaborator and gifted editor — shuffling chapters back

and forth, shepherding the text through production, making sure any

technical issues were properly resolved, and serving as the unofficial

quality control manager. Megan Knoll, our copy editor, earns an editor

of the year award for ferreting out our typos, misspellings, grammatical

errors, and other language faux pas-es, in addition to assisting Chad as

reader advocate — asking the questions we should have asked our-

selves. And, we tip our hats to the production crew for doing such an

outstanding job of transforming a loose collection of text and illustra-

tions into such an attractive bound book.

We also wish to express our appreciation to the National Association

of Mortgage Brokers, National Association of Realtors

, the Mortgage

Bankers Association of America, and the Michigan Mortgage Brokers

Association for their support and assistance.

We owe special thanks to our technical editor, Patrick Lecomte, for

flagging technical errors in the manuscript, helping guide its con-

tent, and offering his own tips, tricks, and insights from the world of

real estate financing.

01_422335-ffirs.qxp 3/11/09 11:49 AM Page v

Publisher’s Acknowledgments

We’re proud of this book; please send us your comments through our Dummies online regis-

tration form located at http://dummies.custhelp.com. For other comments, please con-

tact our Customer Care Department within the U.S. at 877-762-2974, outside the U.S. at

317-572-3993, or fax 317-572-4002.

Some of the people who helped bring this book to market include the following:

Acquisitions, Editorial, and

Media Development

Project Editor: Chad R. Sievers

Acquisitions Editor: Lindsay Lefevere

Copy Editor: Megan Knoll

Assistant Editor: Erin Calligan Mooney

Editorial Program Coordinator: Joe Niesen

Technical Editor: Patrick Lecomte, MA, MBA

Editorial Manager: Michelle Hacker

Editorial Assistant: Jennette ElNaggar

Cover Photos: © Comstock Images

Cartoons: Rich Tennant

(www.the5thwave.com)

Composition Services

Project Coordinator: Patrick Redmond

Layout and Graphics: Melanee Habig,

Melissa K. Jester, Christine Williams

Proofreader: ConText Editorial

Services, Inc.

Indexer: Potomac Indexing, LLC

Publishing and Editorial for Consumer Dummies

Diane Graves Steele, Vice President and Publisher, Consumer Dummies

Kristin Ferguson-Wagstaffe, Product Development Director, Consumer Dummies

Ensley Eikenburg, Associate Publisher, Travel

Kelly Regan, Editorial Director, Travel

Publishing for Technology Dummies

Andy Cummings, Vice President and Publisher, Dummies Technology/General User

Composition Services

Gerry Fahey, Vice President of Production Services

Debbie Stailey, Director of Composition Services

01_422335-ffirs.qxp 3/11/09 11:49 AM Page vi

Contents at a Glance

Introduction.......................................................1

Part I: Gearing Up for Financing

Your Real Estate Investments..............................7

Chapter 1: Taking a Crash Course in Real

Estate Investment Financing ..............................................................9

Chapter 2: Shielding Your Personal Assets from Investment Risks...25

Chapter 3: Gathering Essential Documents, Facts, and Figures.........43

Chapter 4: Scoping Out Prospective Lenders.......................................61

Part II: Financing the Purchase

of Residential Properties..................................77

Chapter 5: Finding the Residential Loan Program

That’s Right for You ...........................................................................79

Chapter 6: Bargain Hunting for Low-Cost Loans ..................................93

Chapter 7: Navigating the Loan Application and Processing ...........105

Part III: Financing the Purchase

of Commercial Properties................................127

Chapter 8: Picking the Right Commercial Property Type for You....129

Chapter 9: Exploring Sources of Financing

for Commercial Properties .............................................................149

Chapter 10: Securing a Loan to Finance

Your Commercial Venture...............................................................163

Part IV: Sampling More Creative

Financing Strategies ......................................173

Chapter 11: Financing in a Pinch with Hard Money

and Other Tough Options ...............................................................175

Chapter 12: Capitalizing on Seller Financing ......................................193

Chapter 13: Partnering to Share the Risk and the Equity .................207

Chapter 14: Profiting from No-Money-Down

and Other Creative Deals................................................................219

Part V: The Part of Tens..................................231

Chapter 15: Ten Ways to Avoid Common Beginner Blunders...........233

Chapter 16: Ten Steps to Take before Closing....................................239

Chapter 17: Ten Tips for Surviving a Credit Crunch..........................245

Glossary........................................................251

Index.............................................................261

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Table of Contents

Introduction .......................................................1

About This Book .........................................................................1

Conventions Used in This Book................................................2

What You’re Not to Read............................................................3

Foolish Assumptions ..................................................................3

How This Book Is Organized......................................................3

Part I: Gearing Up for Financing

Your Real Estate Investments......................................4

Part II: Financing the Purchase

of Residential Properties .............................................4

Part III: Financing the Purchase

of Commercial Properties............................................4

Part IV: Sampling More Creative

Financing Strategies .....................................................4

Part V: The Part of Tens...................................................5

Icons Used in This Book.............................................................5

Where to Go From Here..............................................................5

Part I: Gearing Up for Financing

Your Real Estate Investments...............................7

Chapter 1: Taking a Crash Course in Real Estate

Investment Financing . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

Pumping Up Your Purchasing Power with Borrowed Money ...10

Minimizing your potential by owning

property free and clear ..............................................10

Maximizing your potential with

other people’s money.................................................10

Paying cash with borrowed money..............................11

Brushing Up on Basic Real Estate Financing Lingo ..............12

Identifying types of lenders...........................................12

Grasping different loan types........................................13

Brushing up on important legal lingo ..........................14

Pointing out mortgage concepts ..................................16

Examining equity ............................................................16

Looking at loan-to-value (LTV)......................................17

Distinguishing Investment and Home Financing...................17

Paying a premium for riskier investment loans..........17

Using quick cash to snag bargain prices .....................18

Accounting for taxes on your capital gains

(or losses)....................................................................18

Protecting your personal assets...................................19

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Exploring Common Sources of Investment Capital..............19

Tapping your own cash reserves..................................20

Borrowing from commercial lenders ...........................21

Obtaining a hard money loan........................................22

Financing your purchase through the seller...............22

Taking on a partner ........................................................22

Prepping to Meet with a Lender..............................................23

Gathering paperwork and other info ...........................23

Crafting a business plan.................................................24

Chapter 2: Shielding Your Personal

Assets from Investment Risks . . . . . . . . . . . . . . . . . . . 25

Understanding Why You Need to

Protect Your Personal Assets..............................................26

Limiting Your Personal Liability by Forming an LLC............26

Understanding the pros and cons................................27

Setting up an LLC............................................................28

Taking and securing title to real estate........................28

Eyeing Sub-S corporations and partnerships .............29

Transferring Personal Assets via Trusts................................30

Weighing the pros and cons of owning property

in another’s name .......................................................31

Gaining asset and tax protection

with an irrevocable trust ...........................................32

Considering real estate investment trusts (REITs) ....33

Staying Away from Promissory Notes

with Recourse Clauses .........................................................33

Opting for a nonrecourse loan......................................34

Negotiating the recourse clause...................................34

Avoiding cross-collateralization ...................................35

Steering Clear of Real Estate and Mortgage Fraud ...............36

Telling the truth on your application...........................37

Dodging predatory lenders ...........................................38

Saying “no” to inflated appraisals ................................39

Turning your back on cash-back-at-closing

schemes .......................................................................40

Avoiding illegal flipping..................................................40

Defending yourself against chunking schemes...........41

Refusing a builder bailout..............................................41

Acting with integrity: The golden rule .........................42

Chapter 3: Gathering Essential Documents,

Facts, and Figures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43

Examining Your Credit Reports...............................................43

Obtaining free copies of your reports..........................44

Checking your credit score ...........................................45

Inspecting your report for problems ...........................46

Financing Real Estate Investments For Dummies

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Repairing your credit and boosting your score..........47

Avoiding mistakes that can sabotage

your loan approval...................................................................48

Chasing Down Vital Paperwork...............................................49

Delving into your personal financial information.......49

Accounting for business income ..................................53

Documenting the property you plan to purchase......54

Show Me the Money: Identifying Sources of Ready Cash....59

Sources of cash for down payments,

closing costs, and prepaid items..............................59

Rainy day funds: Cash reserves....................................60

Getting Prequalified or Preapproved......................................60

Chapter 4: Scoping Out Prospective Lenders . . . . . . . . 61

Borrowing Directly from Banks...............................................61

Weighing the pros and cons..........................................62

Conventional loans.........................................................64

Subprime (nonconforming) loans ................................65

Dealing with a Middleman (or Woman): Mortgage Brokers ...66

Weighing the pros and cons..........................................67

Shaking the branches for a broker...............................68

Checking a broker’s credentials....................................68

Taking the Hard-Money Route through Private Lenders .....70

Borrowing from Uncle Sam: Government Loan Programs ......72

Financing through the Seller ...................................................73

Lease options ..................................................................73

Land contracts................................................................74

Teaming Up with a Cash-Heavy Partner.................................74

Opting for a limited partnership...................................75

Going the corporation route .........................................76

Part II: Financing the Purchase

of Residential Properties ...................................77

Chapter 5: Finding the Residential Loan

Program That’s Right for You . . . . . . . . . . . . . . . . . . . . 79

Understanding Why Finding the Right

Residential Loan Is Key ........................................................79

Choosing a Loan Type to Maximize Your Cash Flow............80

The power of OPM (other people’s money)................81

Interest-only mortgages.................................................82

Grabbing a hold of ARMs...............................................83

Hybrids.............................................................................85

Hard-money loans: Private investors...........................85

Taking Advantage of Government-Secured Loans................86

Tapping the FHA for a loan............................................86

Viewing Veterans Affairs (VA) loans.............................89

Table of Contents

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Financing Real Estate Investments For Dummies

xii

Considering REO loans ..................................................89

Tapping into state and local grants and loans............90

Digging up USDA Rural Development loans ................92

Avoiding the Prepayment Penalty Trap .................................92

Chapter 6: Bargain Hunting for Low-Cost Loans. . . . . . 93

Understanding How This Interest Thing Works....................93

Keeping simple with simple interest............................94

Grasping the concept of amortization .........................94

Telling the difference between the

interest rate and APR ................................................96

Exploring how adjustable rate mortgages work.........97

Paying interest upfront with points .............................98

Considering the Mortgage Term .............................................99

Accounting for Closing Costs ................................................100

Getting socked with origination fees .........................100

Forking over other fees................................................100

Examining the Good Faith Estimate ...........................102

Calculating a Loan’s Total Cost.............................................103

Chapter 7: Navigating the Loan Application

and Processing. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105

Completing Your Loan Application.......................................105

Walking through the parts of the loan application...106

Reviewing the lender’s disclosures............................108

Supplying the requested documentation ..................111

Signing a release of information .................................112

Following the Loan Processing Trail ....................................112

Getting up to speed on the underwriting process ...113

Obtaining an appraisal or AVM...................................113

Having the property inspected...................................114

Obtaining a survey .......................................................119

Navigating the Closing............................................................120

Keeping your attorney in the loop .............................120

Dealing with the preliminaries....................................120

Signing the documents.................................................122

Knowing your right of rescission . . . or lack thereof ...122

Dealing with surprises .................................................123

Financing Other Types of Residential Properties...............124

Digging up money for vacation properties................124

Financing investment properties................................125

Purchasing vacant land................................................126

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Table of Contents

xiii

Part III: Financing the Purchase

of Commercial Properties.................................127

Chapter 8: Picking the Right Commercial

Property Type for You. . . . . . . . . . . . . . . . . . . . . . . . . . 129

Estimating the Income Potential

of a Commercial Property..................................................130

Calculating effective gross income (EGI)...................130

Calculating Net Operating Income (NOI)...................131

Estimating the property’s true value .........................132

Projecting future profits with a pro forma ................133

Dwelling On the Thought of Multifamily Homes.................134

Two- to four-family homes...........................................135

Garden apartments.......................................................136

Large multifamily properties.......................................136

Crunching the numbers...............................................138

Buying and Renting Out Office Space:

The A-to-D Grading Scale ...................................................139

Investing in Retail Real Estate ...............................................140

Collecting your cut of gross sales...............................141

Comparing strip malls and convenience stores .......142

Running Your Own Hotel or Motel........................................142

Distinguishing between flagged

and unflagged properties.........................................143

Encountering income challenges................................144

Checking Out Industrial or Warehouse Properties.............145

Calculating income and costs .....................................145

Considering storage facilities......................................146

Exploring Mixed-Use Properties ...........................................146

Sampling Some Special Use Properties................................146

Restaurants and bars ...................................................147

Gas stations...................................................................148

Adult foster care...........................................................148

Chapter 9: Exploring Sources of Financing

for Commercial Properties . . . . . . . . . . . . . . . . . . . . . 149

Sizing Up Various Commercial Loan Programs...................150

Exploring the middle market (local

and national banks)..................................................150

Hitting up the private sector:

Hard-money lenders.................................................151

Financing Main Street property

with Wall Street money ............................................152

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Financing Real Estate Investments For Dummies

xiv

Pursuing Government Loans.................................................153

Financing housing and medical facilities

through FHA loans....................................................153

Tapping into economic development

funds and grants .......................................................154

Securing a loan through the SBA................................154

Harvesting investment capital through the USDA....156

Getting a hold of a CDBG .............................................157

Deconstructing Construction Loans ....................................158

Financing Fixes with Rehabilitation Loans ..........................158

Exploring Other Creative Financing Options ......................159

Borrowing from pension programs

and life insurance companies..................................159

Enlisting the services of venture capitalists .............160

Sharing the costs and the equity................................161

Participating in participation loans ...........................161

Taking on a partner ......................................................162

Considering other potential sources of capital ........162

Chapter 10: Securing a Loan to Finance

Your Commercial Venture. . . . . . . . . . . . . . . . . . . . . . 163

Deciphering the Broker-Borrower Agreement ....................163

Accounting for Upfront Fees .................................................165

Obtaining Third-Party Reports..............................................167

Verifying a property’s market value

with an appraisal ......................................................167

Plotting the perimeter with a survey .........................168

Inspecting the title........................................................168

Obtaining an engineering report ................................169

Getting a clean bill of environmental health.............169

Navigating the Closing............................................................170

Protecting yourself with title insurance ....................170

Insuring your property ................................................171

Attending to existing tenant rights.............................172

Part IV: Sampling More Creative

Financing Strategies .......................................173

Chapter 11: Financing in a Pinch with Hard

Money and Other Tough Options . . . . . . . . . . . . . . . . 175

Weighing the Pros and Cons of Hard Money .......................176

Perusing the pros..........................................................176

Considering the cons ...................................................177

Managing the Expense of a Hard-Money Loan....................179

Calculating points.........................................................179

Adding up the interest .................................................180

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Table of Contents

Subtracting the tax savings.........................................180

Paying back the loan sooner to save money.............181

Locating Local Hard-Money Lenders....................................183

Asking your broker for leads.......................................183

Networking through local investment groups ..........183

Perusing ads in local newspapers ..............................184

Searching the Web ........................................................184

Getting preapproval .....................................................185

Hitting Up Friends and Relatives for a Loan........................185

Grasping the pros and cons ........................................186

Identifying the moneybags in your circle..................187

Drawing up an agreement............................................187

Honoring securities laws .............................................189

Financing Fix-Ups with a Home

Equity Loan or Line of Credit ............................................189

Understanding home equity loans and LOCs ...........190

Maxing out your LOC ...................................................190

Applying for an LOC .....................................................191

Supplementing Your Financing with Credit Cards..............191

Eyeing the pros to credit card use .............................191

Choosing a credit card with low

interest and plenty of perks ....................................192

Chapter 12: Capitalizing on Seller Financing . . . . . . . 193

Buying Property on Contract with a Land Contract...........193

The ups and downs of buying

a property on contract.............................................194

Inspecting the title........................................................195

Beware of the due on sale clause ...............................197

The how-to: What you need to do ..............................197

Protecting yourself against fraud ...............................199

Renting to Own with a Lease Option Agreement................199

Grasping the fundamentals of a

lease option agreement............................................201

Using the lease to earn some cash.............................202

Dealing with the option................................................203

Paying Close Attention to the Forfeiture Clause.................206

Chapter 13: Partnering to Share the Risk

and the Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 207

Differentiating between a Partnership

and a Joint Venture .............................................................207

Weighing the Pros and Cons of Partnerships......................208

Finding a Partner with the Right Stuff ..................................210

Scoping out prospective partners..............................211

Checking a prospective partner’s qualifications......212

Making sure your partner has what you need

and needs what you have ........................................213

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xvi

Drawing Up a Partnership Agreement..................................214

Drafting the agreement ................................................215

Complying with the tax code ......................................217

Avoiding Common Pitfalls......................................................217

Chapter 14: Profiting from No-Money-Down

and Other Creative Deals . . . . . . . . . . . . . . . . . . . . . . 219

Financing Your Down Payment with a Second Mortgage ...220

Taking out an 80-20 loan ..............................................220

Disclosing your second mortgage ..............................221

Wholesaling for Fun and Profit..............................................221

Buying and selling options ..........................................222

Assigning a purchase agreement................................224

Selling the Tax Benefits ..........................................................226

Trading Spaces: 1031 Exchanges ..........................................226

Qualifying for a 1031 exchange ...................................228

Meeting the deadlines..................................................229

Selling Other Equitable Interests ..........................................229

Leaseholds and other rights .......................................229

Naming rights, air rights, and

other unimaginable stuff..........................................230

Part V: The Part of Tens...................................231

Chapter 15: Ten Ways to Avoid Common

Beginner Blunders. . . . . . . . . . . . . . . . . . . . . . . . . . . . 233

Focusing on More than Just a Low Interest Rate................233

Getting Preapproved ..............................................................234

Doing Your Homework: Property Research.........................234

Making a Reasonable Down Payment...................................235

Comparing at Least Three Good Faith Estimates...............236

Viewing at Least Ten Properties before Making an Offer...236

Checking Your Credit Score before Applying for a Loan ...237

Buying with Your Brain and Not Your Heart........................237

Monitoring the Pulse of Current Market Conditions..........238

Calculating the NOI and DSCR

on Commercial Properties .................................................238

Chapter 16: Ten Steps to Take before Closing . . . . . . . 239

Get and Review a Copy of the Appraisal..............................239

Review the Title Commitment

and Obtain Title Insurance ................................................240

Review All Closing Documents..............................................241

Review a Copy of the HUD-1 Closing Statement .................241

Get an Insurance Policy .........................................................242

Do a Walk-Through on the Property.....................................242

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Obtain Utility Final Readings and Schedule

the Transfer .........................................................................243

Review Updated Tenant Rent Roll ........................................243

Have Certified Funds or Wire Transfer Ready to Go..........244

Confirm Date, Time, and Location of Closing......................244

Chapter 17: Ten Tips for Surviving

a Credit Crunch. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 245

Expand Your Search................................................................245

Choose Properties More Carefully........................................246

Focus on Foreclosures ...........................................................246

Look for Short-Sale Opportunities........................................247

Buy REO Properties................................................................247

Search for High-Equity Properties ........................................248

Shift from a Buy-Sell to a Buy-Hold Strategy .......................248

Team Up with Your Mortgage Broker...................................249

Offer Your Agent a Bonus.......................................................249

Partner Up and Get Creative .................................................250

Glossary.........................................................251

Index .............................................................261

Table of Contents

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Introduction

eal estate investing is an expensive habit. You need money to

finance the purchase, renovate your fixer-upper, and cover

the holding costs while you prepare to sell or rent the property.

The good news is that it doesn’t all have to be

your money. In fact,

the less of your own money you can use and the more you can

borrow, the bigger the return on your investment. Add the poten-

tial credit and market woes like the first decade of the 2000s, and

investing in real estate also becomes a bit more of an adventure.

Lining up financial resources well in advance of scouring the neigh-

borhood for investment opportunities enables you to pounce on a

bargain and gives you leverage in negotiating the price you ulti-

mately pay for a property. When you place an offer on a house and

other bids come in, the seller may accept your offer of thousands

of dollars less simply because you have the financing in place to

quickly close the deal. Ready cash also frees you to plan and begin

rehabbing the property immediately instead of waiting around for

sluggish loan approvals and credit checks.

If you’re thinking that you can’t possibly get your mitts on enough

cash to finance your venture,

Financing Real Estate Investments For

Dummies

is the book for you. Here you discover the best sources

for investment capital and how to go about tapping into these

sources to fuel your next venture.

About This Book

This book isn’t a get-rich-quick guide to investing in real estate

or a guide or a tutorial on how to buy property with no money

down (although we do cover that topic).

Financing Real Estate

Investments For Dummies

delivers what the title promises — a

treasure map that shows you where to find sources of real estate

investment capital and guidance on how to dig it up.

Ralph and Chip are both seasoned investors. We’ve each built wealth

through investing in real estate — buying and selling fixer-uppers and

buying and renting out both residential and commercial property.

Although we have used our own money on occasion to finance our

purchases and renovations, we’ve primarily succeeded with the

use of other people’s money (OPM). Our grandmothers were our

first financial backers, but we’ve expanded our options since then.

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We have more than 50 years’ worth of combined experience in

buying and selling real estate and securing the financing to do it. In

this book, we share what we know with you, showing you how to

tap into loans from banks; mortgage companies; private lenders;

federal, state, and local government programs; and more. In the

process we cover financing for both residential and commercial

properties.

Conventions Used in This Book

Compared to other books on financing real estate investments,

Financing Real Estate Investments For Dummies is anything but con-

ventional, but we do use some conventions to call your attention

to certain items. For example:

⻬ Italics highlight new, somewhat technical terms, such as hard

money,

and emphasize words when we’re driving home a

point.

⻬ Boldface text indicates key words in bulleted and numbered

lists.

⻬ Monofont highlights Web addresses.

Financing the purchase and renovation of residential properties,

such as homes, is quite different from financing the purchase and

renovation of commercial properties. You deal with different

lenders who use different methods for evaluating your loan appli-

cation and the property you’re planning to buy.

In this book, we cover both types of financing, but you should

know up front the differences between residential and commercial

property:

⻬ Residential: One- to four-family dwellings classify as residen-

tial properties, which qualify for residential financing.

⻬ Commercial: Properties used to conduct business and any

rental properties designed to house more than four families

qualify as commercial real estate. Loan approval for these

properties hinges more on the property’s potential for gener-

ating sufficient income to make the payments than on the bor-

rower’s financial strength.

In addition, even though you see three author names on the cover

of this book — Chip, Ralph, and Joe — the “we” is usually Chip and

Ralph talking. Joe is the wordsmith — the guy responsible for

Financing Real Estate Investments For Dummies

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keeping you engaged and entertained and making sure we explain

everything as clearly and thoroughly as possible.

What You’re Not to Read

Although we encourage you to read this book from cover to cover

to maximize the return on your investment, we realize that in

today’s busy world you may have time to read only the information

pertinent to your situation. If so, you can safely skip anything you

see in a gray shaded box. We stuck this material in a box for the

same reason that most people stick stuff in boxes — to get it out of

the way, so you wouldn’t trip over it. However, you may find the

stories and brief asides uproariously funny and perhaps even

mildly informative (or vice versa).

Foolish Assumptions

We assume you already mastered the basics of investing in real

estate. If you haven’t, we encourage you to pick up a copy of either

(or both)

Real Estate Investing For Dummies, 2nd Edition, by Eric

Tyson and Robert S. Griswold, or

Commercial Real Estate Investing

For Dummies

by Peter Conti and Peter Harris (Wiley).

If you’re interested in flipping houses or focusing on foreclosure

properties, check out

Flipping Houses For Dummies or Foreclosure

Investing For Dummies

by Ralph R. Roberts with Joe Kraynak. If

you’re thinking of becoming a landlord, we strongly encourage you

to first read

Property Management For Dummies by Robert S.

Griswold. Not everyone has the right stuff to be a landlord, but if

you know what you’re getting into before you take on the role, you

can significantly improve your survival odds.

How This Book Is Organized

Financing Real Estate Investments For Dummies facilitates a skip-

and-dip approach. It presents the information in easily digestible

chunks, so you can skip to the chapter or section that grabs your

attention or meets your current needs, master it, and then skip to

another section or simply set the book aside for later reference.

To help you navigate, we took the 17 chapters that make up the

book and divvied them up into five parts. Here, we provide a quick

overview of what we cover in each part.

Introduction

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Part I: Gearing Up for Financing

Your Real Estate Investments

When you become a real estate investor, you’re essentially building

a business; you should build it on a strong foundation. In this part,

we cover the basics, providing you with definitions of standard ter-

minology and concepts you’re likely to encounter, introducing you

to the various sources of investment capital, showing you how to

protect yourself against potential risks, and leading you through

the process of gathering all the documents and other information

you need to apply for financing.

In the process, we reveal the power of using OPM to gain leverage

and expose your own money and other assets to less risk.

Part II: Financing the Purchase

of Residential Properties

In this part, we explore the many residential loan programs cur-

rently available, show you how to compare different loan packages

to find the one that costs the least overall, and lead you through

the loan application process from filling out the forms to closing.

By the end of this part, you should have the financing you need to

start hunting for residential real estate investment opportunities.

Part III: Financing the Purchase

of Commercial Properties

In this part, we introduce you to the most common commercial

property types, so you can choose the type best suited to your

investment goals and evaluate the properties based on their poten-

tial for generating a positive cash flow. We take you on a tour of

some of the unique sources of financing available for commercial

ventures. Finally, we step you through the process of applying for

commercial real estate loans from application to closing.

Part IV: Sampling More Creative

Financing Strategies

In this part, you discover the pros and cons of hard money — cash

that’s generally easier but more expensive to borrow for purchasing

Financing Real Estate Investments For Dummies

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investment properties. We also show you how to finance the pur-

chase through the seller by purchasing properties on contract,

how to partner with an investor who’s cash heavy, and how to

track down no-money-down deals.

These options aren’t for everybody, but when you’re in the market

for investment properties and can’t get your hands on conven-

tional financing, these unconventional sources can be a deal saver.

Part V: The Part of Tens

The Part of Tens is the highlight of every For Dummies title, offer-

ing quick strategies, tips, and insights on whatever subject the

book covers. The chapters in this Part of Tens reveal how to avoid

the ten most common mistakes when financing real estate invest-

ments, which questions you should ask prospective lenders, ten

steps to take to prepare for your next closing, and ten strategies

for surviving a credit crunch.

Icons Used in This Book

Throughout this book, we sprinkle icons in the margins to cue you

in on different types of information that call out for your attention.

Here are the icons you’ll see and a brief description of each.

We want you to remember everything you read in this book, but if

you can’t quite do that, be sure to remember the important points

flagged with this icon.

Tips provide insider insight from behind the scenes. When you’re

looking for a better, faster, cheaper way to do something, check out

these tips.

“Whoa!” This icon appears when you need to be extra vigilant or

seek professional help before moving forward.

Where to Go From Here

Financing Real Estate Investments For Dummies is sort of like an

information kiosk. You can start with the chapters in Part I to

master the basics and then skip to Part II if you’re planning on

financing the purchase of residential property or Part III if your

focus is more on commercial properties.

Introduction

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For a quick primer on financing the purchase of real estate invest-

ments, check out Chapter 1. Chapter 4 is a great place to start if

you’re not sure where to start looking for lenders — this chapter

touches on everything from banks and mortgage companies to pri-

vate lenders and partnering with others who have cash.

We do consider Chapter 6 required reading. All too often investors

get burned because they focus too much on interest rates and not

on other factors contributing to the overall cost of borrowing

money. This chapter offers a quick way to compare two loans side-

by-side to determine which one costs less over the life of the loan.

If you’re planning to invest in commercial properties, Chapter 8 is

also required reading. In this chapter, we show you how to evalu-

ate different types of properties the way lenders do it when you

apply for a loan.

If you’re looking for information on a very specific topic, flip to the

back of the book, where you can find a comprehensive index of key

topics.

Financing Real Estate Investments For Dummies

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Part I

Gearing Up for

Financing Your Real

Estate Investments

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In this part . . .

he key to scoring affordable ﬁnancing and keeping a

bigger chunk of your after-tax proﬁts from real estate

investments is preparation. By understanding the leverage

you can gain using other people’s money (OPM) to ﬁnance

your investments and having all your ﬁnancial records in

place, you increase your odds of securing ﬁnancing with

attractive terms and interest rates.

By understanding tax laws and loopholes before you get

started, you can lay the groundwork necessary to maxi-

mize your tax deductions and exclusions and keep more

proﬁt for yourself. And by understanding the differences

between different types of lenders, you gain access to

additional sources of investment capital you may never

have considered.

In this part, we help you build your real estate investment

venture on a ﬁrm foundation so you have ready access to

cash while minimizing your exposure to risk.

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Chapter 1

Taking a Crash Course in

Real Estate Investment

Financing

In This Chapter

䊳 Gaining leverage with other people’s money

䊳 Deciphering key terms

䊳 Grasping the difference between a home and investment property

䊳 Discovering vital sources of real estate investment capital

䊳 Getting ready to meet your lender

re you eager to set out on the road to building wealth through

real estate? Although we hate to hold you back, we do dis-

courage you from moving forward without the proper preparation.

Our advice doesn’t necessarily mean, however, that you need to

read the entire book from cover to cover before you purchase your

first investment property.

Here, we provide a quick primer on real estate financing along with

what you need to do to secure financing for your real estate invest-

ments. We also provide a generous supply of references to other

chapters in the book where you can find more detailed information

on specific topics. So without further ado, let the real estate financ-

ing primer begin.

Don’t let negative economic and credit information dampen your

desire to invest in real estate. The best time to purchase real estate

is when prices are low. You can still find and secure financing; you

just may need to look and work a little harder and smarter to get it.

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Pumping Up Your Purchasing

Power with Borrowed Money

If you have any reservations about borrowing money to buy real

estate, you need to overcome those reservations by developing a

better understanding of leverage — using borrowed money to buy

more and better properties, thus improving your chances of earn-

ing bigger profits.

In the following sections, we show you why the goal of owning a

property free and clear isn’t such a smart move, reveal the secret

of leveraging the power of borrowed money, and explain how you

can offer “cash” for properties even when financing the purchase.

Although we encourage investors to borrow money to increase

their leverage, keep in mind that borrowing money can carry signif-

icant risks. As an investor, you can take action to minimize the

risks — by carefully evaluating your real estate market and proper-

ties under consideration, overestimating costs, underestimating

profits, developing realistic backup plans, and so on; however you

can never completely eliminate the risk. You have to decide for

yourself what an acceptable level of risk is.

Minimizing your potential by owning

property free and clear

For many Americans, paying off their mortgage early and owning

their home free and clear is the real American dream. Life would be

so much better if they didn’t have to deal with a house payment.

For real estate investors, however, owning property free and clear

means that valuable equity is locked up in those properties —

equity they can use to finance the purchase of other revenue-

generating real estate. Don’t get caught in the trap of thinking that

paying off a mortgage loan is a smart move — it may be a noble

goal, but it’s rarely a savvy strategy.

Maximizing your potential

with other people’s money

Other people’s money (or OPM for short) is money that you borrow

from other people to finance your investments. OPM isn’t much of

a secret. Assuming you own a home, you probably used OPM to

buy it. You may have put down 5 to 10 percent of your own money

as a down payment and then borrowed the rest.

Part I: Gearing Up for Financing Your Real Estate Investments

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In most cases, OPM helps you earn a profit. When you calculate in

the appreciation of the home, the tax savings it represents, infla-

tion, and other factors, you’re likely to earn more money off the

home than you pay out in interest over the life of the loan —

barring a major housing meltdown.

The same applies to your real estate investments. The more OPM

you can put to work for you, the more you stand to earn — as long

as your earnings from it exceed the cost of borrowing it. For more

info about OPM, check out Chapter 5.

Paying cash with borrowed money

In the world of real estate, cash is king. The buyer who shows up

with cash is in a significantly stronger position to purchase a prop-

erty and negotiate an attractive price and terms than a buyer who

shows up needing financing.

Chapter 1: Taking a Crash Course in Real Estate Investment Financing

Dealing with a major credit crunch

The mortgage meltdown, foreclosure epidemic, and global financial crisis that all

came to a head in 2008 led many real estate investors to believe that credit had all

but dried up. Banks were failing left and right, and the United States was forced to

step in with more than $1 trillion in economic rescue funds to keep cash flowing to

individuals and businesses that needed credit. Surely, real estate investors would

be the last on the list for cheap and easy credit.

Actually, the credit crunch didn’t put real estate investors out of business. In fact,

in many cases, it made conditions better for investors:

⻬ When the bubble burst, properties became much more affordable. Investors

could buy better properties for less money.

⻬ As millions of people worked through foreclosure, demand for rental properties

soared.

⻬ Financial institutions, eager to rid their books of empty, expensive, cash-sucking

foreclosures, became more willing to offer great deals. I (Chip) just had a client

pay $82,000 for a brand new property with a market value of about $275,000. The

bank had taken it back from a builder, was more than glad to just get it off the

books, and was willing to finance it with a 15-year loan.

A credit crunch doesn’t mean that financing disappears — it just means that you

probably need to look for it in some unusual places. Even FHA has investor financ-

ing with 25 percent down — and a lot of foreclosures they’re willing to deal on.

Throughout this book, we show you how to tap into these markets — credit crunch

and all.

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When we say cash is king, however, we’re not advising you to show

up with a suitcase full of money. We’re telling you to show up with

preapproved financing — a financial backer who can deliver the

cash on closing day. In other words, although you’re financing the

purchase as explained throughout this book, you’re still placing

yourself in a position to offer cash.

Brushing Up on Basic Real

Estate Financing Lingo

Throughout this book, we toss around some jargon common in the

real estate and mortgage lending industries. To the average con-

sumer, these terms may sound Greek, but we assure you that

they’re part of the English language. In the following sections, we

define the most common and often misunderstood of these terms.

Identifying types of lenders

The moneymen and -women you deal with when securing financing

for purchasing investment property play various roles in the

process. You need to know whom you’re working with:

⻬ Commercial lenders: They’re financial institutions rather

than individuals. They include banks, credit unions, mutual

savings banks, savings and loan associations, and stock sav-

ings banks. (Chapter 9 discusses commercial lenders in

greater detail.)

⻬ Private lenders: A private lender is any individual who loans

money outside the channels of institutional lending. This

person can be a friend or relative, such as your Aunt Mabel,

or an investor. Real estate investors often rely on private

lenders for access to investment capital when banks and

other financial institutions turn them down. (For more about

private lenders, check out Chapter 11.)

⻬ Mortgage banker: Mortgage bankers are financial institutions

that directly fund home loans and either service those loans

themselves (arranging and collecting monthly payments and

managing any escrow accounts) or sell the mortgages to

investors and contract out the servicing of the loans.

⻬ Servicer: The servicer is the institution contracted or

appointed to collect the monthly payments from the bor-

rower. They have to account for all payments and disburse-

ments and provide yearly statements showing all transactions

within a mortgage account to the borrower.

Part I: Gearing Up for Financing Your Real Estate Investments

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⻬ Mortgage broker: Mortgage brokers are licensed by the state

to assist borrowers in finding mortgage lenders, comparing

loan programs, applying for mortgage loans, and securing

financing for purchasing real estate. They act as the eyes and

ears for many different mortgage lenders.

⻬ Loan officer: Loan officers work for mortgage bankers or bro-

kers to assist clients in securing financing for purchasing real

estate. They essentially do the same thing brokers do, but

they have to work for a licensed broker or lender.

⻬ Loan originator: Another name for a mortgage broker or loan

officer.

See Chapter 4 for more on these types of lenders.

Grasping different loan types

Throughout this book, we introduce you to various types of loans

for financing the purchase of real estate, including conforming and

nonconforming loans, jumbo loans, and hard money loans. In the

following list, we define the most common loan types and toss in

some additional information that you may find useful.

⻬ Conforming loan: A conforming loan is one that meets the cri-

teria set forth by Fannie Mae or Freddie Mac — the organiza-

tions that purchase the loans and then package them up to

sell on Wall Street. In general, to qualify for a conforming loan,

the borrower must

• Show sufficient income to cover monthly payments.

• Have enough cash for a down payment and reserves.

• Have a good credit history.

For additional details about conforming loans and current cri-

teria, visit the Fannie Mae Web site at

www.efanniemae.com.

⻬ Nonconforming loans: These include everything else outside

the Fannie/Freddie box. Sometimes referred to in the market

subprime or even exotic loans, they’re bought by other

financial companies or investment banks and packaged to be

sold to Wall Street investors. When the subprime market suf-

fers, as it did starting in 2008, far fewer of these types of secu-

rities make it to market.

⻬ Conventional loans: These loans are outside the sphere

of the government. In other words, they’re not FHA- or VA-

secured loans and aren’t underwritten by any government

agency.

Chapter 1: Taking a Crash Course in Real Estate Investment Financing

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⻬ Jumbo loans: As its name suggests, a jumbo loan represents a

lot of money — specifically, more money than you can borrow

under the limits of a conforming loan.

⻬ Hard money loans: Also referred to as bridge loans, they’re

typically short-term, high-interest loans that enable investors

to get their mitts on some cash in a hurry. You can expect to

pay several points upfront (a

point is equivalent to one per-

cent of the total loan amount) plus up to double the going

interest rate. (For more about hard money and strategies for

using it to your advantage, check out Chapter 11.)

⻬ Government loan programs: The government isn’t really in the

business of loaning money to homeowners and investors, but

it facilitates the process for lenders by insuring the loans — if

the borrower defaults on the loan, the government steps in to

cover any losses for the lender.

The two most common government loan programs are Federal

Housing Authority (FHA) and Veterans Administration (VA)

loans. But federal, state, and local governments also provide

loan programs to encourage investment in disaster areas and

neighborhoods that they’re seeking to develop. Within the

FHA and VA programs are some great hidden opportunities for

investors. (See Chapter 4 for more about specific government

loan programs.)

Brushing up on important legal lingo

Even though real estate deals are generally classified as financial,

they involve plenty of legalities, especially in relation to who owns

the property or has a stake in it. Although real estate–related legal

terms can fill an entire dictionary, you should have a working

knowledge of the following three:

⻬ Deed: A deed is a legal document that grants rights to a prop-

erty. Whenever you purchase a property, whoever is handling

the closing must file the deed with the county’s register of

deeds to make the transfer of ownership official. As the offi-

cial owner, you have the right to borrow against the property

and transfer your rights of ownership.

Be careful signing any deed, especially a

quitclaim deed (the

deed that allows a property’s owner to relinquish all rights to

the property). Real estate con artists often use the quitclaim

deed to hijack property from unwary owners. They may hide

a single page quitclaim deed in a stack of papers, fooling the

owner into signing the document without knowing what

they’re signing. Then, they run down to the register of deeds

and file the deed, making themselves the new owners, so they

can take out bogus loans against the property.

Part I: Gearing Up for Financing Your Real Estate Investments

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⻬ Lien: A lien is a legal claim that a creditor holds against a

property in lieu of payment. Several parties can place a lien

on a property, including the lender who holds any first or

second mortgage, the county tax assessor (for unpaid taxes),

and contractors (if they financed the repairs or renovations).

As an investor, knowing who (if anyone) has a lien against a

property you’re purchasing and the monetary value of that

lien is important. All lien holders need to be paid in full upon

sale of the property. If the property has a lien against it that

the seller fails to disclose, you may become liable for paying it

when you take ownership of the property.

⻬ Promissory note: Whenever you borrow money, you have to

sign a promissory note pledging to pay back the loan in full

according to terms of the loan, which always specifies a dead-

line for full payment. Think of a promissory note as an IOU (as

in “I owe you” this amount of money).

The promissory note is your pledge to pay back the loan. The

mortgage or deed of trust names the property as collateral in

the event that you default on the loan.

Chapter 1: Taking a Crash Course in Real Estate Investment Financing

Who gets first dibs?

In the event of a foreclosure, certain liens take

precedence

over others, meaning

that when the property is sold at auction, certain lien holders are paid off first:

⻬ Tax lien: The proceeds from the foreclosure sale pay off any unpaid property

taxes first.

⻬ First mortgage: If any money from the proceeds of the sale remain, it pays off

the first mortgage or as much of the first mortgage as possible. This is also

referred to as a

senior lien.

⻬ Second mortgage: If the homeowner took out a second mortgage, any remain-

ing proceeds from the sale go toward paying it off. Any second (or third or

fourth) mortgages are also referred to as

junior liens

⻬ Construction liens: If money still remains, it goes to the next lien holders in order

of precedence.

⻬ Homeowners: After all the lien holders receive their cuts, the foreclosed-upon

homeowners get the remaining crumbs, which can actually be quite a chunk of

change if they had a lot of equity in the property.

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Pointing out mortgage concepts

When you take out a loan, the lender requires something of value

(collateral) to make sure it has something valuable to sell and

recoup its investment if you default on the loan. This collateral is

officially presented in the form of a mortgage or deed of trust

depending on the jurisdiction:

⻬ Mortgage: A mortgage is a contract between the lender and

borrower that gives the lender the right to foreclose on the

property in the event that the borrower defaults on the loan.

⻬ Deed of trust: A deed of trust is a mortgage contract that

places control of the deed in the hands of a third party — a

trustee. The trustee has the power to foreclose on the prop-

erty in the event that the borrower defaults on the loan.

The mortgage market is large and complex, but it consists of two

main divisions: a

primary and a secondary mortgage market.

⻬ Primary: This is the market in which you do business. It con-

sists of financial institutions that lend you money.

⻬ Secondary: This is the market where institutional lenders and

Wall Street investors converge. The primary lenders who actu-

ally loan money to homeowners and investors turn around

and sell the mortgages or deeds of trust to investors. This

gives the lenders more money to make available to borrowers.

Examining equity

Equity is the amount of money you’d have if you sold the property

today and paid off the balance due on the loan. More importantly,

as an investor, you can pull equity out of a property by borrowing

against it. This power enables you to put that equity to work for

you in other investments.

Thanks to the credit crisis in 2008 and 2009, the equity require-

ments to obtain financing are growing. Lenders are taking a closer

look at market values, especially in what they call

declining areas —

areas showing a pattern of recently declining housing values. As an

investor, you should be doing the same thing. Be cautious when

calculating equity positions and profit margins.

Although we encourage investors to tap the power of equity, keep-

ing some equity in a property (especially the home you own) is a

good idea. Having equity to borrow against in the event of a finan-

cial setback may save you from foreclosure and bankruptcy.

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Looking at loan-to-value (LTV)

The loan-to-value (LTV) is the ratio of the total loan amount to

the value of the property. If you’re buying a $200,000 home with

$40,000 down and applying for a $160,000 loan, the LTV would be

$160,000 ÷ $200,000 = 80 percent

Generally speaking, lenders want to see lower LTVs for investment

properties than for homes because a lower LTV provides more of a

buffer to cover the increased risks inherent in investment proper-

ties. Check out Chapter 3 for more about calculating the LTV and

how lenders use this number to evaluate risk.

Distinguishing Investment

and Home Financing

Your first real estate investment should be your own home. In fact,

if you don’t own your home, we advise you to put down this book

and pick up a copy of

Home Buying For Dummies by Eric Tyson and

Ray Brown (Wiley) first. Owning your own home carries the least

risk and the most potential tax benefits while bringing you up to

speed on the basics of real estate investing and ownership.

After you’ve purchased a home, you should have a fairly good

understanding of the mortgage loan application and approval

process. (We provide a refresher course in Chapter 7.) However,

real estate financing differs quite a bit when you take on the role of

investor rather than homeowner. You and the lender take on more

risk. As a result, you can expect to pay more for the privilege of

borrowing money. In addition, your borrowing strategy is likely to

change. In the following sections, we cover these differences in

greater detail, so you know what to expect before diving in.

Paying a premium for riskier

investment loans

When you invest in your own home, you literally have a vested

interest in making payments — if you don’t, you lose the roof over

your head. On the flip side, if you lose an investment property, it

may be painful, but it’s never

that serious, and lenders are well

aware of the difference. For them, investment loans are riskier

propositions. To mitigate the risk, they generally

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⻬ Require a larger down payment.

⻬ Demand a larger loan-to-value ratio. (See “Looking at loan to

value (LTV)” earlier in this chapter.)

⻬ Charge more interest upfront in the form of points.

⻬ Charge a higher interest rate.

⻬ Require proof that you have reserves or liquid assets available

in case things don’t go as planned.

The actions that lenders take to mitigate the risks and the interest

rates and fees they charge vary greatly depending on the borrower

and the deal that’s on the table. Just make sure you have all the

documentation and figures ready when you meet with your lender

for the first time, as explained in Chapter 3.

Using quick cash to

snag bargain prices

When you’re shopping for a mortgage to buy a home for your

family, you’re usually looking for a low-interest package, no or very

few points, and attractive terms. With investment properties,

cash

flow

trumps interest rate. In other words, access to cash is often

more important than the cost of the loan. To find out more about

the relative importance of cash flow and how to shop for loans

with the lowest interest rates and fees, see Chapter 6.

If the numbers work, what you pay in interest doesn’t matter.

Interest is just another expense. If you subtract all your expenses

and can still earn the profit you want, paying thousands of dollars

in interest over a relatively short period is acceptable.

Accounting for taxes on your

capital gains (or losses)

When buying and selling a primary residence, you don’t have to

think too much about the tax ramifications of the transactions. In

the United States, a huge chunk of any profit you earn from the sale

is usually tax exempt — up to $250,000 if you own the home your-

self or double that if you and your spouse sell the home.

However, when you’re selling investment real estate, any profits

are subject to capital gains taxes. During the writing of this book,

profits from real estate investments were taxed as follows:

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⻬ Long-term capital gains: 15 percent if you hold the property

for at least a year and a day.

⻬ Short-term capital gains: 35 percent if you sell the property in

fewer than 12 months from the date you purchased it.

⻬ Income tax: If profits from investing in real estate are your

sole income, the IRS may consider it your job and tax your

profits as income, complete with an additional 15 percent in

self-employment tax.

We’re not tax experts. Consult a CPA who has experience dealing

with real estate investors for details on how the government is

going to tax your profits and for suggestions on how to reduce

your tax burden. Your measure of success isn’t how much you

gross but how much you net. By reducing your tax bill, you can sig-

nificantly increase your net gain.

Protecting your personal assets

Just like most things worth doing, real estate investing exposes

you to risk. Perhaps the biggest risk is that you’re working with

borrowed money from lenders who expect you to pay it back. If

you make a lousy investment decision or an investment goes belly-

up despite your best efforts, lenders are going to do everything

legally possible to collect their money.

You also face the ever-present risk of litigation — having a dis-

agreement with a buyer, seller, tenant, contractor, or someone else

that eventually leads to a costly lawsuit.

Eliminating risk isn’t possible, but you can take several measures

to lessen the risk, including operating through an LLC, transferring

personal assets to someone else, or having a qualified attorney

cover your back. Check out Chapter 2 for more details.

Exploring Common Sources

of Investment Capital

You probably picked up this book because you want to start

investing in real estate, but you don’t know where to dig up the

cash to do your first deal. In the following sections, we show you

where to start digging.

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Tapping your own cash reserves

If you’re single, or you and your significant other are on the same

page about this real estate investing thing, cracking into your nest

egg to finance your investments may be the quickest way to get

your fingers on some investment capital.

It’s also the riskiest option, because if anything goes wrong — you

get laid off or fired, become too ill to work, or encounter unex-

pected expenses — you have fewer reserves to keep you afloat. In

addition, limiting yourself to your own resources also limits your

purchase power — you have to buy houses in a lower price range

and may not have sufficient cash to properly renovate the property.

A great way to ruin a relationship is to bet the farm on big profits

without the knowledge and complete agreement of your spouse or

significant other. If your investment doesn’t pan out (and even if it

does), the other person may take offense at not being consulted.

Even with these caveats, many beginning investors have gotten

their start by financing their own ventures — partially or in full.

And you want to know about these resources if you need some

quick cash in a pinch.

Clearing out your bank accounts

Having a few thousand dollars socked away in a savings account is

always a good idea, just in case you run into a cash flow problem. If

that house you bought and fixed up is taking a few months longer

than expected to sell, your little nest egg can help cover the pay-

ments until you find a buyer.

Use your savings as a reserve, not as your main mode of financing.

Having some cash to fall back on can save you in a pinch.

Borrowing against the equity in your home

As your home’s value rises and you pay down the principal, you

build equity. You can often borrow against this equity by taking out

a home equity loan or line of credit and then use the money for

whatever you want, including purchasing other real estate. The

recent credit crisis has made it harder to find these loans, but

they’re still out there for well-qualified borrowers.

We don’t recommend that you cash out all the equity in your

home, but if you have a substantial amount of equity, cashing out a

portion of it can help you come up with a down payment or cover

the cost of repairs and renovations. (For more about home equity

loans and lines of credit, skip to Chapter 11.)

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Financing investments through a self-directed IRA

More and more investors are choosing to set up self-directed IRAs

and other types of retirement accounts that enable them to invest

in real estate rather than in stocks and bonds. The reasoning: Real

estate often provides a better and sometimes even more secure

return on your investment.

With a self-directed IRA, you can buy and sell properties out of

your retirement account. Setting up a self-directed IRA, however, is

no simple matter. Typically, a trust company manages the money

and properties in the account, and all profits and losses from your

investments must stay in that account. Withdrawing money from

the account results in the same IRS penalties you have to pay if

you withdraw money from any type of retirement account.

Consult your financial advisor and accountant for details about

using a self-directed IRA to finance your real estate investments. If

a self-directed IRA isn’t an option, you may be able to borrow

money against your retirement account. Keep in mind, however,

that borrowing against your retirement savings places those sav-

ings at risk, as does any other investment.

Charging expenses on your credit cards

Maxing out your credit cards to purchase a car, clothes, electron-

ics, groceries, and other items that provide no return on your

investment is never a good idea. Using your credit cards to pur-

chase investment properties that offer a solid, relatively quick

return on your investment, however, can be a savvy (though risky)

financial move.

Consider credit cards a last resort to cover the costs of repairs and

renovations if financing is tight near the end of a project. With this

strategy, your investment activities can directly affect your per-

sonal finances, which increases your exposure to risk. For more

about this option, check out Chapter 11.

Borrowing from commercial lenders

One of the best ways to finance the purchase of investment proper-

ties is to meet with a qualified mortgage broker who can help you

find and evaluate various loan programs. These plans are often

your best deals — costing the least in upfront fees and interest.

For more about finding commercial lenders, check out Chapter 4. If

you’re investing in residential property, Chapter 5 reveals the vari-

ous residential loan programs to choose from. If you’re buying

commercial property, turn to Chapter 9 for guidance on choosing

the right loan program.

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Don’t confuse “commercial property” with “commercial lender.” A

commercial property is any property that isn’t a one- to four-family

residential dwelling. A

commercial lender is an institution (as

opposed to an individual) that loans money. In other words, you

can use a commercial lender to finance the purchase of residential

investment property.

Obtaining a hard money loan

When banks and other financial institutions turn down your

requests for investment capital (or you don’t have the time to con-

vince them that a deal is pure gold), consider borrowing money

from a hard money lender, as explained in Chapter 11.

One of the main advantages of a hard money lender is that the

person is likely to accept the property you’re buying as all the col-

lateral needed to secure the loan, so you don’t have to place your

home at risk.

Financing your purchase

through the seller

Property owners who are eager to sell and don’t need all the cash

at once are often willing to finance the purchase themselves. This

tactic enables them to profit in two ways — by selling you the

property for more than they paid for it and collecting interest from

you. Seller financing take either of the following forms:

⻬ Land contract: A land contract is like a mortgage, except the

seller acts as the bank.

⻬ Lease option agreement: A lease option agreement is like a

rent-to-own deal — you lease the property for a specified

period, at the end of which time you have the option to buy it.

For more about seller financing, check out Chapter 12.

Taking on a partner

Whenever you don’t have something (like money, skills, time, or

talent) to accomplish a particular goal, you can acquire those

skills, buy or hire them, or create a partnership with someone who

already has what you need. If you have something someone else

needs and they have what you need, you have what it takes to form

a mutually beneficial relationship. For details on how to partner

with someone who has the cash you need, check out Chapter 13.

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Choose a partner as carefully as you choose a spouse. Partnerships

often end when one person scams the other or disagreements arise

over who’s putting more into the projects and who’s getting more

out of them. Have your attorney write up a contract, complete with

a prenuptial type agreement stating how all the assets will be

divvied up in the event that you part company.

Prepping to Meet with a Lender

Walk into a bank empty-handed and explain to the loan officer that

you need a loan to start investing in real estate, and we can almost

guarantee that you’ll be laughed out the door. Before you even

think about meeting with a prospective lender, get all your ducks in

a row. Copy all the financial documents lenders are going to ask for

and construct a fairly detailed plan on how you’re going to profit

by investing in real estate. This section gives you an overview of

what you need to do before visiting your lender. Chapter 4 pro-

vides complete in-depth info.

Gathering paperwork and other info

Before approving your request for a loan, lenders want to know

whether you’re good for the money — how likely you are to make

the monthly payments and pay back the loan in full. For investors,

this means two things:

⻬ You’re in pretty good financial shape right now and have a

fairly clean credit history.

⻬ The property you’re planning to buy is more than worth the

money you’re borrowing to pay for it, and (if you’re going to

be renting out the property) it will generate sufficient income

to more than cover all your expenses along with the monthly

payments.

To verify your creditworthiness for yourself and be sure you have

all the documents and other information your lender requires, stuff

a folder full of a copy of each of the following items:

⻬ Credit reports from all three credit reporting agencies

⻬ A net worth statement (assets – liabilities = net worth)

⻬ A debt ratio statement (ratio of what you owe to what

you own)

⻬ Last two months’ bank statements

⻬ Last 30 days’ pay stubs

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⻬ Last two years’ federal tax returns and schedules

⻬ Statements of any business income

⻬ Appraisal or comparative market analysis for the property

⻬ Cash flow analysis of the property

⻬ Loan-to-value ratio of the property

⻬ Zoning information for the property’s location

⻬ City and county records for the property

Crafting a business plan

Real estate investors often scoff at the idea of creating a business

plan

— a detailed presentation that shows how an investor plans

to purchase a specific property and earn a profit from it. Investors

often just want to buy and sell and rent out property and make a

lot of money — that’s the plan. They don’t like to think of them-

selves as pencil-necked pencil pushers. If they feel in their gut that

a property is a solid investment, that’s good enough for them.

At least that’s the false image that many people have of investors.

The most successful investors, however, do the math. They crunch

the numbers. And if the numbers don’t work, they don’t do the deal.

Do your homework. Do a comparative market analysis of the prop-

erty to make sure it’s worth what you think it’s worth. If you’re

buying rental property, check the rental history of the property —

the owner’s tax records showing income and expenses. Craft a

business plan showing exactly how this property is going to be a

revenue generator.

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Chapter 2

Shielding Your Personal

Assets from Investment Risks

In This Chapter

䊳 Grasping the need to cover your assets

䊳 Investing as a corporation to reduce your exposure to risk

䊳 Assigning ownership of certain assets to others

䊳 Avoiding collateral and cross-collateral damage

䊳 Dodging real estate and mortgage fraud

unny thing about lenders — when you borrow money from

them, they expect you to pay it back. To ensure repayment of

a loan, the lender usually requires that you sign a promissory note

and a mortgage or deed of trust. The

promissory note is your per-

sonal promise to repay the loan in full. The

mortgage or deed of

trust

names certain property as collateral for the loan.

If you happen to

default on the loan (fail to make payments as stip-

ulated), the lender has the right to

foreclose (sell your property to

the highest bidder). If the lender can’t sell the property for at least

as much as you owe on it, it may be able to sue you for the differ-

ence

(deficiency) in jurisdictions that allow deficiency judgments.

As an investor, you want to limit the assets that the lender has the

right to seize in lieu of payment. If you fail to make payments on a

loan you took out to purchase an investment property, for exam-

ple, you want to make sure that the bank can’t take possession of

the home you live in, other businesses you own, or other assets,

such as your car. To prevent the lender from going after personal

assets and other business assets as payment, you need to

shield

those assets — keep them legally and financially separate from

your investment properties. In this chapter, you discover various

strategies for doing just that.

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It’s a jungle out there. Fraud is more common in the real estate

industry than most professionals are willing to admit, so in this

chapter, we also show you how to protect yourself against becoming

a victim or unwitting accomplice to real estate and mortgage fraud.

Understanding Why You Need to

Protect Your Personal Assets

As an investor, you’re a small-business owner, but you’re also an

individual who may have a spouse and a family to support. You

probably have a home, a car, one or more personal bank accounts,

a retirement account, and other valuables that you’ve worked very

hard for a long time to accumulate. You want to build even more

wealth by investing in real estate, and you’re willing to take some

risks, but can you live with losing everything you now own?

The correct answer is (or should be) “no.” No, you shouldn’t risk

everything you now own to invest in real estate. Why? We can

think of two very good reasons:

⻬ You don’t want to or have to risk everything. You can protect

some or all your assets from risk by following the advice we

offer in this chapter.

⻬ If your investment goes belly up, you can recover much more

quickly and perhaps even pursue future investments by hold-

ing on to more of your current assets.

In any investment, you should try to limit your exposure (both

financially and emotionally) to the individual deal. You’re investing

your time and talent and perhaps a little of your own money. In

addition, you’re the one who’s taking on the burden of managing

the project, dealing with hassles, and worrying about whether your

investment is going to eventually turn a profit. All the lender is

doing is putting up the money, so let the lender step up to the plate

and take the

financial risk. That’s the price it pays for being able to

do business with you.

Limiting Your Personal Liability

by Forming an LLC

Businesses form corporations for any number of reasons, but one

of the primary reasons is to establish the business as a separate

entity. If, for example, you do business in your own name, you

become personally liable for anything that happens in the course

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of doing business. If someone decides to sue you over something

related to your business, all your personal belongings are at stake.

By setting up a corporation, you essentially create a fall guy who

takes the blame if something terrible happens. A customer can sue

your corporation to the point of bankruptcy, and in most cases,

you can simply walk away with your home, your car, and your per-

sonal savings and belongings all intact.

One of the best and most popular corporate entities for real estate

investors is the

limited liability company or LLC. By forming an LLC,

you limit your exposure to risk to the company, so it can fold with-

out negatively affecting your personal finances.

In the following sections, we provide guidelines on setting up an

LLC and managing your investments through it. For details about

creating and managing an LLC, check out

Limited Liability

Companies For Dummies

by Jennifer Reuting (Wiley).

Understanding the pros and cons

On its surface, an LLC appears to be the best of all possible busi-

ness entities, and in some ways it really is, but prior to taking the

plunge, consider its potential advantages and disadvantages.

An LLC offers the following benefits:

⻬ Generally requires less paperwork and fewer hassles: Small

business owners who form S-corps often get frustrated pre-

tending that they’re some huge corporation — filing all sorts

of forms, holding or pretending to hold corporate meetings,

and keeping a record of each meeting’s minutes. With an LLC,

you avoid most of that nonsense — at least the meetings and

the minutes.

⻬ Provides greater protection: Operating as a sole proprietor-

ship leaves you completely vulnerable to lawsuits and other

legal claims against your personal assets. An LLC provides the

same sort of protection you can expect under the corporate

umbrella.

⻬ Allows you to dodge the passive income bullet: If too much

of your income from real estate holdings is classified as

pas-

sive

, the IRS could convert your Sub-S into a C-corp (a regular

corporation), exposing you to double taxation. With an LLC,

you can do a

pass-through, in which your real estate earnings

pass through the company and are treated as personal

income so that the company isn’t taxed separately, as well.

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Although an LLC offers the protection of limited liability, it does

have a couple of its own limitations, as well:

⻬ If a member of the LLC dies or goes bankrupt, the LLC is dis-

solved, whereas a corporation can continue to exist as long as

it has shareholders.

⻬ All properties within the LLC are exposed to risks associated

with the other properties held in the same LLC. In other

words, someone trying to collect money for one of the LLC’s

properties can go after the other properties to collect pay-

ment. For this reason, limiting the number of properties held

in any one LLC is a good idea.

Setting up an LLC

Anyone with a free weekend, a computer, and an Internet connection

can set up an LLC (although we recommend that you use an attor-

ney). You download the forms, fill them out, and submit them to

your state commerce department, secretary of state, or bureau of

corporations. Although each state has slightly different procedures

to follow and forms to complete, you should be able to find all the

instructions and documents you need on your state’s Web site.

Go to your favorite online search engine and type in “corporation”

followed by the name of your state — for example, “corporation

Arizona” (without the quotation marks). This search should bring

up a link to the department in your state that handles LLCs and

corporations.

You can set up most LLCs on your own for very little expense and

paperwork, but we encourage you to consult with an attorney. A

savvy attorney can ensure you’ve set up your corporate shield in a

way that makes it less vulnerable to being pierced. You may also

want to hire an accountant to manage the finances for the com-

pany and ensure that any taxes that come due are paid on time.

The choice of which state you form your corporation in is of

utmost importance, especially in terms of how you’re taxed.

Delaware, for example, is very corporation-friendly, which is why

you see so many financial institutions, especially credit card com-

panies, centered in Delaware. Discuss the options with your

accountant and attorney.

Taking and securing title to real estate

When you have an LLC in place, perform all business transactions

in the name of the LLC rather than in your own name. Whether

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you’re taking out a loan, signing a purchase agreement, or putting

your John Hancock on closing papers, make sure your LLC is listed

as the responsible party and that you’re signing as a representative

of the company.

Accomplishing this task is fairly easy on your part because other

people are usually in charge of drawing up the paperwork. All you

need to do is instruct the person (real estate agent, closing agent,

loan officer, or whoever is handling the paperwork) to prepare it in

the name of the LLC.

Unfortunately, on conventional loans with conventional lenders for

typical one- to four-family dwellings, getting a loan in the name of

the LLC is nearly impossible, but you can still have the LLC

hold the

property, providing some protection from personal liability. You

have an easier time taking loans out in the name of the LLC when

purchasing larger properties (5+ units) and commercial deals.

If you can’t take title in the name of your LLC, move the property

into the LLC as soon as practical. You can do this by using a

quit-

claim deed

— typically a one-page legal document that enables you

to deed the property to another individual or business entity. You

simply sign the quitclaim deed, specifying that the LLC is the new

deed holder, and then file the quitclaim deed with your county’s

deed that’s valid in your county.

Follow your attorney’s advice carefully, because this strategy can

trigger a

due-on-sale clause, in which case you would need to pay

back the loan in full immediately. The IRS allows investors to trans-

fer real estate for estate-planning purposes, so you’re in the clear

as long as you follow the rules.

Some LLCs choose to perform certain transactions under an

assumed name — a name that differs from that of the company. We

strongly discourage the use of assumed names in real estate trans-

actions, because they provide little, if any, protection for you.

Always transact your investment business under the LLC’s name.

Eyeing Sub-S corporations

and partnerships

Although we recommend LLCs for most investors, a Subchapter S

corporation (or Sub-S for short) is a viable alternative. A Sub-S is

an actual

corporation (as opposed to a company) that chooses not

to pay taxes on earnings but instead have those earnings pass

through to the shareholders so they pay taxes on them. It’s

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another way of dodging the double-taxation bullet (taxing the cor-

poration as well as the individual shareholders).

A Sub-S can also provide you with a great measure of protection

and allow for other deductions and a wider variety of activities

than are possible under an LLC. For example, a Sub-S allows you to

partner with other business entities in addition to individuals.

If you plan on partnering up with another investor, you need to for-

malize the relationship by forming a partnership, as we discuss in

Chapter 13. A

partnership is simply a business entity in which the

members agree to work toward a common goal. You need to have a

written agreement in place that stipulates how the partnership

functions, who’s responsible for what, and how assets are to be

divided should the partnership dissolve. The partnership itself,

however, provides you with little or no protection. You still need to

set up a corporation or an LLC for protecting your personal assets

and those of your partner(s).

Transferring Personal

Assets via Trusts

As an investor, you’re a business owner, and most responsible

business owners keep their business and personal finances sepa-

rate. You can be sued by anyone at any time, and you want to pro-

tect your family and personal assets as best as possible. An

excellent way to accomplish this is to place your personal assets

under someone else’s name or into a separate entity — a

trust.

Consider the following options:

⻬ Transfer personal assets to your spouse, one of your children,

another relative, or a designated third-party administrator

such as an attorney or financial planner.

⻬ Shift your assets into a trust — a legal device you as an indi-

vidual place your assets in for the benefit of others, such as

your family.

Investors often spend a great deal of time and effort building

wealth only to see the fruits of their efforts chipped away by unjus-

tified lawsuits and taxes. By holding your assets in an estate or

trust, you not only protect them against legal claims, but you can

also reap substantial tax benefits. Sophisticated investors often

use multiple business entities (including LLCs and other corporate

structures) to manage their assets and protect them from a variety

of risks. As you acquire more properties, consider employing a

similar strategy. For more about estate planning, check out

Estate

Planning For Dummies

by Jordan Simon and Brian Caverly (Wiley).

Part I: Gearing Up for Financing Your Real Estate Investments

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In the following sections, we address the advantages and disadvan-

tages of placing your assets in someone else’s name and assist you

in deciding which option is best for you.

Weighing the pros and cons of owning

property in another’s name

Investors and business owners often protect assets by placing

them in the name of a spouse or other relative. Before you make

this move, however, you need to have a firm grasp of the pros and

cons to protect the property.

Some investors hold some investments in their own names, and

some in the name of their spouses. This strategy increases the

number of properties you can finance (by getting around Fannie

Mae and Freddie Mac limits on the number of residential proper-

ties/mortgages you can hold) and also enables you to diversify

your assets and limit liabilities.

A real estate investor, for example, may choose to have her spouse

listed as the sole owner of their home, car, and other big-ticket

assets and then take out loans and the title to investment proper-

ties in her own name only. If she defaults on a loan, she can lose

the investment property, but the family home and car are safe.

So, what’s the catch? Placing assets in someone else’s name can

increase your exposure to several risks:

⻬ You lose some control over those assets. If all your personal

assets are listed in your husband’s name only, for example, a

divorce may leave you at a severe disadvantage.

⻬ You may affect your kids’ future financial aid. If you own

property in the name of your children, the value of that

property can influence the financial aid calculations should

your children decide to attend college and require financial

assistance.

⻬ You may encounter tax consequences. Putting assets in the

names of your children may also trigger gift tax requirements

or estate tax issues.

⻬ You’re at the mercy of that person’s legal issues. If the

holder of your assets becomes disabled or runs into his own

liability issues, your assets can get tied up for a long time in

the legal wrangling. Bankruptcy, insolvency, or even death

(and the subsequent probate) can turn the best of plans into a

financial fiasco.

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Placing assets in someone else’s name can be a bit of a hassle, but

it usually doesn’t cost all that much. For example, you can head

down to the bureau of motor vehicles and change the name on the

title for any vehicles you own for a small fee. Likewise, you can use

a quitclaim deed to assign ownership of a property for a small

recording fee. Before you do, however, consult your attorney or

accountant to find out about all the ramifications of transferring

ownership of your properties because the laws and procedures

vary from state to state.

Gaining asset and tax protection

with an irrevocable trust

Trusts are the most versatile tool for transferring title of assets

without tax implications or increased risk, but they have some lim-

itations. We encourage you to discuss your situation with a quali-

fied estate planner who can assist you in weighing the potential

benefits and drawbacks of different options and then set up the

trust for you.

Trusts come in two flavors — revocable and irrevocable. A

revoca-

ble

trust is one you can change or terminate during your lifetime.

irrevocable trust is one that you can’t change or dissolve — as

grantor (creator of the trust), you no longer own the assets held in

trust. The trust does. An irrevocable trust benefits you in two

important ways:

⻬ Because you no longer own the assets, they’re protected

against any legal actions taken against you.

⻬ The property and its appreciation are outside of your taxable

estate, allowing you to avoid paying estate taxes on the value

of your holdings.

Both revocable and irrevocable trusts protect assets from probate,

but only irrevocable trusts can eliminate estate taxes.

The ultimate way to protect assets is to hold them in an offshore

asset protection trust, but we’re not advising that you do that. The

next best thing is to have your assets owned by a Sub-S or LLC and

then have the shares of the corporation owned by an irrevocable

trust — this is the fortress of U.S. asset protection. The IRS frowns

upon any sort of tax optimization scheme, particularly the offshore

variety, so before employing any such scheme, consult a tax

attorney.

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Considering real estate investment

trusts (REITs)

Real estate investment trusts (or REITs for short) give small

investors a way to pool their assets and own investment real estate

as a group. REITs offer investors three significant benefits:

⻬ Investors can diversify their real estate holdings by owning

pieces of multiple properties.

Instead of purchasing a

$200,000 property, for example, a small investor can own a

$10,000 share in 20 properties, spreading the risk.

⻬ Small investors can afford to buy into higher-end real

estate.

REITs allow minor league investors to play a smaller

role in the major leagues, because it costs less to buy in.

⻬ REITs simplify the transfer of ownership to different

investors.

Instead of selling the property, you simply transfer

shares.

If you have an LLC with 100 or more investors, consult your attor-

ney for assistance in setting up a REIT, to ensure that it meets all

the requirements, including the following:

⻬ Your REIT must have at least 100 shareholders. Why 100?

That’s just one of the rules.

⻬ You must distribute at least 90 percent of your REIT’s taxable

income. In other words, at least 90 percent of the profits earned

by the assets in the REIT must flow through to shareholders.

⻬ Ninety five percent of your REIT’s income must come from

financial investments (including real estate, securities, and

annuities), with 75 percent of that total coming from real estate

(net profit from sale of assets, rent/lease payments, and so on).

Staying Away from Promissory

Notes with Recourse Clauses

Promissory note is a fancy term for an IOU. Whenever you borrow

money, the lender almost always requires that you sign a promis-

sory note promising to pay back the money under a set of specific

conditions, including the

term (amount of time you have to pay the

loan in full), interest rate,

principal (total amount you borrowed),

and payment amount of each scheduled payment.

Promissory notes usually include a

recourse clause stipulating that

the person signing for the loan is pledging individual assets as

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additional collateral to secure the loan. If the loan goes bad, the

lender can then come after the borrower’s personal assets to

recoup any losses.

In the following sections, we explain nonrecourse loans (the most

desirable option), discuss what you need to do if your contract has

a recourse clause, and point out the risks involved in

cross-collater-

alized loans

— loans that enable the lender to lay claim to prop-

erty other than the property the loan was used to purchase.

Opting for a nonrecourse loan

If you’re trying to borrow money for a potentially lucrative invest-

ment, a recourse loan may be your only option, but in most cases,

you want a loan that places only the property you’re financing at

risk — a

nonrecourse loan.

Nonrecourse means that the property stands on its own. Fail to

make your payments, and all you stand to lose is the property you

borrowed the money to buy . . . and your pride. Borrowers typi-

cally use nonrecourse loans for financing the purchase of larger

commercial-type properties, where the lender understands that

the real value is in the property and the income it generates. If a

$15 million loan on a hotel goes bad, the lender knows he can’t

shake enough quarters and nickels out of you to pay it back.

Instead, he can get the money out of the property.

In some cases, lenders allow you to buy into a nonrecourse clause

by paying a higher interest rate or agreeing to other terms that are

more favorable to the lender. It never hurts to ask, but on smaller

properties, you can usually count on having to agree to some sort

of recourse clause. (See the next section for more on how to nego-

tiate this recourse clause.)

Any type of fraud, misrepresentation, or misappropriation of funds

in respect to the loan or the property — such as claiming that the

building generates more rental income than it really does — can

void the nonrecourse clause and give the lender the right to come

after your personal assets.

Negotiating the recourse clause

Although we suggest you go the nonrecourse route as often as pos-

sible, some contracts require a recourse clause. Fortunately, this

clause is usually negotiable. A lender typically doesn’t remove it

entirely, but you may be able to negotiate a recourse clause that

limits your liability. Ask your loan officer or broker whether any

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options are available. Following are some areas that may be open

for negotiation:

⻬ Property limitations: You may limit the recourse, for exam-

ple, to other real estate holdings in your LLC, thus protecting

your personal residence and other assets.

⻬ Time limitations: You may be able to place a time limitation

on your liability; for example, if you make payments on time

for five years, your personal liability is released.

⻬ Partial recourse: This provision limits your liability to a cer-

tain percentage of the loan or a certain amount (less than the

full amount). Partial recourse can also limit the lender’s abil-

ity to collect only under certain conditions.

Almost every residential loan (for one- to four-family investment

property) requires personal recourse. Just make sure you under-

stand the limitations and options. When signing a promissory note,

make sure that the recourse clause is limited to the assets you’re

willing to put at risk.

Avoiding cross-collateralization

To protect their money, lenders like to know that you have plenty

collateral — anything of value that they can take from you and

sell to get their money back in the event you’re unable or unwilling

to pay back the loan. When the housing market is thriving and

property values are on the rise, lenders tend to accept the prop-

erty you’re financing as collateral on the loan. If you don’t make

your payments, they can foreclose, sell the property, and get back

all or nearly all their money.

Chapter 2: Shielding Your Personal Assets from Investment Risks

Your recourse to recourse loans

I (Chip) once had 16 doctors who went in together on a commercial building as an

investment. The bank wanted a full recourse loan on each of them, which would

have given them a total of 1600 percent coverage on the loan. We negotiated for a

10 percent personal recourse on each investor, which still provided the lender with

160 percent coverage. We were also able to eliminate personal liability after five

years of satisfactory payments.

The moral of this story is this: Don’t accept what the lender offers as a final offer. As

long as you’re a serious investor with a solid plan in place, you can usually negoti-

ate more attractive terms with the lender.

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On riskier investments — when property values are declining or

the property’s value is close to the amount being borrowed or a

large loan is being taken out to purchase multiple properties —

the lender may want to

cross-collateralize the loan. With cross-

collateralization, two or more properties act as collateral for a

single loan. If you fail to make payments on the loan, the lender

can foreclose on other properties to collect the amount due.

For the investor, cross-collateralization exposes other properties to

the liabilities of one. Stay away from these types of loans if at all

possible. You can’t always avoid cross-collateralization, but we

encourage you to at least try. Otherwise, you may lose a good

income property just because one of your other properties is a dog.

Steering Clear of Real Estate

and Mortgage Fraud

Wherever you find money, you find crooks — con artists deter-

mined to score some quick cash. As a real estate investor, you’re

vulnerable to real estate and mortgage fraud in any or all of the fol-

lowing three ways: as a target, as a perpetrator, or as an unwitting

accomplice. And all these roles can ultimately undermine your

long-term success, not to mention your reputation.

Part I: Gearing Up for Financing Your Real Estate Investments

Cross-collateralization nightmare

Several years ago, I (Chip) had a friend who had a great idea for a retail clothing

store. Couldn’t lose, or so he thought. Unfortunately, his overconfidence led him to

be careless in borrowing money for his new venture. He allowed the loan he

secured to buy the building to be cross-collateralized with the store’s inventory and

many of his personal assets.

A sharp downturn in the market transformed his dreams to dust in a mere 18 months,

but the worst was yet to come: The lender not only foreclosed on the building and

took his inventory but also went after his home, car, boat, and retirement fund. The

financial strain eventually ended his marriage.

Any investment that’s worth pursuing usually involves some risk, but going all in

when you don’t really have to is folly. By avoiding the cross-collateralization trap,

you limit your risk to the new investment.

No investment is a sure thing. Protect yourself from unforeseen and unfortunate

circumstances as much as possible.

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In the following sections, we describe the main types of real estate

and mortgage fraud, to empower you to steer clear of scams and

schemes that can get you into trouble.

Ignorance of the law is no excuse for breaking it. Unfortunately,

ignorance is as rampant as fraud in the real estate industry. Many

real estate professionals may try to convince you that something

illegal is okay because everybody does it or because these are “vic-

timless crimes.” However, as we’ve seen from the mortgage melt-

down beginning in 2008, homeowners and investors ultimately pay

the price. For more about real estate and mortgage fraud, check

out

Protect Yourself from Real Estate and Mortgage Fraud: Preserving

the American Dream of Homeownership

by Ralph R. Roberts and

Rachel Dollar (Kaplan Publishing).

Telling the truth on your application

A huge percentage of real estate and mortgage fraud could be elim-

inated if everyone in the industry, including investors, would work

together to ensure that all the information on loan applications is

complete and accurate.

Buyers and those who assist them often think that accuracy is

optional, but the loan application, the 1003 (commonly referred to

as a ten-oh-three, or officially as the Uniform Residential Loan

Application), clearly states, just above the space for your signa-

ture, the following:

Chapter 2: Shielding Your Personal Assets from Investment Risks

Refusing to play a role in fraud for housing

Fraud for housing used to be the most common type of real estate and mortgage

fraud and the most “harmless” (although still illegal). It consists of lying on a loan

application so you can purchase a home to live in – as opposed to “fraud for profit,”

in which you’re committing fraud to obtain money.

When you’re acting as an investor, you’re at a pretty low risk of becoming a perpe-

trator of fraud for housing because you’re not buying the property to live in it.

However, you may be at risk for becoming an accomplice if you’re trying to sell a

property to buyers who are having trouble qualifying for a mortgage loan.

If prospective buyers are having trouble qualifying for a loan to buy the property

you’re selling, they may just not be able to afford the payments. Don’t try to “help”

them by encouraging them to lie on their loan application or by referring them to a

loan officer who’s known for bending the rules.

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I/We fully understand that it is a federal crime punishable by fine

or imprisonment, or both, to knowingly make any false state-

ments concerning any of the above facts as applicable under the

provisions of Title 18, United States Code, Section 1001, et seq.

What constitutes a

false statement? Here’s a list of what may be

considered false:

⻬ Stating or providing false records that you’re employed some-

where you’re not.

⻬ Stating or providing false records of income.

⻬ Providing false identification.

⻬ Boosting your credit score by piggybacking on someone else’s

better credit.

⻬ Falsifying ownership of assets, either by stating that you own

items you don’t or by renting assets. (Some disreputable com-

panies allow you to rent assets, so you appear to own more

assets than you really do.)

⻬ Failing to disclose a silent second. A silent second is a separate

mortgage typically taken out to cover the down payment. As

we discuss in Chapter 14, taking out a second mortgage to

finance the down payment is okay, but not disclosing it is ille-

gal. It creates the false impression that you’re more financially

secure than you really are.

Dodging predatory lenders

Although lenders are often the victims of mortgage fraud, they may

also be guilty of committing fraud and are even more frequently

guilty of lending practices that prey on uninformed borrowers.

Whenever you’re applying for a loan, keep one hand on your wallet

and one eye out for the following questionable and perhaps illegal

lending practices:

⻬ Charging you higher-than-normal loan origination fees (includ-

ing points).

⻬ Encouraging you to bend the truth on a loan application, so

you can qualify for a loan you would otherwise not qualify for.

⻬ Having you sign a blank loan application and then filling in the

details for you later.

⻬ Refinancing your mortgage repeatedly within a short period of

time.

⻬ Selling you a high-cost, high-interest loan when you would

qualify for a low-cost, low-interest loan.

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⻬ Adding products or services such as credit life insurance to a

loan without adequately informing you about the need or cost

of these products or services. Watch out for hidden (undis-

closed) fees.

⻬ Selling you products or services that are nonexistent or offer

no benefit.

⻬ Convincing you to borrow more than you can reasonably

afford to pay back.

⻬ Pressuring you to accept high-risk loans, such as balloon-

payment loans, interest-only mortgages, subprime or

adjustable rate mortgages (ARMs), and loans with high

prepayment penalties.

⻬ Selling high-interest loans based on ethnicity or nationality

rather than your credit history and financial situation.

Always obtain three or more quotes from different companies

before choosing a loan and compare the quotes carefully (see

Chapter 6 for details). Doing so enables you to see any hidden loan

costs more clearly. When applying for and closing on a loan, read

the documents carefully to make sure the information is accurate

and complete.

Saying “no” to inflated appraisals

One of the main instruments that real estate con artists use to ply

their trade is the

inflated appraisal — a document showing that a

property is worth significantly more than its true market value. By

obtaining an inflated appraisal (forging one or paying off a crooked

appraiser), the con artist can create equity in a property where

none exists.

As an investor, never try to sway the opinion of an appraiser or

allow a loan officer, real estate agent, or anyone else to convince

you to go along with a deal that involves an inflated appraisal.

Also, be careful about overpaying for a property whose value has

been artificially boosted by inflated appraisals. You can protect

yourself by ordering your own independent appraisal before pur-

chasing a property. Find an appraiser in the area who has a solid

gold reputation and plenty of experience in the market you’re

buying into. Don’t let the seller or seller’s agent recommend an

appraiser. You pay a few hundred dollars for your own appraisal,

but it can save you from making a mistake costing tens or even

hundreds of thousands of dollars.

We also recommend against using online appraisals or computer-

ized valuation models. You want a real live person, a qualified

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appraiser who knows the local market, to physically inspect the

property and provide you with an educated estimate of its market

value. There’s really no substitute.

Turning your back on cash-

back-at-closing schemes

One of the most prevalent forms of fraud, particularly when the

market is down, consists of providing the buyer with

cash back at

closing

. The buyer agrees to pay more for the property than it’s

worth and obtains an inflated appraisal showing that the property

is actually worth the purchase price. The seller agrees to raise the

asking price and kick back the excess money to the buyer at clos-

ing. Many people think these arrangements are okay, but don’t be

fooled — cash back at closing is illegal. Protect yourself:

⻬ Don’t offer buyers cash back at closing or any other “perks”

that the lender is actually financing, including “free” furniture,

a cruise, upgrades, and so on.

⻬ Don’t accept cash back at closing, even if it comes in some

other form, such as “free” furniture, upgrades, rebates,

refunds, or anything else that’s actually being paid out of the

loan amount.

Avoiding illegal flipping

Flipping houses, as described in Flipping Houses For Dummies, is

perfectly legal. You buy a house below market value, fix it up, and

then sell it for a profit. However, another type of flipping is clearly

illegal. It consists of buying a property, typically a dilapidated

house, at well below market value, doing a few cosmetic repairs to

make it look nice, and then selling it for much more than its true

market value.

As an investor, avoid illegal flipping. In addition to breaking the

law, this type of flipping ruins your long-term success. Illegal flip-

pers may score some quick cash, but they quickly ruin their repu-

tations and often end up in legal trouble. It’s not worth it.

To avoid becoming the victim of an illegal flip, always check the

recent sales prices of similar homes in the same neighborhood to

make sure the asking price of the property you’re about to pur-

chase is realistic. Make sure you’re the one choosing the home

inspector and the appraiser. If the seller offers to handle this for

you, politely decline the offer.

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Defending yourself against

chunking schemes

Real estate investors often become the targets of con artists

through what is commonly referred to as a

chunking scheme. The

con artist dangles a quick-cash, no-hassle investment opportunity

in front of the eager investor and offers to take care of all the

details. The investor only has to put up the cash or sign the papers

for the loan that to finance the deal.

The organizer promises to place renters, collect the rent, make the

mortgage payments, and so on, and tells the investor that the rental

payments will cover the mortgage and maybe even earn a little

extra cash each month. The investor can sell the property at any

time and profit from it because the property is sure to appreciate.

The truth behind the deal is that the properties are usually over-

valued, the renters don’t exist, and the con artist never intends to

make the mortgage payments. Investors are left with dilapidated

homes, unpaid mortgages, and destroyed credit.

The best way to avoid getting sucked in by a chunking scheme is to

plug your ears when you hear someone pitching a no-risk, no-

hassle way to earning riches in real estate. Quite frankly, such

deals don’t exist. Do your homework. Visit the property and

inspect it with your own two eyes. Oversee the management of the

property. Don’t let someone else “handle all the details” because

they probably intend to handle you out of your money.

Refusing a builder bailout

Builders who become overextended may try to dig themselves out

of a financial hole by selling homes (or whatever they’re building)

before completion to unsuspecting buyers. In some cases, the

builder eventually completes the project. In other cases, he may

take the cash and leave the buyer with an unfinished building or

even a vacant lot.

When banks finance new construction (see Chapter 9), they don’t

give the builder all the money at once. They set up an account that

the builder draws from during the building process. The bank

wants to make sure the project is completed, so it ties the cash

draws to success and to certain milestones. When those mile-

stones are completed, the bank can then free up the money to pay

for the supplies and services. For example, if the rough lumber

needed for a project costs $28,000, the bank would give the builder

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a draw for $28,000, which would then flow to the lumber company

after the framing was complete. The lumber company would then

sign a waiver of lien, acknowledging payment and freeing up its

claim to the property.

When a builder becomes strapped for cash, he may try to get the

money sooner by employing any of the following strategies:

⻬ Falsifying inspection reports

⻬ Submitting fake certifications of work performed

⻬ Fooling the inspectors by removing items from some buildings

and installing them in others to make it appear as though

progress is being made

⻬ Selling an incomplete property to the buyer

The best way to avoid builder bailout scams is to choose a rep-

utable builder and refuse to close on the deal until you have the

building thoroughly inspected by a professional inspector of your

choosing.

Acting with integrity:

The golden rule

Far too many investors succumb to the temptation to commit

fraud because they’re in a hurry to make a quick buck. All these

“investors” eventually fail because they tarnish their own reputa-

tions and damage the very industry that puts money in their

pockets.

The best way to achieve long-term success as a real estate investor

is to make a commitment to follow the golden rule — treat others

as you would want to be treated. You can still earn a handsome

profit in real estate by purchasing properties legitimately and set-

ting a fair price when you sell. You don’t have to break or bend the

laws to be successful. You just need to do your homework.

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Chapter 3

Gathering Essential

Documents, Facts,

and Figures

In This Chapter

䊳 Obtaining, checking, and correcting your credit history

䊳 Gathering all the facts, figures, and documents you need

䊳 Keeping track of where all your money’s coming from

䊳 Telling the difference between prequalification and preapproval

enders aren’t exactly tripping over themselves to lend money,

especially in the recent credit debacles of the mid-2000s. They

want to know who they’re lending it to, for what, and how and

when they’re going to get paid back. They usually operate conserv-

atively, weighing the risks before quoting you a price. If they see

your venture as too risky, they may reject your loan application

outright. If they believe you’re in a strong position to pay back the

loan in full, they may offer you financing at lower interest rates to

win your business. If they see you as a moderate risk, you may

receive financing at higher rates.

In any event, the lender wants to see how you look on paper — the

value of what you own, how much you owe, how much you earn,

your credit history, and so on. Before you even think about applying

for a loan, gather all the documents and information that lenders are

likely to request. This chapter leads you through the process.

Examining Your Credit Reports

Good credit is gold. Without it, you have access to your money

only. With it, you can put other people’s money to work for you.

Whenever you apply for a loan, the lending institution performs a

credit check — a background check to make sure that you’re not up

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to your gills in debt, that your income covers expenses, and that

you pay your bills on time. They examine your credit history (doc-

umented by the three major credit reporting agencies), bank state-

ments, pay stubs, W-2s, tax forms, and other financial records.

To ensure success at obtaining loans, become proactive in ensuring

your credit history remains unblemished. Check your credit report

every three months or so, correct any errors, and take steps to

improve your credit rating, as instructed in the following sections.

No irregularity is too small to correct. (Checking your own credit

report doesn’t negatively affect your credit score as can too many

credit inquiries from prospective creditors. Check your credit history

regularly, but keep loan and credit card applications to a minimum.)

The following sections show you how to obtain, review, and cor-

rect your credit report. We also offer suggestions on how to

improve your credit score.

Obtaining free copies of your reports

As of September 1, 2005, the Federal Trade Commission (FTC) man-

dated each of the three major credit reporting companies provide

you with a free credit report once every 12 months (a total of three

free credit reports per year). These three major national credit

reporting bureaus contain slightly different information about your

credit history, or what’s called a

credit report or credit profile.

To obtain your free credit report, do one of the following:

⻬ Submit your request online at

www.annualcreditreport.com.

⻬ Phone in your request by calling toll-free 877-322-8228.

⻬ Download the Annual Credit Report Request Form from www.

annualcreditreport.com

(click the link to request your

report through the mail), fill it out, and mail it to Annual

Credit Report Request Service, P.O. Box 105281, Atlanta, GA

30348-5281.

Some banks offer free credit reports, so consider checking with

your bank or credit union, too.

If you already obtained your three free credit reports this year

and want something more recent, you can order a credit report for

less than ten bucks from any of the following three credit report

agencies:

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⻬ Equifax: 800-685-1111 or online at www.equifax.com.

⻬ Experian: 888-397-3742 or online at www.experian.com.

⻬ TransUnion: 800-916-8800 or online at www.transunion.com.

Financial institutions may not file reports with all three agencies.

To obtain a complete credit history, order a three-in-one report

that contains data from all three agencies. All three agencies offer

these three-in-one reports.

Checking your credit score

To give your credit rating an air of objectivity, credit reporting

agencies often assign you a

credit score that ranges roughly

between 300 (you never paid a bill in your life) and 900 (you

borrow often, always pay your bills on time, and don’t carry any

huge balances on your credit cards). A “good” credit score is 700

or above. A “great” credit score is anything higher than 780.

Your credit score determines not only whether you qualify for a loan

but also how much you’re qualified to borrow and at what interest

rate. A high credit score enables you to borrow more and pay less

interest on it. A high score can also lower your home and auto insur-

ance rates so keeping a close eye on your score is important.

Chapter 3: Gathering Essential Documents, Facts, and Figures

Credit score stats

Credit reporting agencies rely on one or more statistical models to determine your

credit score. One of the most popular models is the Fair Isaac Company (FICO) rating

system. The credit company assigns numerical values to particular pieces of data

in your credit history, such as the length of your credit history and the various types

of interest you’re paying. They then plug these numbers into the statistical model,

which spits out your credit score. It’s basically a numbers game that weighs the

data on your credit report in the following manner:

⻬ 35 percent of the score is based on payment history

⻬ 30 percent is based on outstanding debt or how much you currently owe

⻬ 15 percent is based on the length of your credit history or how long you’ve been

borrowing

⻬ 10 percent is based on recent inquiries on your report (whenever a lending insti-

tution requests a report)

⻬ 10 percent is based on the types of credit, such as mortgage or credit card interest

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Although the law requires each credit agency to supply you with

one report annually, it doesn’t require them to provide your credit

score. When you’re getting your free report, you can choose to pay

extra to include your credit score.

Inspecting your report for problems

When you receive your credit report, inspect it carefully for the

following red flags:

⻬ Names that are the same as or similar to yours, but aren’t you.

⻬ Relative with the same name; for example, a father (Senior) if

you’re Junior.

⻬ Addresses of places you’ve never lived.

⻬ Aliases you’ve never used, which may indicate that someone

else is using your Social Security Number or the credit report-

ing agency has mixed someone else’s data into yours.

⻬ Multiple Social Security Numbers, flagging the possibility that

information for someone with the same name has made it into

your credit report.

⻬ Wrong date of birth (DOB).

⻬ Credit cards you don’t have.

⻬ Loans you haven’t taken out.

⻬ Records of unpaid bills that you either know you paid or have

good reason for not paying.

⻬ Records of delinquent payments that weren’t delinquent or

you have a good excuse for not paying on time.

⻬ Inquiries from companies with whom you’ve never done busi-

ness. (When you apply for a loan, the lender typically runs an

inquiry on your credit report, and that shows up on the report.)

An address of a place you’ve never lived or records of accounts,

loans, and credit cards you never had may be a sign that some-

body has stolen your identity. Yikes! Contact the credit reporting

company immediately and request that a fraud alert be placed on

your credit report. For tips on protecting yourself against identity

theft and recovering from it, check out

Preventing Identity Theft For

Dummies

by Michael J. Arata, Jr. (Wiley).

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Repairing your credit and

boosting your score

If you have a credit score of 700 or higher, pat yourself on the back.

You’re above average and certainly qualified to borrow big bucks

at the lowest available rates. Anything below about 680 sounds the

warning sirens that you need to dispute errors on your report or

repair your credit as quickly as possible. This number is the point

at which lending institutions get out their magnifying glasses and

begin raising rates and denying credit.

If your credit rating dips below 700, take steps to improve it, such

as the following:

⻬ Dispute any erroneous items on your credit report.

Disputing a claim doesn’t always result in a correction, but

you can add a paragraph to your report explaining your side

of the story.

⻬ Apply for fewer loans and credit cards. When you apply for a

loan or credit card, the lending institution typically orders an

inquiry that shows up on your credit report. Evidence that

you’re applying for several loans or credit cards in a short

period of time can make you appear financially desperate.

⻬ Pay off your credit card balances, if possible, or at least

enough so the balance is 50 percent or below your available

credit limit.

Doing so shows that your credit isn’t maxed out.

Paying off high-interest credit card balances is always a good idea,

but don’t start consolidating loans and closing out accounts. Having

four open accounts with a balance of $1,000 each on a $5,000 credit

limit looks better than one account with a credit limit of $5,000 and a

$4,000 balance. Why? Because of something called

credit utilization —

your total debt relative to the amount of credit available to you.

Keeping your credit utilization below 80 percent (preferably below

60 percent) improves your score.

Avoid credit enhancement companies on the Web that claim to

provide seasoned credit within 90 days. Law enforcement authori-

ties are shutting down these sites on a regular basis. Legitimate

credit counselors can help you repair your damaged credit, but it

takes some work and a little belt-tightening. Quick fixes are typi-

cally fraudulent fixes. For additional tips on boosting your credit

score, check out

Credit Repair Kit For Dummies, 2nd Edition, by

Steve Bucci (Wiley).

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Avoiding mistakes that can

sabotage your loan approval

After you apply for a loan, resist the urge to make any life-changing

decisions that negatively affect your current financial status. Major

changes can undermine your efforts to secure a loan, so follow

these sage do’s and don’ts:

⻬ Do stay married: Divorce drains your emotions, energy, and

finances. It cuts your assets in half and increases your liabili-

ties, obliterating your chances of securing a loan.

⻬ Don’t apply for other loans or credit cards: Any last-minute

inquiries that pop up on your credit report can be a red flag

that cautions prospective lenders.

⻬ Do avoid buying big-ticket items: Buying an expensive vehi-

cle can sink a deal. If you must have the vehicle, buy, fix, and

sell the investment property first, and then purchase the vehi-

cle with your profit.

⻬ Don’t make any major purchases on credit: This advice goes

for a car, furniture, health club membership, big-screen TV,

and any other purchase that can throw off your debt-to-

income ratio (see “Calculating your debt ratio” later in this

chapter).

⻬ Don’t cosign for any loans: No matter what your relationship

with the borrower is (or how badly your son, daughter, or

long-lost uncle needs the money), don’t cosign a loan. Doing

so exposes your credit history to potential blemishes when

others fail to make their payments.

⻬ Don’t withdraw or move substantial amounts of cash: If a

prospective lender looks at an account expecting to see $10,000,

and it shows a $50 balance, you have some explaining to do.

⻬ Do pay your bills on time: Records of unpaid bills and delin-

quent payments can get back to prospective lenders. If you

have a stack of unpaid bills, pay them now. If a bill is due on

the 1st and you pay it on the 15th, you can avoid the late fee.

Paying it before the 30th typically keeps the late payment off

your credit report. But any bill payment after the due date is

considered late and qualifies as

slow pay, which lenders can

figure into their formula assuming they know about it.

If your financial situation changes between the application and the

time of closing, you’re legally obligated to inform the loan officer

and lender of the change.

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Chasing Down Vital Paperwork

You can approach a loan application in one of two ways: Either

show up with all the paperwork, facts, and figures in hand or con-

sult with a lender first and find out what she needs. The first

approach is best, because it demonstrates to lenders that you’re

well organized and are committed to providing them with every-

thing they need to do their job.

However, in order to come prepared to your lender, you must know

which paperwork you need for the meeting. In the following sec-

tions, we reveal the information and documentation most lenders

are going to require to process your loan application.

Delving into your personal

financial information

Unless you plan to borrow money solely against business assets,

lenders are going to want to know everything about your personal

finances — the value of everything you own, the total you already

owe on other loans and credit cards, your monthly and annual

income, monthly bills, and so on. And they’ll want documentation

to back up all those figures.

The following sections show you how to calculate some of these

important figures, including your net worth and debt ratio, and list

the documentation required to prove the amount of cash you have

and the monthly and annual income you earn.

Calculating your net worth

Most people in real estate and banking know their own net worth.

Asking folks in these circles, “What’s your net worth?” is about as

natural as asking them their name. When we ask most consumers

to estimate their net worth, however, they look puzzled, as if we

had asked them for the square root of pi. They simply have better

things to entertain themselves.

Net worth is simply whatever money you would have if you sold all

your stuff and then paid off all your debts, including your taxes.

Officially, the equation goes like this:

Net Worth = Assets – Liabilities

A strong positive net worth indicates that you

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⻬ Own more than you owe

⻬ Don’t borrow more than you can afford to pay back

⻬ Can pay off a loan by liquidating assets, if needed

⻬ Pay your taxes on time

⻬ Probably know more about net worth than you realize

To prove to a lender that you’re net worthy, follow these simple

steps to calculate your net worth:

1. Jot down a list of your assets and liabilities.

The tough part is identifying assets and liabilities.

Following these steps are lists of common assets and liabili-

ties, which can help you identify yours.

2. Total your assets.

3. Subtract your liabilities.

The next time someone asks, “What’s your net worth?”

you’re prepared to answer.

The following lists of items may stimulate your brain cells and help

you identify different examples of assets and liabilities.

⻬ Home: If you sold your home today, what could you get for it?

If you recently had an appraisal, use that number, assuming

the appraiser assigned it an honest value.

⻬ Other real estate: If you have a vacation home or other real

estate, consider how much you could get for it if you sold it

today.

⻬ Car: The blue book value (current value), not what you paid

for it.

⻬ Savings account: Whether you have $5 or $50,000, it counts.

⻬ Checking account: The current balance as recorded in your

check register. No cheating. If you just wrote five checks that

haven’t cleared yet, you don’t really have that money.

⻬ Retirement savings: 401(k), IRA, SEP, or other account that

you don’t dip into for your daily living expenses.

⻬ Investments: Stocks, bonds, and mutual funds that aren’t part

of a retirement account.

⻬ Jewelry, antiques, and artwork: If you’re not sure what this

stuff is worth, have it professionally appraised. People often

think that their stuff is worth much more than it really is.

⻬ Furniture: If you sold all your furniture at an auction or

garage sale, what could you get for it?

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⻬ Cash value of life insurance: If you have term life insurance,

it’s worth $0. If you use a life insurance policy as an

investment, how much is it worth today?

If you don’t have it, don’t count it. The money you stand to inherit

when Aunt Millie kicks the bucket doesn’t count.

Now for the painful part — liabilities. These are items such as the

following:

⻬ Mortgage principal: The amount you owe on your house

today and on any other loans you’ve taken out on the house.

⻬ Car loan: How much would paying off your car loan today

cost? Write it down.

⻬ Student loans: If you’re paying off any student loans from

your old college days or are named as a cosigner on any of

your kids’ student loans, record the amounts as liabilities.

⻬ Credit card debt: Dig out your credit card bills and tally up

the total you currently owe on them.

⻬ Taxes owed: Do you owe any back taxes or property taxes?

Total the amount.

⻬ Personal loans: Did you borrow $5 from the neighbor to buy

candy from the neighborhood kids? Write it down.

You may be able to obtain most of the liability information you

need from your credit report, as discussed earlier in this chapter

in the section “Examining Your Credit Reports.” However, if you

know that you have a debt that doesn’t appear on the credit

report, be sure to include it in your calculations.

Calculating your debt ratio

Almost every lender examines your debt ratio, so you should know

what it is before the topic ever comes up. Your

debt ratio is how

much you pay out in monthly bills compared to your gross

monthly income. Generally speaking, you can estimate your debt

ratio by dividing your total monthly payments (on loans and credit

cards) by your total monthly income:

Debt Ratio = Total Monthly Payments ÷ Total Monthly Income

Your total monthly payments apply only to payments on loans and

credit card balances, not for other expenses like groceries, gas, or

clothing. They include payments on long-term debts, such as a car

loan or student loan payments, alimony, child support, or a bal-

ance you carry on one or more credit cards. Debt ratios come in

two flavors:

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⻬ Back-end debt ratio: The back-end ratio consists of your total

debt payments (including your house payment with home-

owner’s insurance and property taxes) divided by your

monthly income. According to the Federal Housing Authority

(FHA), your back-end debt ratio should not exceed 43 percent.

⻬ Front-end debt ratio: The front-end debt ratio (also called the

housing ratio) consists of your house payment alone (includ-

ing property taxes and insurance) divided by your total

monthly income. According to the FHA, your front-end debt

ratio should not exceed 31 percent. If your total gross house-

hold income is $6,000 per month, for example, your house

payment alone should not exceed $1,860.

Gathering bank statements

Almost all lenders are going to ask for copies of the most recent

two months’ bank statements, so they can see how much cash you

have in savings and checking, determine whether you have a

healthy cash flow, and check for any activity that looks out of the

ordinary (such as large deposits or withdrawals that can’t be

explained by other documentation). Make a copy of your two most

recent bank statements — whether you receive statements

monthly or quarterly.

On the copies, take a black magic marker and mark out the

account numbers to prevent others from gaining unauthorized

access to your accounts.

Tracking down your pay stubs and W-2s

If you work a regular job, you probably get a paycheck every week

or two that shows your gross pay, your deductions (state and fed-

eral income tax, Social Security, and so on), and what’s left — your

net pay. Most lenders want a full month (30 days’ worth) of consec-

utive paycheck stubs — not one from last week and another from

two months ago; they need to be the most recent and consecutive.

They should also show your year-to-date (YTD) earnings.

Most lenders also want to see proof of previous years’ income. Of

course, they can obtain this evidence by looking at your previous

two years of federal income tax returns, but many lenders also like

to see your W-2 forms, so be sure to make copies of these as well.

If you don’t have a regular job, skip ahead to the section

“Accounting for business income” to find out which records you

need to supply to prove your business income.

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Gathering tax returns and schedules

Every lender requires you to submit along with your loan applica-

tion your federal income tax returns. Make sure you provide copies

of your two most recent federal income tax returns. Copy the com-

plete federal tax return, including all schedules and attachments,

not just the first two pages of the return. Include

everything — don’t

leave something out just because you don’t think it’s relevant.

You don’t need to supply your state income tax returns unless state

grants or subsidies are involved in the transaction or financing.

Pulling up other useful documents

If you follow the instructions in the previous sections, you now

have all the major facts, figures, and documentation you need

related to your personal finances. However, additional documenta-

tion may also be useful (and necessary) in determining whether

you qualify for a particular loan. Your lender or broker may need

the following:

⻬ Any documents that support your income, such as employ-

ment contracts with step increases; union benefit agreements;

notes receivable; real estate earnings; earnings from trusts,

estates, or settlements; or documentation showing major lot-

tery winnings.

⻬ Property income, including GAI (Gross Annual Income) from

rents; storage fees; fees for facilities, such as clubhouse,

pools, satellite TV, cable, laundry, or Internet; parking or car-

port fees; pet income; income from signage; a percentage of

tenant sales (for retail commercial properties); and so on.

⻬ Documentation of any unusual liabilities (or the exclusion of

them), such as major reimbursed business expenses, person-

ally guaranteed business loans (appearing on your credit

report), or old loans that you’ve paid off but that haven’t

cleared from your report.

Create copies of any documentation that supports your claims of

assets, liabilities, and income. Prospective lenders may request

specific documents, but gathering everything you have available in

advance makes your job that much easier later on.

Accounting for business income

If you don’t have a regular job or you have income (or losses) from

a business, you need to supply proof of your income or loss:

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⻬ Some of this documentation may already be included in your

federal income tax returns. Be sure to include

all schedules

(C’s E’s, K-1’s, and so on) so that the lender has an accurate

picture of each of your investments and business holdings.

⻬ If you own 25 percent or more of any company, corporation,

or LLC, provide copies of each entity’s federal returns for the

past two years.

⻬ To provide more recent data, produce a report showing YTD

income and expenses for the business. You can produce such

reports fairly easily by using a business or personal finance

program, such as Quicken or QuickBooks. If you have an

accountant, ask the accountant to produce a report for you.

Documenting the property

you plan to purchase

Your gut feeling that a particular property is a great investment

may be enough to convince you to sign a purchase agreement, but

it’s rarely enough to convince lenders to finance the purchase. You

need to have a plan in place for how you’re going to profit from the

investment, complete with fairly realistic estimates concerning the

costs and revenue potential.

Many novice investors view the loan application process as a big

hassle that just gets in the way of their vision and profits. However,

by forcing you to think ahead, the process actually protects you

from making bad investment decisions. As an investor, you should

only purchase a property to make money or create future wealth,

and you should be able to show how an investment will further

those goals before you ever sign a purchase agreement.

In the following sections, we show you how to estimate and

document the profit potential for investment properties.

Obtaining an appraisal or comparative market analysis

As a real estate investor, your goal is to discover properties that are

likely to generate profits. Basically you don’t want to pay more for

the property than it’s worth. To help in your calculations, get your

hands on a

comparative market analysis or appraisal. Your real

estate agent can provide you with a comparative market analysis

that shows the probable value of the property in relation to similar

properties that have sold recently or are currently on the market.

You want to keep your eyes open for property that’s likely to make

you profits in one or both of the following two ways:

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⻬ Income from sale: You’re looking to buy low and sell high or

legally “flip” the property. For more about flipping properties,

check out

Flipping Houses For Dummies.

⻬ Rental income: You’re planning a buy-and-hold strategy, in

which your rental income covers (or more than covers) your

expenses until you decide to sell the property (hopefully for

more than you paid for it).

If you want something more formal and more detailed, you may

consider hiring an appraiser. A qualified appraiser can evaluate the

market value of the property (to assist in estimating your potential

income from selling it) or evaluate the income of the property by

using a Net Operating Income (NOI) formula (see Chapter 8).

When you’re just checking out some properties, bringing in an

appraiser may be premature (and an unnecessary expense). Most

investors rely on their own market knowledge and perhaps their

agents’ insight to estimate the property’s value. The appraiser

enters the picture just prior to closing to confirm that the property

is worth the price you’re paying. However, if you’re seriously consid-

ering a property and are questioning your instincts, you may want to

hire an appraiser for a second opinion before moving forward.

The seller whose property you’re thinking of buying may already

have had an appraisal done, in which case, you may be able to

review it just by asking. (Don’t place blind faith in the seller’s

appraisal — use it only to confirm or question your own evaluation.)

Looking ahead to potential resale value and repair costs

When you obtain an appraisal, the appraiser usually takes into

account the property’s current condition. If you plan to flip the

property for a quick profit, estimate the market value of the prop-

erty after repairs. What’s a realistic price you think you can get for

the property after fixing it up? Your real estate agent should be

able to help you come up with a realistic value.

You also need to estimate your total costs for the project, includ-

ing the cost of repairs and renovations, holding costs for the dura-

tion of the project (the total you plan to spend on loan interest,

property taxes, loan interest, and utilities), and the cost of selling

the property (any real estate agent commissions and closing fees).

Overestimate costs and underestimate the final sale price, so you

have a bit of a buffer. For details about making well-calculated

investments when flipping properties, check out

Flipping Houses

For Dummies

by none other than Ralph and Joe, two of your

esteemed authors (Wiley).

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If you’re planning on holding the property for several years rather

than doing a quick flip, you still need to consider the potential

future value of the property. For example, if you’re buying into a

neighborhood where home values are on the rise, then paying close

to the appraised value of the property may make sense. The ques-

tion you need to answer is this: How likely is it that I will more than

recoup my investment when I finally decide to sell the property?

Performing a quick cash flow analysis

One of the best ways to build wealth in real estate is to purchase

property and hold it indefinitely. During the time you hold the prop-

erty, you profit in three ways:

⻬ The property appreciates, gaining in value.

⻬ Renters pay down your principal (the amount you owe on the

property).

⻬ You get a tax write-off for any expenses you incur relating to

the rental property.

Of course, your profit hinges on the assumption that you earn

more in rent than the property costs you in expenses (including

taxes, insurance, landlord-paid utilities, repairs, and improve-

ments). In short, you (and your lenders) want to make sure that

that your investment delivers a positive cash flow so you’re not

losing money.

The formulas for calculating cash flow (or NOI) are fairly basic:

GAI – VAC = EGI

EGI – TOE = NOI

If those formulas look like Greek to you, read on:

⻬ GAI is your Gross Annual Income; simply calculate your

yearly income from all possible sources (rent, carport, laun-

dry, storage, parking, and so on).

⻬ VAC is a vacancy allowance; use a minimum of 5 percent of

the GAI to allow for vacancy (periods when you have no

renters).

⻬ EGI is your Effective Gross Income — the total workable rev-

enue you see from the property. Another way of looking at it is

that this is the amount of money you have on hand to cover

your property’s expenses.

⻬ TOE represents your Total Operating Expenses; this figure

includes all the costs to operate the property, except the loan

payments. It includes maintenance, taxes, insurance,

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management, landscaping, landlord-paid utilities, office

expenses, and so on.

⻬ NOI is your Net Operating Income; this number represents

your profit on a yearly basis, assuming you pay

cash for the

property.

This formula works for

all buy-and-hold properties. It shows you

and your lenders how much you can afford to pay monthly for the

financing. We look at calculating those numbers in Chapter 8.

Calculating the loan-to-value (LTV) ratio

The loan-to-value (LTV) ratio is a mathematic representation of how

much you owe on your home compared to its appraised value.

Banks use LTVs to justify lending money to high-risk borrowers.

Even if you have a low credit score and a history of paying your

bills a little late, a bank may be willing to cut you some slack and

approve your loan if your LTV ratio is low. In other words, the more

equity you have in your home, the more likely the bank will

approve your loan.

For example, if your home appraises for $250,000 and you owe

$200,000 on it, the LTV is $200,000 ÷ $250,000, or 80 percent.

Anything below 80 percent is considered great and often qualifies

you to borrow more money at a lower interest rate.

Be realistic and know how much you can really afford to borrow.

Don’t cause yourself stress and future problems by trying to stretch

your finances too thin. If after you do your calculations it looks as

though you can’t afford to borrow more money, don’t. Check out

some of your other options instead, as we explain in Part IV.

Obtaining zoning information

Most counties or cities zone properties for specific uses, usually to

keep businesses out of residential districts or vice versa. Before

you purchase a property, find out how it’s zoned so you know

about anything that could restrict the way you use the property.

Check with the local city or county assessment or building

inspection office regarding the following:

⻬ How the property is currently zoned

⻬ Any plans to change the zoning for this area

⻬ Whether your intended use of the property fits the current

and any new zoning restrictions

⻬ Whether the property is subject to changes in zoning require-

ments; some properties have “grandfather” clauses that allow

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them to operate without being subject to changes in the zoning

requirements, but these clauses may expire when ownership of

a property changes

Pulling city and county records

When you’re investing in real estate, knowledge is power; the more

you know about a property before you buy it, the less likely you

are to encounter nasty surprises later. The info you gather may

also improve your chances of obtaining financing to purchase and

restore the property. One way to obtain additional information is

to research the public records.

Call the city or county assessor’s office or the County Real Estate

Mapping Division (every county has one) and find out how to

access the parcel maps, aerial maps, tax records, building records,

zoning or building appeals, violations, and ownership records. The

county has to make all these documents available to the public.

Many cities and townships post their records and even property

histories online.

If you notice any red flags in the property records, such as a build-

ing code violation, address them before you purchase the property

and they become

your headache. In many cases, liabilities for viola-

tions and/or discrepancies (such as boundary lines, easements,

riparian rights [relating to a body of water], natural resource claims,

and so on) reach back to only a certain number of previous owners.

You don’t want to get stuck on the hook for someone else’s problem

from long ago.

Part I: Gearing Up for Financing Your Real Estate Investments

Zoning fiasco

If you think that zoning restrictions are something you can deal with later, think

again — they may just deal with you later. Several years ago, I (Chip) bought a

property without thinking too much about zoning restrictions and grandfather

clauses. I planned to use the property pretty much the same way the owner before

me used it. Because no grandfather clause was in place that would expire when

I took ownership, I figured I was safe.

Unfortunately, a different type of grandfather clause was in place — one I hadn’t con-

sidered. The clause stated that if the property burned down,

nothing

could be built in

its place. The lot would have to remain vacant regardless of how it was zoned!

Fortunately, the building didn’t burn down when I owned it, but getting insurance

was tough, and I was severely limited in what I could do with the property. It was

zoned for multifamily, but I had to convert it back to single family to get the Certificate

of Occupancy that’s required before you can lease the property.

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The “cleaner” the package, and more documentation you have, the

more valuable the property becomes — and the easier to sell later

on. Get your ducks in a row early on so that problems don’t cause

expensive delays later.

Show Me the Money: Identifying

Sources of Ready Cash

When you’re applying for a loan, the lender will ask you to do one

important thing: “Show me the money!” Where will you get the nec-

essary cash for the down payment, the closing costs, the pre-paid

items, any repairs or inspections, any third-party fees, or commis-

sions? Do you have sufficient cash reserves to cover unexpected

expenses or income shortfalls?

You need to be able explain and document those sources of avail-

able cash, as we discuss in the following sections.

Sources of cash for down payments,

closing costs, and prepaid items

Although you can usually count on financing the major portion of

the purchase price, you probably need to pay some closing costs

and other expenses out of pocket. Your lender wants to know up

front where the money’s going to come from. The money can come

from just about any source, as long as you have documentation to

prove the money exists:

⻬ Checking and savings accounts

⻬ Retirement accounts

⻬ Money from the sale of other properties

⻬ Refinancing or selling other assets

⻬ Commissions

⻬ Bonuses

⻬ Gifts

⻬ New loans

Documentation can include bank or other financial statements,

sales receipts, HUD-1’s from the sale/refinance of real estate, loan

agreements, and credit card statements.

Chapter 3: Gathering Essential Documents, Facts, and Figures

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Rainy day funds: Cash reserves

On most transactions, lenders want to know you have reserves —

cash set aside to cover the cost of unpleasant surprises. Simple

transactions may require two to three months’ cash reserves of the

monthly payment or principal, interest, taxes, and insurance (PITI).

More-complex transactions may require reserves for construction

allowances, credit losses, tenant improvements, and replacement

reserves (for example, for new refrigerators or stoves in apartment

units). The lender establishes the reserve requirements, and different

lenders have different guidelines for calculating minimum reserves.

The more reserves you have, the better. Even shaky loans get

approved based on a borrower having strong reserves.

Getting Prequalified

or Preapproved

You’re always in a stronger position to purchase a property at an

attractive price if you have cash or financing in place when making

your offer. Cash is king. Financing is queen. Having to secure

financing is about a

2. Because you’re reading a book on financing,

we can safely assume that, like most investors, you don’t have

enough cash on hand to purchase investment properties. The next

best option is to prequalify or obtain preapproval for a loan:

⻬ Prequalification: Prequalification means a lender or broker has

reviewed your financial records and determined that you would

probably qualify for a particular loan. The lender performs some

basic calculations to determine whether your front-end and

back-end debt ratios meet the FHA qualification requirements.

⻬ Preapproval: Preapproval is a more formal, final step in which

the lender obtains all the borrower’s documentation and

underwrites the loan — without a property. With preapproval,

the lender agrees to finance the purchase of an investment

property up to a certain amount. As long as the property

complies with the lender’s standards, the loan is a done deal.

Gaining preapproval puts you in a much stronger position to nego-

tiate. To the seller, it’s almost as good as cash. Preapproval is also

much better for you as a borrower because it insulates you from

changing market conditions. You can move quickly on a property

and lock in an approval even if credit tightens and interest rates

rise. (Chapter 7 leads you through the loan process so you can do

everything necessary to obtain preapproval.)

Part I: Gearing Up for Financing Your Real Estate Investments

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Chapter 4

Scoping Out Prospective

Lenders

In This Chapter

䊳 Hitting up banks for a loan

䊳 Getting a broker to do your legwork

䊳 Exploring the private sector

䊳 Financing through the seller or your Uncle Sam

䊳 Joining forces with a cash-endowed partner

o pursue your dream of owning some investment property, you

need some start-up cash. Sure, you can shake all the money

out of your piggy bank and cookie jar, but that probably won’t

score you enough cash to finance your first major acquisition. You

need serious cash — probably at least 100 grand — and you don’t

want to have to go through the neighborhood loan shark to get it.

If you haven’t shopped for money before, you may have the mis-

conception that the answer is simple — just head down to the

bank. But as we reveal in this chapter, you have many more

options from which to choose. If the bank won’t loan you the

money or offer you a decent deal, maybe someone else will.

In this chapter, we introduce you to the money lenders, including

bankers, brokers, and some less-conventional sorts. You may be

surprised at the variety available. In later chapters, we get into the

nitty-gritty of actually asking for the money.

Borrowing Directly from Banks

You don’t need a treasure map to locate huge stores of cash. At

just about every major intersection in every town or city, you can

find a bank chock-full of greenbacks. Unfortunately, depending on

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Part I: Gearing Up for Financing Your Real Estate Investments

market conditions, your friendly neighborhood bank may not be as

eager as you might expect to give you the combination to the vault.

But is a bank the best place to go for a loan? Maybe, maybe not. In

the following sections, we weigh the pros and cons of financing

through a bank and examine the types of loans banks typically

offer. After reading through these sections, you should have a

pretty clear idea of what banks can and can’t do for you as an

investor.

Weighing the pros and cons

Financing your investments through a bank, particularly the bank

you use to manage your personal finances, may seem like the perfect

solution, at first. It’s probably convenient, you already know some of

the people, and you feel comfortable doing business with them.

Don’t dismiss any source of financing without first exploring it.

Before you head down to your bank to apply for a loan, however,

weigh the pros and cons of borrowing from a bank. You may dis-

cover that a bank is the perfect solution for your financing needs

or that the perfect solution isn’t so ideal after all.

Pros

Financing your real estate investments through a bank, especially a

local bank, offers several perks, including the following:

⻬ Security and reliability: Federally insured banks are generally

dependable institutions, although even the most solid institu-

tions are vulnerable to bankruptcy.

⻬ Convenience: Banks typically have many branches, which can

give you access to convenient locations when you need assis-

tance or a quick draw from a line of credit to act on an invest-

ment opportunity.

⻬ Portfolio lending: Smaller financial institutions, including

banks and credit unions, may be more open to holding loans in

their own portfolios rather than selling them to bigger banks

or mortgage companies. This allows them to be more flexible

on interest and terms. However, portfolio lending is usually

available only for short-term (less than three years) loans.

⻬ Community Reinvestment Act (CRA) goals: Banks may be

required by federal law to lend money for certain projects

(including residential and commercial properties) within their

immediate geographical area. A lucrative rehabilitation invest-

ment project can get the green light just because of the bank’s

CRA requirements. (For more about the CRA option, check out

Chapter 9.)

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⻬ Insights and guidance: Local banks understand the local real

estate market. They’re aware of trends and market conditions,

and can provide a great deal of insight into the viability of an

investment property in a specific area. Your banker may just

develop into your own personal real estate investment advisor.

⻬ Preferential treatment: Although the world may seem to be

becoming more impersonal, relationships still count, espe-

cially when dealing with money. As you develop a relationship

with people at the bank, especially loan officers and execu-

tives, you place yourself in a stronger position to negotiate

more affordable loans.

⻬ Improved access to REO properties: When a bank forecloses

on a mortgage, it often takes possession of the foreclosure

property and transfers it to its Real Estate Owned (REO)

department, which then tries to sell the property. If everyone at

the bank knows you as a trustworthy investor, you may have a

better chance of obtaining good deals on these properties.

During economic slowdowns, when credit usually tightens, REO

(or bank-owned) properties become more available. In addition,

because banks get stuck holding so many of these properties, they’re

often willing to finance purchases. Through careful negotiations, you

can not only buy properties at great prices but also have the bank

finance them. For more about this strategy, check out Chapter 17.

Cons

Although banks offer a host of valuable benefits, they also come

with a few drawbacks, including the following:

⻬ Limited financing options: Unlike brokers, banks don’t help

you shop for loans. They can offer you the loan programs

from their own menu only. They may not even offer certain

loans (such as government loans) for particular types of prop-

erties. A

mortgage broker can provide more options by work-

ing with dozens of banks. Check out “Dealing with a

Middleman (or Woman): Brokers” later in this chapter.

⻬ Possible complications: Many banks broker their loans out

(sell them to other lenders or institutions), so you end up

dealing with another lender anyway without reaping any of

the benefits of working through a broker, such as a faster,

hassle-free closing.

⻬ Possible loan processing delays: Many banks rely on hourly

employees to handle loan transactions. As a result, they have no

financial incentive to wrap things up quickly. Mortgage brokers,

on the other hand, are paid only when the loan closes. They’re

typically paid on a straight commission for producing the loan,

so they have an added incentive to see that it closes quickly.

Chapter 4: Scoping Out Prospective Lenders

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Part I: Gearing Up for Financing Your Real Estate Investments

Conventional loans

Banks typically deal in loans that are considered conventional or

conforming — meaning the loan conforms to all the requirements

of Fannie Mae and Freddie Mac (see the nearby sidebar).

Conventional loans are the bread and butter of residential real

estate financing, particularly for homeowners but also for

investors. With conventional loans, you can always be sure that

⻬ Capital is available.

⻬ Loan costs and interest rates are generally attractive.

⻬ Interest rates among lenders vary only slightly because the

money is coming from Wall Street through Fannie and Freddie.

Because conventional loans are primarily intended for consumers

borrowing money to purchase a home, plenty of information is

available on how to find the best deals on conventional mortgages.

For more information, we recommend

Mortgages For Dummies, 3rd

Edition, by Eric Tyson and Ray Brown (Wiley). To separate mort-

gage fact from fiction, check out our book

Mortgage Myths: 77

Secrets That Will Save You Thousands on Home Financing

(Wiley).

Conventional loans are also available for investors, although they

tend to cost more and be more restrictive — with a loan-to-value)

usually no higher than 75 percent and 1 to 1.5 points. (For more

about LTV, see Chapter 3. For information about points, refer to

Mortgage broker or loan officer?

You’re likely to hear plenty of industry lingo bandied about, but the first two terms

you need to sort out are “mortgage broker” and “loan officer.” A

mortgage broker

is a licensed company or professional who assists clients in finding and arranging

financing through lenders. Brokers are regulated by the state. A

loan officer

may

simply be an individual who works on behalf of a licensed lender or mortgage broker

to facilitate the process. Some states license the individual loan officers as brokers.

For all practical purposes, a loan officer offers the same services as a mortgage

broker but is required by law to work for the licensed broker or lender. It’s sort of like

going into your doctor’s office and seeing a nurse practitioner — sometimes the

practitioner offers better advice than the doctor even though the practitioner isn’t

licensed to practice medicine.

Of course, you’re usually better off working directly with an experienced broker, but

if you find a great loan officer, you may do just as well or better.

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Chapter 6.) As an investor, keep in mind that having access to cash

is often more important than the cost of gaining access.

Subprime (nonconforming) loans

Subprime loans (also known as nonconforming loans), are the bad

boys of the mortgage lending industry. At least that’s what many

people were led to believe during the great mortgage meltdown in

the late 2000s. Due to some irresponsible underwriting by lenders

and irresponsible borrowing on the part of consumers, subprime

loans did contribute to the mortgage meltdown, but that doesn’t

make them all bad. They do serve a useful purpose when used

appropriately.

Subprime loans are everything that Fannie Mae and Freddie Mac

aren’t. Although some subprime loans known as Alt-A loans can go

through Fannie and Freddie, most don’t. (An

Alt-A loan or alterna-

tive A-paper

loan is one for which the approval is based primarily

on the borrower’s lower credit score, or other situations such as

self-employment, that increase the risk of repayment.) Instead,

subprime loans are usually available through other institutional

investors, pension funds, insurance companies, various large and

small mortgage banking firms, and even individuals.

Chapter 4: Scoping Out Prospective Lenders

Fannie and Freddie who?

The question is more like “Fannie and Freddie what?” Fannie Mae is actually a nick-

name for the FNMA, or Federal National Mortgage Association. Freddie Mac is a

nickname for FHLMC, or Federal Home Loan Mortgage Corporation.

Both organizations do pretty much the same thing — they purchase residential mort-

gages and then convert the mortgages into securities for sale to Wall Street investors,

indirectly financing the purchase of homes. In other words, they sort of act as the

middlemen between banks and Wall Street investors. The end result is that they make

money readily available for the purchase of homes and other real estate.

Although both institutions began as government-chartered, private companies,

they’re now controlled by the government as a result of the problems they ran into

during the mortgage meltdown that started in 2008. While we were writing this book,

it was still too early to tell whether the end result would be a consolidation, merger,

or something else entirely, but whatever happens, Fannie and Freddie should essen-

tially function the same way but with more restrictions.

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Part I: Gearing Up for Financing Your Real Estate Investments

Instead of Fannie and Freddie setting the qualifications for these

loans, the market and individual investors lay down the rules and

decide what’s available and to whom. As a result, they can offer a

much greater variety of loan packages that appeal to niche markets

and address specific needs, such as the following:

⻬ Limited-documentation loans make it easier for investors who

don’t have the necessary financial documents (tax returns,

pay check stubs, and W-2s) to qualify for loans.

⻬ Hybrid adjustable rate loans can help investors with short-term

financing and cash flow by providing flexibility in interest rates.

⻬ Rehabilitation programs can open doors to investors by

funding special projects or development in certain areas.

Subprime loans have some drawbacks, particularly if the borrower

doesn’t fully understand the terms, which can be complicated. When

shopping for any loan, make sure you’re working with a qualified and

trustworthy professional who can clearly explain your options and

the ramifications of choosing a particular option. In short, know what

you’re getting into before signing on the dotted line.

One of the main drawbacks of subprime mortgages is that certain

programs can disappear overnight as the appetites of Wall Street

investors and consumers change. Numerous creative subprime loan

packages emerged leading up to the mortgage meltdown, and many

of these options disappeared as soon as loan defaults shot up.

Dealing with a Middleman (or

Woman): Mortgage Brokers

A mortgage broker is sort of like a real estate agent, but instead of

helping you find the right house, the broker helps you find the

right loan. Ideally, a broker sits down with you to determine what

you’re planning on using the money for and then assists you in

selecting the lender and loan package that best meets your needs.

Through a broker, you gain access to dozens of financing options

as opposed to the limited few you may find with a local bank.

In the following sections, we discuss the pros and cons of working

through a broker and then show you how to find brokers and

research their credentials and references.

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Weighing the pros and cons

As you probably already guessed, we think that most investors can

benefit by shopping for loans through a broker — a good broker,

that is. In the following sections, we list the reasons why. To give a

balanced perspective, we also list a couple of reasons why you

may not want to use a broker. Furthermore we give you clues to

uncovering a good broker and what you can do to verify the broker

is reputable and the right choice for you.

Pros

Mortgage brokers offer a host of benefits for fueling your real

estate purchases and development, including the following:

⻬ Better selection: A broker has access to many different

lenders, each of whom may offer several different loan pack-

ages, so you’re more likely to find a loan that meets your

unique needs.

⻬ Bargaining power: Mortgage brokers can negotiate fees and

terms with large lenders and play one off the other to negoti-

ate the best deal on your behalf.

⻬ Marketplace knowledge: Brokers are more in tune with new

and creative financing programs and options. When new pro-

grams become available, they’re often the first to know.

Although mortgage brokers specialize in the mortgage lending indus-

try, many are also very knowledgeable about the real estate market in

their area. In addition, a well-established broker is likely to have con-

nections with other investors, local bankers, real estate attorneys,

and so forth. Take full advantage of what your broker has to offer.

Cons

Mortgage brokers are sort of like doctors and lawyers — if you find

the right one, you have no reason not to use a broker. However,

finding and keeping a qualified broker who’s dedicated to serving

your needs can be quite a challenge. Watch out for the following:

⻬ Lack of experience: Many brokers may not be experienced

enough or large enough to deal with the right lenders. You can

spend a lot of time researching and checking credentials and

references before you find a great broker.

⻬ High turnover: Brokers can disappear overnight. Becoming a

broker doesn’t require a huge capital investment, so brokers

often come and go. After a long search, you may find a top-

notch broker only to discover that several months later the

person is no longer in business. You may end up losing time,

money, and a valuable resource.

Chapter 4: Scoping Out Prospective Lenders

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Part I: Gearing Up for Financing Your Real Estate Investments

Shaking the branches for a broker

Although you can certainly flip through the “Mortgages” section of

the phone-book ads or search the Internet for “mortgage brokers

any town, your state USA” to find brokers in your area, these meth-

ods don’t focus in on the highest quality prospects. The best way

to find qualified, experienced mortgage brokers is to search

through the people who actually borrow money to finance their

real estate investments — real estate investors.

Obtain referrals from investors in your area, so you know the

broker has experience working with investors and has provided

satisfactory service to at least one person. Most investors will also

tell you which brokers to avoid.

If you don’t know other real estate investors in your area, you have

some work to do. Join a reputable real estate investment club such

as the Rental Property Owners Association (RPOA) and start net-

working. (Search the Web for “rental property owners association”

followed by your state.) You can pick up plenty of market knowl-

edge just by attending meetings and talking with people who’ve

been there and done that.

Checking a broker’s credentials

Ideally, a mortgage broker works on your behalf to find you the

best deal. Unfortunately, brokers don’t have a

fiduciary (legal finan-

cial) responsibility to you as the borrower. As a result, some bro-

kers may try to sell you on a loan that brings them a higher

commission rather than provide you with a better deal. This is why

finding a trustworthy broker who has a stellar reputation is so

important.

In the following sections, we show you how to do your own back-

ground check on mortgage brokers, verify their credentials, and

interview the top three candidates.

Doing a background check

After you have a list of possible candidates, start trimming that list

to three finalists by doing a background check on each candidate:

⻬ Check the National Association of Mortgage Brokers (NAMB)

Web site at

www.namb.org to make sure the broker is a

member.

NAMB members follow a strict code of ethics, tend

to be more dedicated to the profession, and are required to

take continuing education courses.

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⻬ Search the Internet for the company’s or individual’s name.

If the candidate has a bad reputation, dissatisfied clients are

likely to post something about it on the Web.

⻬ If the company or individual has a Web site or blog, visit the

site and explore.

Make sure the broker deals in both conven-

tional and subprime loans. The more established brokers also

offer government loans, including Federal Housing Authority

(FHA) and Veteran’s Administration (VA) loans. (Check out the

section “Borrowing from Uncle Sam: Government Loan

Programs” later in this chapter for these types of loans.)

⻬ Visit your state’s Web site and verify that the broker is

licensed in your state.

If you can’t find your state’s Web site,

call the licensing board in your state capital. All 50 states have

licensing requirements for mortgage lenders. Some states have

licensing for individuals as well. Check for any administrative

actions or sanctions, or complaints (many complaints aren’t

public unless the department of licensing takes action). You

may also want to check your state attorney general’s Web site.

⻬ Check the Better Business Bureau (BBB) for any complaints.

Start at the national Web site’s home page at (www.bbb.org),

which can direct you to the Web site for your local branch.

⻬ Contact your local chamber of commerce to determine

whether the broker is a member in good standing.

Being an

established member of the local business community is

always a big plus.

⻬ Contact each broker who’s made the first cut and obtain

three references from investors and three references from

real estate agents the broker has worked with.

(Make sure

the real estate agents are well-established in the community,

not just part-timers.) Call the references and ask about their

experience working with the broker.

Don’t just go with the broker who has the largest ad in the phone

book or the local newspaper. Check their credentials with the state

licensing board, the BBB, and the state attorney general’s office for

complaints and/or regulatory actions or sanctions.

Interviewing the top candidates

After you’ve chopped your list of candidates down to three, call to

set up an interview with each of them. During the interview, be

sure to ask the following questions:

⻬ How long have you been in business? You’re looking for

someone who’s been a broker for at least a couple of years.

⻬ How many transactions do you process in a year? Good bro-

kers average at least 40 to 50 transactions per year. Someone

Chapter 4: Scoping Out Prospective Lenders

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Part I: Gearing Up for Financing Your Real Estate Investments

who processes way fewer than average may lack motivation.

A broker who processes way more may not be careful enough.

⻬ What percentage of your transactions are conventional,

non-conventional, and government loans?

Brokers generally

deal with far more conventional loans, but look for a broker

who has experience with all three types.

⻬ What percentage of your transactions are investor loans?

Brokers who do a substantial percentage of their business

with investors are usually a better choice than those who

exclusively serve consumers/homeowners.

⻬ How many lenders do you work with? Generally speaking,

the more the merrier. The more lenders the broker has access

to, the wider the selection of loan packages.

⻬ What’s your specialty? Just as real estate agents specialize in

certain types of homes, mortgage brokers specialize in certain

types of loans (such as government loans, first-time home

buyers, construction loans, and so on). Choose a broker who

specializes in the types of loans that best fit your investment

strategy. (See Chapters 5 and 9 for descriptions of different

residential and commercial loan types.)

⻬ What are your application fee requirements? Determine how

much money the mortgage broker charges upfront at the time

of application and what those fees are applied toward.

Compare costs among the brokers and make sure they’re

applying any fees to real services rather than pocketing them

as extra money.

⻬ What’s your policy on locking in interest rates? Does locking

in a rate cost extra? How long does the rate remain locked?

How soon before closing does the rate have to be locked?

⻬ What’s your refund policy for cancelled loan applications?

Some brokers actually charge upfront fees up to $1,000 or

more if you cancel a loan application. You’re better off know-

ing about it now than when you need to cancel an application.

During the interview, make sure you get along with the broker and

that your personalities match up pretty well. If this is a good fit,

you’ll be working together for some time. You want somebody you

can get along with.

Taking the Hard-Money Route

through Private Lenders

Hard money is called “hard” for a reason — it’s hard to get, hard to

pay, and generally costs more than your average loan. Hard money

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comes from individuals or small groups of private investors who

like to obtain a high return on their money and are willing to take

some additional risk in order to get it.

Because hard money costs more, you may wonder why anyone on

earth would even consider it. Just like any other type of invest-

ment method, hard money has its upsides and downsides. Hard

money offers several benefits:

⻬ More financing options: You gain access to cash you may not

be able to get through a conventional lender. Hard money

loans typically cost more in points upfront and interest, but

the terms can be more flexible than with conventional loans.

⻬ More collateral options: Hard-money lenders often accept the

future value (after renovations) of a property as collateral, so

you don’t have to borrow against other assets, like your home.

⻬ More flexibility: You can often close the transaction faster, with

less paperwork, and even set up a separate escrow account

with a hard money lender to pay for repairs and renovations.

⻬ Less intrusion into your business: Banks tend to be more

intrusive, wanting more information about the business oper-

ation than a hard money investor does. The hard-money

lender sets a lower LTV requirement, so you have less equity

risk from the start. Even so, hard-money lenders do want to

know the plan for repayment and see a business plan if it’s

contingent on a business tenancy arrangement.

On the flipside, hard money does have a few significant drawbacks:

⻬ Higher cost: Sometimes gaining access to cash, whatever the

cost, is good investment decision — as long as you account

for that cost in your calculations and can still turn the profit

you want.

⻬ Lower ratios: Another disadvantage of hard-money loans is

that the LTV’s (loan-to-value ratios) are typically lower. For

example, instead of being able to borrow 80 to 90 percent of

the value of the property, you may only be able to borrow 65

to 75 percent. However, hard-money lenders are often willing

to make the calculations on the future value of the property.

For more about using hard money to finance your real estate

investments, check out Chapter 11.

Hard-money lenders may be more willing to negotiate with

investors, especially investors who have a solid track record. Some

lenders, for instance, may charge three or four points upfront to

reduce their exposure to the risk of an early default but then agree

to refund one or two points when you’ve paid off the loan.

Chapter 4: Scoping Out Prospective Lenders

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Part I: Gearing Up for Financing Your Real Estate Investments

Borrowing from Uncle Sam:

Government Loan Programs

The housing market plays an important role in driving the econ-

omy, so the U.S. government does what it can to support this key

industry. One of the primary support mechanisms are government

(or government-secured) loans made available to first-time home

buyers. If you’re like most Americans, you probably used an FHA

(Federal Housing Administration) or VA (Veterans Administration)

loan to purchase your first home.

Through the FHA, the U.S. Department of Housing and Urban

Development (HUD) also offers loans to homeowners and

investors to assist in rehabilitating properties. Government loans

are designed to help the marketplace in areas where the private

sector can’t. After Hurricane Katrina, for example, several govern-

ment programs came to the rescue, encouraging investors to assist

in rebuilding the damaged areas. Special grants and state and fed-

eral loan programs gave investors access to cash that the banks

and private sector wouldn’t or couldn’t offer.

In most cases, the government steers clear of lending money

directly to homeowners and investors. Instead, the government

secures the loans. If the borrower fails to pay back the loan, the

government steps in, picks up the tab, takes the property, and tries

to sell it to recoup its loss. Additionally, most government programs

are limited to owner-occupied properties.

As a homeowner, you’re already aware of some of the benefits that

government-secured loans offer homeowners, but government

loans can also benefit investors in two important ways:

⻬ Understanding government loans can enable you to flip the

property to a buyer down the road. For example, the

Good

Neighbor Next Door loan

(GNND) enables qualified buyers

(including teachers, law-enforcement professionals, and fire-

fighters) to purchase certain HUD homes with only a $100

down payment, or even some HUD repo’s at half price;

203(k)

loans

help an owner rehabilitate a property, pay for additions,

and even purchase new appliances. Using the GNND loan and

a 203k loan, a qualified investor can actually buy a home for

half its market value with a $100 down payment and then sell

it several years down the road to earn a handsome profit.

⻬ You may be able to purchase government-owned properties

directly (usually those foreclosed on due to nonpayment of an

FHA or VA loan) and finance the purchase through the govern-

ment agency.

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For more about using specific government-sponsored loan pro-

grams to finance real estate purchases and rehabilitation, see

Chapter 5.

Financing through the Seller

Before most homeowners can pack up and move, they have to sell

their homes and pay off their current mortgages so they can afford

to buy their new homes. Homeowners who’ve paid off their mort-

gages or have sufficient cash available, however, don’t need the full

purchase price upfront. They can sell you the home and

finance

the purchase. In other words, the seller becomes the bank.

If a seller is willing and able, you can often purchase the property

on contract through a lease option agreement or a land contract.

The contract takes the place of the mortgage document that most

buyers sign when they close on a house. In the following sections,

we explain how these contracts work. For more about the pros and

cons of financing through the seller and the nitty gritty of how to

harness the power of seller financing, check out Chapter 12.

Lease options

A lease option agreement is sort of a rent-to-own deal. You rent the

property from the owner for a fixed period (usually no more than a

few years), at the end of which time you have the option to buy the

property. Normally, the seller requires some sort of down payment

(often less than a typical mortgage lender requires), which should

be applied to the purchase price, along with monthly rent equiva-

lent to about 1 percent of the purchase price.

A lease option agreement can be a great way to finance the pur-

chase of an investment property, assuming you’re working with a

seller who deals aboveboard, and you have a great plan in place

for obtaining cash or alternative financing by the time your option

to buy the property rolls around.

So how does a lease option work? The monthly payment consists

of rent plus some additional money that’s applied to the purchase

price. In other words, if the going rate for rent on the property is

$1,000 per month, you may have a monthly payment of, say, $1,500

with the extra $500 being added to your down payment. This

ensures that you’re building equity in the property during the lease

part of the agreement, and it provides the seller/lender with some

security in the event that you back out of the deal.

Chapter 4: Scoping Out Prospective Lenders

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Part I: Gearing Up for Financing Your Real Estate Investments

Make sure that the lease option agreement is very specific regard-

ing the application of payments and terms of exercising your

option. Otherwise, you may lose a lot of money in rent that you

assumed was being applied to the purchase price or lose your

option to buy on some minor technicality. Have a qualified real

estate attorney look over the agreement before you sign it, and

make sure you understand it completely.

Land contracts

With a land contract (also called a contract for deed), the seller

essentially functions as a bank, so you’re cutting out the middle-

man. In most cases, you handle the transaction through a rep-

utable escrow company. The deed is held in escrow, and you make

payments to the escrow company. When you’ve finally paid the

loan in full, the escrow company releases the deed to you.

Land contracts are often win-win situations, benefiting both the

seller and the investor:

⻬ The seller profits not only from the sale of the property but

also from the interest the buyer is paying. They earn invest-

ment income generated by an asset they know and love —

their own real estate.

⻬ The investor benefits by not having to pay a lot in closing

costs and being able to obtain a loan without having to jump

through hoops for a bank or mortgage company. With the

increased cash flow, an investor can obtain more properties

by using this strategy.

Make absolutely sure that payments are handled by a servicing

company —

not by the seller — and that the deed is placed into

escrow. The last thing you want is to make payments for seven

years, only to find out that the underlying mortgage wasn’t paid,

the property has a tax lien against it, and the seller is nowhere to

be found to sign off on the deed! Been there, done that, not going

back for seconds.

Teaming Up with a

Cash-Heavy Partner

Successful partnerships begin with individuals whose needs and

offerings complement one another — in other words, when one

partner has what the other needs, and vice versa. People who have

plenty of cash often don’t have plenty of time, talent, and motivation

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to purchase, renovate, and manage real estate, and they really don’t

have to — they can hire someone else to do it for them. This is

where you come in as an investor. You have (or should have) the

know-how. All you need is the money.

In the following sections, we introduce you to various ways to

structure a partnership that typically work well in real estate. In

Chapter 13, we go a little deeper to show you how to partner with

the right individual(s).

Opting for a limited partnership

A limited partnership is called “limited” for a very good reason —

the liability protection (none) and tax benefits (insignificant) of a

partnership are very limited. Legal actions against one partner can

lead to actions against all partners, and each partner can be held

personally liable for actions of the partnership as a group. In other

words, if you’re going to partner up with someone, you really need

to form the partnership inside the protective bubble of a corpora-

tion, as discussed in the following section.

Limited partnerships do offer a few benefits. They’re

⻬ Easy to set up

⻬ Inexpensive

⻬ Simple to manage for the few involved parties

You can set up a limited partnership with two or more people

(including yourself) on a per-property basis or to invest in multiple

properties. Just make sure you have all the terms of the partnership

in writing. The agreement should address the following three areas:

⻬ Partner responsibilities: Spell out what each partner is

responsible for — supplying capital, finding and buying real

estate, making repairs and renovations, marketing and selling

the property, and so on.

⻬ Profit sharing: Specify how profits from the real estate ven-

tures are going to be split.

⻬ Dissolution: Stipulate how you’re going to divide any cash

and other assets if you decide to dissolve the partnership

later. Yeah, we know — when forming a partnership, the last

thing you want to think about is the possibility that it will end,

but it’s better to come to an agreement now when you’re

friends than later when you’re at each others’ throats (hope-

fully, that doesn’t happen).

Chapter 4: Scoping Out Prospective Lenders

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Part I: Gearing Up for Financing Your Real Estate Investments

Have an attorney draw up the partnership agreement and explain

the terms to everyone involved. Each partner should have his own

legal representation to ensure that his interests are protected.

If you’re forming a corporation, a partnership agreement is still

very useful in clarifying each partner’s responsibilities. If you

decide not to use a written agreement, at least make sure that your

corporation papers clearly explain how distributions will be

applied — usually determined by shareholder percentage of own-

ership and disclosed on the K-1 (the tax schedule showing the total

annual payments, deductions, and credits to the shareholder).

Going the corporation route

Even if you happen to form a partnership with one or more other

individuals, managing your partnership as a

corporation offers

additional benefits in terms of taxes and liability protection. You

have three options here:

⻬ LLC: A limited liability corporation (LLC) limits your exposure

to risk. If someone takes legal action against the corporation,

your personal assets are protected. For most investors, we

recommend forming an LLC, as discussed in Chapter 2.

⻬ Sub-S corp: A Sub-S corp (short for Subchapter S corporation)

also limits your exposure to risks and allows for pass-through

taxation (unlike a C-corp). With

pass-through taxation, the cor-

poration’s profits pass through to your individual income tax

return, avoiding

double-taxation (in which both you and your

corporation are taxed). Only individuals, not other business

entities, can own a Sub-S corp, and the corporation can have a

maximum of 75 shareholders. With a Sub-S, you run the risk of

the IRS forcing it into C-corp status (described in the following

bullet) if the corporation shows as having too much

passive

income

(income you don’t really do anything to earn, such as

rental income, that’s taxed at a lower rate than

earned income).

⻬ C-corp: A C-corp (short for Chapter C corporation) also limits

your personal liability, but we don’t recommend going the C-

corp route for most real estate investors. First, you need to

have at least 75 shareholders or establish a real estate invest-

ment trust (REIT), as discussed in Chapter 2. A C-corp also

exposes you to double-taxation, which can really take a bite

out of your profits.

A Sub-S corporation is simple to establish and file for, but make

sure to file for the Sub-S election with the IRS right away after form-

ing the corporation. For more about forming and managing a cor-

poration, check out

Incorporating Your Business For Dummies by

The Company Corporation (Wiley).

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Part II

Financing the

Purchase of

Residential Properties

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In this part . . .

hen most folks buy a home, they’re usually best off

to look for a 30-year ﬁxed-rate mortgage that keeps

their payments low and steady and allows them to pay off

the loan in a reasonable amount of time. When you’re

ﬁnancing real estate investments, however, cash ﬂow

becomes much more important. You usually want to use as

little of your own money as possible, so you have cash on

hand to cover other investments and unexpected expenses.

This part gives you the tools to secure the ﬁnancing you

need to start hunting for residential real estate investment

opportunities. In this part, we explore the many residential

loan programs currently available, show you how to com-

pare different loan packages to ﬁnd the one that costs the

least overall, and lead you through the loan application

from ﬁlling out the forms to closing.

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Chapter 5

Finding the Residential Loan

Program That’s Right for You

In This Chapter

䊳 Understanding why choosing the right loan is so crucial

䊳 Focusing more on cash flow than on loan costs and interest

䊳 Checking out what your government can do for you

䊳 Dodging prepayment penalties

onsumers have hundreds of different residential loan programs

to choose from, including zero-down-payment programs, 40-

and 50-year terms, interest-only loans, and complicated adjustable-

rate mortgages that can double your payment overnight! In addition,

investors may have access to government financing through rehabil-

itation loans, renaissance loans, and even grants for redevelopment.

With so many types of loans and other financing to choose from,

how do you pick the type that’s best for you as an investor?

This chapter introduces you to the most common residential loan

types, explains how each program works, and guides you in choos-

ing the right type of loan for your investment needs.

The market is in constant flux, so new mortgage programs are con-

stantly being introduced while obsolete programs are being phased

out. In writing this chapter, we’ve tried our best to provide informa-

tion that’s detailed enough to be useful, but general enough to

accommodate market changes.

Understanding Why Finding the

Right Residential Loan Is Key

You’re not the only one who wants to earn a buck off real estate.

Lenders want to earn their keep, too, so they charge all sorts of

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interest, fees, and penalties. As an investor working through one of

these lenders, you have two primary goals:

⻬ Gain access to cash. You need cash to do deals. Check out the

following section, “Choosing a Loan Type to Maximize Your

Cash Flow” for more information.

⻬ Pay as little as possible for access to that cash. After all, the

more you pay in interest, fees, and penalties, the less money

you walk away with at the end of the day.

In order to meet these two goals, you want to locate the right resi-

dential loan. To help you know what’s available, throughout this

chapter we roll out a veritable smorgasbord of loan types so you

can home in on the type that sounds best for a particular deal.

Another key to locating the right loan is to examine

all the pros

and cons of each available loan before making a selection. We

cover this important step in Chapter 6.

When searching for the right residential loan, you also need to know

the difference between residential and commercial loans.

Residential

mortgage loans finance the purchase of properties that people live

in — single-family homes, multifamily dwellings, apartment buildings,

condos, and co-ops.

Commercial loans finance the purchase of prop-

erties that house businesses. With residential loans, lenders typically

examine the ability of the

borrower to make payments and eventually

pay back the loan. With commercial properties, lenders give more

weight to the

building’s ability to produce sufficient income. (See Part

III for more about financing the purchase of commercial properties.)

Choosing a Loan Type to Maximize

Your Cash Flow

When most folks buy a home to live in, the main ingredients they’re

looking at in a mortgage loan are interest rate,

term (number of years

to pay off the loan), and monthly payment. They want a monthly

mortgage payment they can afford without paying an exorbitant

amount of interest over the life of the loan.

As an investor, your needs are different. Your primary goal is to gain

access to cash, even if you have to pay more to gain that access.

The interest rate, terms, and payment matter only as they relate to

your all-important cash flow. As a result, the criteria you use for

comparing loans are likely to differ a great deal from the criteria

you use to select a mortgage for a primary residence.

Part II: Financing the Purchase of Residential Properties

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We toss the term cash flow around quite a bit and even use it as a

verb, as in “Wow, this property really cash flows!” So what is cash

flow, exactly?

Cash flow simply means that the property is bringing

in more cash than is going out each month. If your property is losing

money, it has a negative cash flow . . . and you have problems.

When you’re more focused on gaining access to financing than

worrying about the cost of financing, your options suddenly multi-

ply. You can begin to consider loans that you would otherwise dis-

miss outright as costing too much. In addition, you can begin to

explore a host of options that aren’t available to the average home-

owner, such as rehabilitation loans.

In the following sections, we show you how cash flow enables you

to leverage the power of using other people’s money to finance

your investments and introduce you to a few types of loans that

can maximize the cash you have available for investments.

The power of OPM (other

people’s money)

One of the secrets to maximizing your investment profits is to use

as little of your own money and as much of other people’s money

(OPM) as possible. By using OPM, you stretch your investment

dollar — you can buy more and better properties and increase

your profit potential as a result.

Whenever you finance the purchase of a property, rather than paying

cash with your own money, you’re using OPM. Throughout this book,

we reveal various sources of OPM, including bank loans, government-

secured loans, hard-money lenders, small-business loans, and so on.

We introduce the concept of OPM here, so you have a better under-

standing of why you want to borrow money (rather than using all

your own money) to purchase real estate. After you grasp the

concept of OPM and understand the leverage it gives you, you’re

better prepared to begin evaluating the sources of OPM.

The magic of using OPM is in the numbers, as the following

examples reveal:

⻬ You invest $100,000 cash to buy, renovate, and sell a house for

$120,000. You just made a 20 percent profit ($20,000 profit

divided by your investment of $100,000 equals 20 percent).

⻬ You invest $20,000, borrowing the other $80,000 to buy, reno-

vate, and sell a house for $120,000. You just made a 100 percent

profit ($20,000 profit divided by your investment of $20,000

equals 100 percent).

Chapter 5: Finding the Right Residential Loan Program

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In these examples, you earn five times more profit percentage-wise

by using other people’s money, even though you earn the same

profit in terms of dollar amount. You may argue that you still end

up with $20,000 in your pocket either way. But say you have $100,000

to invest, as in the first example. Instead of buying one property with

$100,000, you can divvy it up into $20,000 chunks to buy five $100,000

properties (borrowing $80,000 for each). You now control $1,000,000

worth of real estate and when you sell the properties, you earn

$20,000 each for a total profit of $100,000!

Borrowing money is always risky, but you have to take some risk.

Throughout this book, we show you ways to reduce the risk, but

unforeseen events can undermine the best-laid plans. As a real

estate investor, you need to decide for yourself whether the poten-

tial benefits outweigh the risks.

The following sections reveal some loan types that can free up

more of your own money and maximize the use of OPM.

Interest-only mortgages

An interest-only loan is just what it sounds like; if you take out an

interest-only loan for $100,000, in two years, after making 24 interest-

only payments, you still owe $100,000. Sound like a bum deal?

Part II: Financing the Purchase of Residential Properties

Did I overpay for that loan?

Several years ago, I (Chip) obtained a mortgage for a two-family duplex at 9.50 per-

cent interest, and paid 3 points to get it. The market rate for mortgages was about

6 percent at the time, and qualified home buyers were usually able to secure a mort-

gage without paying any points. Most people would have thought I was crazy.

Was I?

Crazy like a fox, maybe. I needed a loan to purchase an investment property, and

because the property had been severely neglected and in disrepair, the type of loan

I needed wasn’t readily available in the marketplace. Without cash, I couldn’t do the

deal, so I was willing to pay a premium to gain access to the cash I needed. It was just

a short-term solution until I could make some repairs to the point that the property

became eligible for more-conventional (and less-expensive) financing. But the cash

flow made it very attractive (and profitable) — even at the higher interest rate.

When financing real estate investments, you have to remember to stop thinking like

an average homeowner and start thinking like an investor. Put your investor cap on

when examining the terms and make sure the cash flow works for the property

you’re planning on buying.

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It may be, if you plan on living in your home for 15 years and the

value of the home doesn’t appreciate significantly. But if you’re

using the loan for a quick flip, it may be perfect. You pay off the loan

in full right after you sell the house. In the meantime, you have more

investment capital to put toward renovations or other properties.

The key to using interest-only loans wisely is in making sure the

property provides a positive cash flow — enough revenue to more

than cover all your costs, including the monthly interest you’re

paying, and the value of the property is stable or rising. When

considering interest-only loans, be aware of the following:

⻬ Most interest-only loans are adjustable rate mortgages (ARMs),

so carefully check the adjustment period, index, margin, and

cap. (For more about ARMs, check out the following section.)

⻬ Rarely is an interest-only loan interest-only for the life of the

loan. Read the fine print to determine when and how you

must pay the principle. Some loans require a lump-sum pay-

ment three to five years down the road. They suck you in with

low monthly payments early and then sock you with huge bills

later. This fake-out may be devastating to the average home-

owner, but if you know about it and plan for it, an interest-only

loan can be your ticket to a profitable investment property.

Nobody can judge a loan type as good or bad without considering

how the investor uses the loan to finance the investment. If a no-

interest loan frees up some cash so you can complete the repairs

and renovations on a property more quickly, the fact that your

entire payment was going only toward interest matters very little.

Grabbing a hold of ARMs

Adjustable rate mortgages (ARMs) have interest rates that fluctu-

ate. You may take out a loan for 5 percent and find yourself paying

8 percent the following year. Even so, ARMs can play a valuable

role in your investment strategy. They’re often easier to qualify for,

and if you can sell the property or refinance the loan before the

rate jumps, you may be able to avoid any huge increases in interest

and payments.

As was revealed during the great foreclosure crisis that began in

2008, ARMs are risky business for most homeowners. Tight credit

can undermine your plans to sell or refinance. In the meantime,

your monthly payment increases could make the property un-

affordable. Realize that when you take out an ARM, you’re taking a

gamble. To minimize your exposure to risk, figure out the worst-

case scenario and plan accordingly.

Chapter 5: Finding the Right Residential Loan Program

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When shopping for ARMs, examine the following factors to deter-

mine the worst-case scenario:

⻬ Initial interest rate: The interest rate when you sign for the

loan. This is usually a

teaser rate to make the initial payments

more attractive.

⻬ Adjustment period: The frequency at which the rate can go

up or down. This is typically one, three, or five years but can

also be months rather than years.

⻬ Index: ARMs are tied to an index that typically rises or falls

based on government lending rates. Ask which index the lender

uses, how often it changes, and how it has performed in the

past. Several indexes are considered standard, including the

Treasury index, the London InterBank Offered Rate (LIBOR),

the Cost of Funds Index (COFI), the Prime Rate, various T-Bills,

and the Fed Funds Rate.

The Treasury index is always a little safer and secure and is the

most common. Take some time to look up whatever index your

lender uses, and make sure you can find it in

The Wall Street

Journal

(the financial rates section) or a similar publication.

⻬ Margin: The percentage above the index that the lender

charges — think of it as a markup. For example, if the index

is at 3 percent and the margin is 2 percent, you pay 5 percent

interest. If the index rises two percentage points to 5 percent, you

pay 7 percent interest. The margin remains the same through-

out the life of the mortgage.

⻬ Cap: The highest interest rate the lender can charge, no matter

how high the index rises. So if the lender sets the cap at 9 per-

cent, you never pay more than 9 percent interest, no matter

how high the index goes. The lender likely will quote a yearly

cap and a lifetime cap as, for example, “2/6”, which means the

rate can go up 2 percent per year (or per adjustment), and

6 percent over the life of the loan.

Make sure you understand all the possible adjustments that can

take place and calculate the payments under a worst-case sce-

nario. Plug this number into your

pro forma calculations (your pro-

jections) to make sure that your property will still cash flow under

the worst of circumstances. We can’t stress enough the need to do

your homework, and possibly consult your highly qualified and

trusted mortgage broker before selecting an ARM.

Part II: Financing the Purchase of Residential Properties

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Hybrids

A hybrid loan is a combination of an ARM and a fixed-rate loan.

With a hybrid term, the interest rate remains fixed for a certain

number of years, after which time the rate is adjustable. For exam-

ple, with a 3/1 hybrid, the interest rate remains fixed for 3 years

and then becomes an adjustable-rate loan in which the rate can be

adjusted every year. A 2/28 hybrid has a fixed interest rate for the

first 2 years and then adjusts each year for the next 28 years.

These types of loans are better suited for situations in which you

plan on holding the property for at least a couple of years before

selling it and you’re fairly certain that interest rates won’t drop

over the next couple years. If you’re planning on selling the prop-

erty quickly, an adjustable rate mortgage with a low introductory

interest rate may be a better choice. (See the previous section for

more on adjustable rate mortgages.) On the other hand, if you plan

on holding the property for longer than a couple of years, a fixed-

rate mortgage may be more appealing.

The main advantage of a hybrid over a straight ARM is that it pro-

vides, at least for a time, a guaranteed fixed interest rate, which

can help you establish more reliable cash flow projections for the

duration of the fixed-interest term. You still need to be careful,

however; hybrid loans can turn into time bombs if your projections

are based on unrealistic assumptions. An unexpectedly steep jump

in the interest rate can quickly create a negative cash flow.

Hard-money loans: Private investors

When easy money is unavailable (money from financial institu-

tions), you can always turn to

hard-money lenders — private

investors who offer loans that typically charge several points

upfront, use higher-than-average interest rates, and require pay-

ment in full after only a few years.

Why would any investor in her right mind even consider a hard-

money loan? Because you gotta have cash to do a deal, and some-

times hard money is the only money you can get your hands on.

For more about financing your real estate investments with hard

money, turn to Chapter 11.

Chapter 5: Finding the Right Residential Loan Program

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Taking Advantage of Government-

Secured Loans

You may be able to hit up your rich Uncle Sam for a loan to finance

your real estate investments (refer to Chapter 4 for more on how

government loans work). Although the government rarely loans

money directly, especially to investors, it often secures loans so

lending institutions can make the money available without exposing

themselves to huge risks. (If a borrower defaults on a government-

secured loan, the government pays the difference and sells the

home to recoup at least part of its loss.)

Although many government loans are available only to finance

the purchase of

owner-occupied properties (properties that the

borrower/homeowner is going to live in), in some cases you can

also use these programs to finance the purchase, repairs, and

renovations of investment properties.

In the following sections, we describe a host of government pro-

grams that may be available to you depending on your investment

strategy and the property you’re planning to purchase. We

also show you how to go about tapping into these government-

sponsored resources.

Tapping the FHA for a loan

Although the Federal Housing Authority (FHA) works with mort-

gage lenders to make loans available primarily to first-time home

buyers, some FHA programs are open to investors. These loans can

directly benefit you by providing government-secured financing for

investment properties, especially if you’re investing in residential

real estate and multifamily housing. The FHA is the federal govern-

ment’s way of promoting the American Dream of homeownership.

As an investor, these programs can also benefit you indirectly —

you can often use FHA loans to assist prospective buyers in financ-

ing the purchase of an investment property you’re selling. One of

the biggest obstacles preventing first-time buyers from purchasing

a home is their inability to qualify for a conventional mortgage.

FHA loans make qualifying much easier for them.

If you’re working with a well-qualified mortgage broker (see

Chapter 4) who has experience working with investors, she can

direct you to FHA loan programs that you may be able to qualify

Part II: Financing the Purchase of Residential Properties

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for as an investor. The same is true if you’re working directly with a

lender who handles FHA loans.

To get more information about FHA loans and other programs

straight from the source, visit the FHA Web site at

www.fha.gov,

where you can find information about the Good Neighbor Next

Door program (described in Chapter 4), special loans for financing

the development of multifamily housing and medical centers,

streamlined FHA mortgages, 203(k) loans, and much more.

If you decide to sell a property you own, you can often attract

more buyers if you advertise that you accept FHA financing. Also

offer to put prospective buyers in touch with your mortgage broker,

who can help them determine whether they qualify for an FHA loan.

In addition to helping the buyers, your broker can screen out any

looky-loos (casual browsers) who may not be able to afford the

property.

If you’re looking to invest in residential real estate, you may be

able to turn to one of the following FHA loans. Check carefully

(your lender or broker can assist you) because they have strict

guidelines.

FHA 203(b) loans

FHA 203 loans are designed for first-time homebuyers and people

who don’t have a lot of money for a down payment. Investors can

utilize these loans to help their potential buyers finance the pur-

chase of their residential real estate, or to acquire and occupy a

multifamily property. (You’d have to occupy at least one of the

units in a multifamily property.) During the writing of this book,

FHA 203b loans

⻬ Are available only for owner-occupied, one- to four-family

homes

⻬ Allow borrowers to obtain a loan for up to 96.5 percent loan-

to-value (LTV)

, meaning they can purchase a home with a

down payment of as little as 3.5 percent of the property’s

market value

⻬ Are assumable for a new purchaser, meaning the owner can

get out from under the loan by arranging to have a buyer pick

up the payments

FHA offers another program that you may find useful as an investor:

streamline refinancing. This program enables you to lower your

interest rate on a previous FHA loan with low or no out-of-pocket

costs faster and with less documentation than most other refinance

loans. For example, if you purchased a home with a $100,000 FHA

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loan as a home buyer a couple of years ago, moved out, and now

use the home as an investment property, you may be able to refi-

nance at a lower interest rate through this program. Even better,

you can refinance all the way back up to the original loan amount

(about $100,000 in this example) without obtaining a new appraisal,

and roll all costs into the new loan — including any points you may

pay to lower the rate.

Title I loans

Title I loans are available only for owner-occupied properties to

enable homeowners to finance the cost of repairs and renovations

up to $25,000.

Title I loans are great for investors who want to flip the property

they’re living in but don’t have the cash on hand to bring the prop-

erty up to market conditions. In a situation like this, you can use

the Title I loan in either of the following ways:

⻬ Take out the Title I loan yourself to pay for repairs and

renovations before placing the property on the market.

⻬ Place the home on the market as is (at a lower asking price)

and let potential buyers know about the Title I loan they can

take out to cover the cost of repairs and renovations after

they take possession.

FHA 203(k) loans

FHA 203(k) loans are similar to Title I loans in that they’re avail-

able only for owner-occupied properties and they allow the owner

to finance the cost of repairs and renovations. The difference is

that 203(k) loans allow the cost of

major repairs to be combined

with the purchase price of the property.

This program is ideal for investors who want to purchase a property,

live in it while they’re making repairs and renovations, and then sell

it. Just make sure you don’t overimprove the property and improve

yourself right out of a profit. Also, your intent has to be to live in the

house for at least 12 months as a primary residence.

For example, if a home is worth $100,000 now but would be worth

$150,000 all fixed up, you can obtain an FHA 203(k) loan for the

full $150,000 upfront, take your time completing the repairs and

renovations, and then sell the property after you’ve lived in it for

at least 12 months total.

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Multifamily loans

For larger residential properties, FHA does offer a multifamily pro-

gram that allows investors to purchase and rehabilitate apartment

complex–type properties. You can often combine the FHA loan

with other government grants or subsidies for improvements, tax

credit, or rental payments such as the Section 8 program.

You can find out more about FHA programs for multifamily housing

through HUD’s Web site at

www.hud.gov/groups/multifamily.cfm.

Viewing Veterans Affairs

(VA) loans

As one of the perks for serving in the military, the U.S. Department

of Veterans Affairs (VA) offers veterans zero-down financing to pur-

chase owner-occupied one- to four-family properties. If you’re a

veteran, these loans are often the best deal in town. As an investor,

you can often leverage the power of VA financing when you decide

to sell a property — these loans give you access to another pool of

potential buyers.

Although VA loans are generally available only to veterans, even

investors who aren’t veterans can often obtain VA financing to pur-

chase foreclosure properties that the VA owns.

Any mortgage broker or lender who handles VA loans can assist

you in determining whether you qualify for one of the programs. Your

broker may also be able to work with any prospective buyers (if you

decide to sell the property) to determine whether they qualify for

a VA loan, which may make the property more affordable to them.

For more about VA loans, visit the VA’s Web site at

www.va.gov

and then click “Benefits, Home Loans.”

Considering REO loans

Real Estate Owned (REO) property is typically property repos-

sessed by the bank after foreclosure. The bank now has to sell the

property to recoup the remaining portion of the unpaid debt. With

government-secured (FHA and VA) loans, the government agency

that secured the loan gets stuck with the property.

Ideally, the government or bank that owns the REO wants someone

to show up with cash and buy the property, but sometimes eager

cash-heavy investors are few and far between. To add a little extra

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motivation, the owner of the REO property may offer to finance its

purchase, sometimes offering very attractive deals and perhaps

even the ever-elusive no-money down deal. These deals can be

ideal for an investor because you can pick up the property at a

great price

and secure attractive financing in one fell swoop.

To obtain an REO loan, first find one or more properties that you

want to purchase from a bank or government agency and then con-

tact that agency and ask whether it’s willing to finance the purchase.

Experienced investors who have a proven track record of getting

(and keeping) bad loans off the books have a better chance of

obtaining this sort of financing. After all, the government or bank

doesn’t want to have to foreclose on the same property again.

For more in-depth information about REOs, check out our book

Foreclosure Investing For Dummies (Wiley).

One of the best times to pursue REO’s is when the housing market

is in a slump and foreclosures are on the rise, as we discuss in

Chapter 17.

Tapping into state and

local grants and loans

State and local governments often identify certain target areas

(such as rundown downtown districts, renaissance zones, and

other areas in need of a pick-me-up) for redevelopment. They then

offer incentives — usually in the form of state or local grants or low-

interest loans — to get investors like you involved in pitching in.

State and local grant and loan programs rarely get you

all the

money you need to purchase and rehab a property. They’re

intended as add-on programs, typically used in conjunction with

other loans. Here we describe the most common types of state and

local programs you’re likely to find:

⻬ State housing development authorities: Meant to encourage

redevelopment in areas like Detroit or areas hit by disasters

such as hurricanes, state housing development authorities

often sell bonds to make money available to both homeown-

ers and investors. They also fund special first-time home

buyer programs and foreclosure rescue grant programs.

⻬ Renaissance zones: Great for investors, renaissance zones are

areas that federal, state, and/or local governments have

declared tax-free (or tax-lite) to encourage development. In

these zones, investors can secure loans with significantly

lower monthly payments, sometimes saving hundreds or

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thousands of dollars per month. It’s like getting an interest-

free loan, which dramatically increases your cash flow.

⻬ Economic development department: To encourage develop-

ment within certain areas, many larger cities have economic

development departments that provide tax breaks, invest-

ment funding, capital expansion funds, construction, or reha-

bilitation grants to projects within their district.

⻬ Grants and specific use loans: States, local governments, and

some nonprofit agencies often provide loans or grants for

improvement projects — such as health care facilities,

women’s shelters, and emergency housing — designed to add

value to specific areas.

If your property is located in an area flagged for development or

meets the state or local program’s criteria, contact the state hous-

ing development authority, the city housing agency, and any non-

profit housing agencies to find out about available funds and what

you need to do to qualify.

Start researching at the top — HUD’s Web site at

www.hud.gov. Here

you can search for information by state, find out about economic

development programs and grants, type in the address of a property

to determine whether it’s located in an enterprise zone, and dis-

cover other community networks and programs that can assist you

in rebuilding communities while earning a profit for yourself.

To find state-level programs, head to your state’s housing authority

Web site. To find it, use your favorite Web search tool to search for

your state’s name followed by “housing authority.” Your county,

city, or town may also have its own housing authority, so use the

same strategy to search for it. The Public Housing Directors

Association (PHDA) also has a directory of members, which you

can access by visiting

www.phada.org and clicking the “Housing

Authority Websites” link.

Chapter 5: Finding the Right Residential Loan Program

REO financing in action

The first foreclosure I (Chip) ever purchased was a vacant two-family dwelling,

which I bought for $500 down and simply had to pay the balance of the previous

loan. The seller, the Bank of Florida, financed the purchase over a five-year term. No

qualifying, no closing costs!

We can’t guarantee that a bank or government agency will be willing to finance the

purchase for you, but it’s certainly worth a try. You never know if you never ask.

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Many mortgage brokers who are approved by their State Housing

Development Authority can also provide valuable assistance.

Digging up USDA Rural

Development loans

To encourage development of rural areas the USDA offers its own

financing through Business and Industry (B&I) loans, discussed in

Chapter 9, and rural development (RD) loans. As an investor, you

don’t qualify for the RD loans designed for residential home

buyers, but these loans can benefit you indirectly if you buy and

sell property in rural areas. Prospective buyers who can’t obtain

financing elsewhere may qualify for an RD loan.

For more about USDA loan programs to encourage rural develop-

ment, visit

www.rurdev.usda.gov/rd/index.html.

Avoiding the Prepayment

Penalty Trap

When a bank loans you money for 30 years, it’s counting on the

fact that you’re going to be paying interest to them for a long time.

They have invested a certain amount of time and energy in origi-

nating that loan and need time to be able to make a profit off their

investment (just like you do). The bank also doesn’t want you refi-

nancing with another bank a year or two down the road and cut-

ting them out of the deal.

To discourage you from refinancing, and to help keep their initial

costs low, the bank may try to slip a

prepayment penalty clause into

your mortgage. With this clause, if you refinance and try to pay off

the loan early, you have to pay a stiff penalty — sometimes thou-

sands of dollars.

When shopping for mortgages, be sure to ask whether the mortgage

loan has any prepayment penalties and then read the mortgage

carefully before signing it. Prepayment penalties typically apply for

up to the first three years of the loan but can extend to longer peri-

ods on larger investment properties. If you have to refinance later,

you don’t want a prepayment penalty getting in the way.

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Chapter 6

Bargain Hunting for

Low-Cost Loans

In This Chapter

䊳 Grasping interest rates concepts and calculations

䊳 Understanding the term term

䊳 Exploring closing costs and how they affect your wallet

䊳 Figuring the bottom line — the total cost of a loan

hether you’re borrowing money to buy a place to live in or

invest in, you’re not just buying real estate — you’re also

buying money to finance the purchase. You’re a consumer buying a

product — in this case, a loan program — and you need to compare

costs and benefits just as you do when you make any major

purchasing decision.

Your goal is to find a loan that costs you the least amount of money

over the life of the loan and requires monthly payments that you

can afford and that ensure positive cash flows (as discussed in

Chapter 5). The monthly payment part is fairly easy to figure out —

lenders have to tell you what your monthly payments are going to

be upfront. Determining how much it will cost you over the life of

the loan, however, is a little trickier.

In this chapter, we show you how to shop for loans to find the one

that costs the least and is best suited to your investment goals.

Understanding How This

Interest Thing Works

Banks and other lenders primarily earn their money by charging

interest on loans — a certain percentage of the principal owed on

the loan (

principal is the amount you owe on the loan). Well, that’s

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certainly easy enough to understand, especially if you’ve pur-

chased any big ticket item like a car or a house on credit.

In practice, however, interest can get pretty complicated. Lenders

may choose to collect interest upfront in points, calculate your

rate as simple interest, amortize the loan, or even play a game of

“moving target” by adjusting the interest rate over the life of the

loan. In the following sections, we sort out the complexities that

surround interest rates and explain the essential jargon you’re

likely to encounter in plain English.

Keeping simple with simple interest

Simple interest is simple because you can usually calculate the

amount of interest you need to pay in your head or with a very

basic calculator. The formula goes like this:

Principal

× Interest Rate = Annual Interest

You can then calculate your monthly interest by dividing by 12:

Annual Interest ÷ 12 Months Per Year = Monthly Interest

For example, say you borrow $100,000 at 8 percent interest:

$100,000

× .08 = $8,000 interest per year

$8,000 ÷ 12 = $666.67 interest per month

Because the formulas calculate only the interest owed on the loan,

simple interest is perfect for interest-only loans. (Check out Chapter 5

for the ins and outs of interest-only loans.) Unless you’re dealing

with interest-only loans or smaller loans, such as home equity loans

or lines of credit, you’re unlikely to encounter simple interest. Most

loans use more complicated methods to calculate interest.

Grasping the concept of amortization

If you ever looked at an amortization table or tried to set up your

own spreadsheet to calculate amortization, you probably ended up

bleary-eyed from trying to figure out how anyone could possibly

have devised such a convoluted system for calculating house pay-

ments.

Amortization is a method for calculating the retirement of

debt that applies significantly higher portions of early payments

toward interest and significantly higher portions of later payments

to pay down the principal.

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The mathematicians who devised this system had a method to their

madness. They were attempting to create a system to provide for

constant loan payments over a fixed period. The system also had to

account for interest on the loan and the fact that each payment

reduces the principal owed on the loan, which ultimately results in

extinguishing the loan. In other words, they set some lofty goals.

Explaining how amortization works in theory is way too compli-

cated, so consider the following example: Say you owe $100,000 at

8 percent interest over a 30-year term. The following steps show

you how to calculate amortization and determine the amount of

interest due for each payment:

1. Determine the total monthly payment due.

This step is the most mathematically complicated. To figure

your payment, plug the numbers into the following formula:

Chapter 6: Bargain Hunting for Low-Cost Loans

iP i

××+

(

)

(

)

−

A is the total monthly payment, i is the periodic interest

rate,

P is the principal, and n is the number of periods (pay-

ments over the life of the loan). The

periodic interest rate is

the annual interest rate divided by 12 months. The

number

of periods

is the number of years times 12 months.

Using this formula, your monthly payment on a $100,000 at

8 percent interest over a 30-year term comes to $733.76.

Yep, this is why everyone uses a loan calculator or a spread-

sheet instead of doing the math by hand, but we think you

should know where the numbers are coming from.

2. Calculate how much of the payment is interest by using

the same formula you use to calculate simple interest.

Your payment consists of interest plus a reduction in the

loan balance (principal). Here’s that formula:

Principal

× Interest Rate ÷ 12 = Monthly Interest

So, in this example, your interest on your first payment is

$666.67: $100,000

× .08 ÷ 12 = $666.67

3. Subtract your interest payment from your total payment

to figure out how much principal you pay off.

Your first monthly payment of $733.76 breaks down like this:

Total payment of $733.76 – $666.67 in interest = $67.09 of

principal.

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4. For the next payment, subtract the amount you paid

toward the principal from the total.

$100,000 – $67.09 = $99,932.91, so this figure is the number

you use when you figure your next payment.

5. Repeat Steps 1 through 4 for each subsequent payment.

Based on the calculation in Step 4, the interest portion of

your second payment is $666.22:

$99,932.91

× .08 ÷ 12 = $666.22

With this payment, $67.54 goes toward principal, and with

each subsequent payment you end up paying more toward

the principal and less toward interest. This pattern continues

until the entire balance is paid off in 360 months (30 years).

If you have Microsoft Excel, select File

➪New and check the tem-

plates on your computer to determine whether your version of

Excel comes with an amortization schedule. If it does, you can click

it and click OK to create a new loan amortization schedule. Just

plug in the loan amount, term, and interest rate, and Excel does the

rest. If your version of Excel has no amortization template, you can

download a free one and other real estate finance–related templates

from Microsoft’s Office Web site. Go to

office.microsoft.com,

click the Templates tab, click in the search box, type “amortiza-

tion,” and press Enter. You have several results to choose from.

Telling the difference between

the interest rate and APR

Most people know that the interest rate and the annual percentage

rate (APR) differ, but few people understand how they differ. The

interest rate reflects the simple cost of the money you’re borrowing.

The

APR is designed to reflect the total cost of the loan, including

any loan origination fees and prepaid costs. As a result, the APR is

higher than the simple interest rate.

Why use an APR? Congress designed the system back in 1974 as a

way to enable consumers to more easily compare the actual costs

associated with the loans. It sort of functions as a consumer pro-

tection tool, helping borrowers compare apples to apples in the

world of personal finance.

For example, say you came into my (Chip’s) office and I quoted you

a 30-year mortgage loan for $200,000 at 6.50 percent. You talk to

another loan officer who offers you the same deal at 6.25 percent.

On the surface, you think this is a no-brainer — paying one-quarter

percentage point less is going to save you money over the life of

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the loan. However, what if I’m charging zero points (points are pre-

paid interest; see “Paying interest upfront with points” later in this

chapter), and this other guy is charging three points (in this case,

$6,000)? Now it’s not such a no-brainer.

Which deal is better? All other factors (loan origination fees and

any other costs) being equal, mine is, and you can quickly see by

looking at the APR:

⻬ APR on 30-year fixed mortgage $200,000 at 6.50 percent with

zero points: 6.5 percent.

⻬ APR on a 30-year fixed mortgage $200,000 at 6.25 percent with

three points: 6.626 percent.

What makes my deal even more attractive is that if you were to pay

off the loan in less than 30 years (highly common, especially for

investors), you’d save the $6,000 you would have paid in points to

the other guy.

You can find several APR calculators on the Web by searching for, you

guessed it, “APR calculator.” One of our favorites is at

mortgages.

interest.com/content/calculators/aprcalc.asp

Exploring how adjustable

rate mortgages work

Adjustable rate mortgages (ARMs) are mortgage loans with interest

rates that can fluctuate (rise or fall). During the mortgage meltdown,

many unsuspecting homeowners got burned by ARMs they probably

never should have been placed into. Although this has given ARMs a

bad name, they’re actually very useful, particularly for investors, as

long as you use them strategically.

Not all ARMs are created equal, though. Several factors influence

the best-case and worst-case scenarios of how low or high the inter-

est rate can go, including the initial interest rate, the

adjustment

period

(how often adjustments can be made), the index (the base

interest rate you pay), the

margin (the lender’s markup on the

index), and the

cap (the highest rate the lender can charge). We

explain these factors in greater detail in Chapter 5.

For example, say you take out an ARM to purchase a property that

you’re almost certain you can renovate and sell within a year.

Taking out an ARM with a rate that stands to rise at the end of one

or two years could be a reasonable gamble. And if you can get the

ARM for a lower interest rate than the going rate for fixed-rate

mortgages, the ARM can actually save you quite a bit of money.

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Of course, taking out an ARM always carries some risk. Being

“almost certain” you can sell the property within the year for more

than you have in it is no guarantee. Whenever you invest in any-

thing, you need to assess the risk/benefit ratio for yourself and

determine just how much risk you’re willing and able to take on.

Paying interest upfront with points

Plenty of lenders, particularly hard-money lenders, charge interest

upfront in the form of points. (Hard-money lenders are private

lenders; check out Chapter 11 for more on using these types of

lenders.) So what are points? One

point is equivalent to 1 percent

of the total loan amount, so for every $100,000 you borrow, a point

costs you $1,000. A point on a $200,000 loan costs $2,000.

So why do lenders use points? Lenders typically charge points for

one of the following reasons:

⻬ To lower the interest rate: When you choose to pay interest

upfront, the lender may reduce your interest rate, so you pay

less interest with each payment.

⻬ To get the money upfront: If you pay back the loan quickly, the

lender earns enough for taking the time to process your loan.

When you pay interest upfront to lower the interest rate, you may

not see a net savings for several years. You can calculate the break-

even point to determine whether you’ll actually save money by

paying upfront for a lower interest rate. The

break-even point is the

payment period at which you’ve saved enough money with the

lower interest rate to pay the cost of the points:

1. Start with the cost of the points.

Two points on a $100,000 loan cost $2,000.

2. Determine your monthly savings per payment as a result

of the lower interest rate.

To do this, simply subtract the monthly payment at the

lower interest rate from the monthly payment at the higher

rate. In this example, assume you’re saving $50 per month.

3. Divide the cost of the points by the monthly savings.

In this example, you divide $2,000 by $50, which equals 40.

Your break-even point is at 40 months. If you plan on keeping

the property for more than 40 months, you’ll save money

paying points. If not, it costs you more to pay points.

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Of course, it gets more complicated when you take taxes into con-

sideration, but this gives you a general idea of how points work.

Another reason you may want to pay points is so you can qualify

for a larger loan, because the points you pay lower your monthly

payment. Does paying points make sense? That depends. Crunch

the numbers yourself. For example, a $100,000 loan at 7 percent

interest over 30 years with zero points requires a monthly payment

of $665.30. The same loan at 6 percent with 2 points would cost an

extra $2,000 upfront but lower the payment to $599.55 — a monthly

savings of $65.75. At that rate, breaking even on the upfront cost

would take just under 31 months, but the investor would likely be

able to claim a tax deduction for the costs, depending on his tax sit-

uation. In this case, paying points is an okay deal.

Although some people say they never pay points, and others rec-

ommend doing everything you can to lower the interest rate, points

really have no

never or always. Sometimes you have to pay points

to gain access to the cash you need to do the deal, as we explain

in Chapter 5.

Considering the Mortgage Term

When investing in residential real estate and looking for a low-cost

loan, you need to take a close look at the mortgage term. A lender

often quotes the mortgage

term in years; for example, you may

have a 15- or 30-year mortgage. However, for payment purposes

you calculate the term on a monthly basis — 12 payment periods

per year over 30 years equals a total of 360 months or payment

periods. A 15-year mortgage has 180 payment periods.

Understanding the term is important because it ultimately affects

how much money you end up paying for the loan over the life of

the loan. For your average homeowner, a shorter term can pay div-

idends. Pay off a $200,000 loan in 15 years rather than 30, and you

save a whopping $155,437.

However, as an investor, you have a different perspective. Investors

like longer terms because they increase a property’s cash flow, giving

them more cash to do more deals. For example, payments on that 15-

year mortgage would cost in excess of $467 more per month. That

would significantly reduce monthly profit on any rental property and

give you much less money to work with on other deals.

Remember:

As an investor, the longer the term, the better.

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Accounting for Closing Costs

Every major newspaper has a financial section where banks, bro-

kers, and other lending companies post their interest rates and

often the points (prepaid interest) they’re currently charging.

Although this financial information gives you a general comparison

of the going rates, it really doesn’t help investors or home buyers

comparison shop. These figures usually don’t mention other costs

associated with the loan, such as the loan origination fee, discount

points, processing fees, paperwork fees, and junk fees. (For more

about junk fees, see “Forking over other fees” later in this chapter.)

When comparison shopping for loans, you need to take these fees

into account. In the following sections, we explain the most

common closing costs you’re likely to see.

Getting socked with origination fees

The loan origination fee is what the lender or broker charges you

as a service fee for processing your loan. They’re usually calcu-

lated the same way as points are — as a percentage of the total

loan amount and charged as a cost to the borrower. For example, a

1 percent loan origination fee is 1 percent of the total loan amount,

or $1,000 for every $100,000 you borrow.

Although most lenders charge a maximum of 1 percent, the loan

origination fee is always negotiable. Sometimes, all you need to do is

ask the loan officer to reduce the fee. In other cases, you may need

to mention that Julie Swanson on the other side of town is charging

less. For more tips on negotiating, check out

Negotiating For

Dummies

by Michael C. Donaldson and David Frohnmayer (Wiley).

Although you may not consider the loan origination fee part of the

loan, you should always include it in your calculations of the total

cost of the loan. This strategy enables you to more effectively

comparison-shop for the best deal.

Forking over other fees

Points and loan origination fees are only a couple of the legitimate

expenses you can expect to see on a Good Faith Estimate (GFE) or

HUD-1 (see the next section). Other legitimate fees include the

following:

⻬ Appraisal fee

⻬ Closing or escrow fee

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⻬ Credit report fee

⻬ Flood certification fee

⻬ Lender fee (negotiable)

⻬ Recording fees

⻬ Reserves for paying taxes or insurance

⻬ State tax/stamps

⻬ Title insurance

⻬ Underwriting fee (negotiable)

Some lenders include a

processing fee, which is fairly standard but

usually negotiable. (This fee covers the time and effort invested in

handling the paperwork, along with any copy or printing costs.)

You can usually figure out whether any of these fees is exorbitant

by comparing a few Good Faith Estimates from other lenders.

Although we like to think of brokers and bankers as being trust-

worthy professionals, some are less forthright than others and are

infamous for padding their closing fees with what the industry

calls

junk fees. One time I (Chip) was surprised to find an “e-mail

fee” of $35 tacked onto my closing statement. Upon inquiry, I was

told that this amount was what the title company charged to e-mail

the documents over to the lender. How ridiculous! I was able to get

it removed in about 45 seconds. Here are some other more

common junk fees to watch out for:

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101

⻬ Administration fee

⻬ Affiliate consulting

fee

⻬ Amortization fee

⻬ Application fee

⻬ Bank inspection fee

⻬ Document

preparation fee

⻬ Document review fee

⻬ Express mail fee

⻬ Funding fee

⻬ Lender’s attorney fee

⻬ Lender’s inspection fee

⻬ Messenger fee

⻬ Notary fee

⻬ Photograph fee

⻬ Settlement fee

⻬ Signup fee

⻬ Translation fee

Junk fees can also be inflated costs of standard fees. If the going

rate for overnight fees is $75, for example, and one lender tries to

charge you $150, ask why.

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Examining the Good Faith Estimate

By law, your broker or lender is required to provide you with a

detailed breakdown of all the costs associated with the loan (resi-

dential, not commercial loans). Lenders typically provide a Good

Faith Estimate prior to processing your residential loan application

and then a HUD-1 statement at closing detailing the actual final

costs. (The

Good Faith Estimate is a list of projected costs to the

borrower, while the

HUD-1 breaks down all the actual costs that the

seller and buyer are responsible for paying at closing.)

If the lender doesn’t provide a Good Faith Estimate upfront, ask for

one and make sure it’s legible and understandable. Some lenders

like to use fine print and shading to conceal what they’re really

charging and then give you a copy of the copy of the copy of the

faxed original to make it completely unreadable.

Costs, particularly the loan origination fee and points, shouldn’t

change dramatically from what’s on the Good Faith Estimate to

what you see on the HUD-1 at closing. If you notice any change,

bring it up at the closing table and don’t sign the papers until any

issues are resolved to your satisfaction and in writing. See Chapter 7

for more about covering your back at closing.

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Are Good Faith Estimates standardized?

When you start shopping for loans, you’re likely to see all sorts of Good Faith

Estimates, each of which categorizes its expenses differently and assigns each

expense a different name. All these differences can make it difficult, if not impossi-

ble, to compare estimated closing costs.

Fortunately, the federal government is stepping up to deal with this issue. On

November 12, 2008, HUD announced several new mortgage rules to help consumers

shop for lower-cost home loans. One of the new rules requires that starting on

January 1, 2010, lenders use a standardized GFE. The new three-page GFE benefits

borrowers in two ways:

⻬ When all lenders start using the form, the standardized model enables borrow-

ers to compare costs line by line without having to decipher different names for

the same charges.

⻬ The new GFE contains line-item references to the same amounts on the HUD-1,

making it easier to spot any changes between the estimated charges on the

GFE and the actual charges on the HUD-1 at closing.

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Calculating a Loan’s Total Cost

Your bank or mortgage broker is likely to lay out a virtual buffet of

loan types for you to choose from: fixed-interest, adjustable rate

mortgage (ARM), interest-only, and others. We describe the pros

and cons of these loan types in Chapter 5. If you’re still unclear

about the benefits and drawbacks of a particular loan program, ask

the bank representative or your mortgage broker lots of questions.

Don’t get too caught up in the various loan types. For people buying

houses they plan to reside in for 30 years, loan type is a big factor.

For real estate investors, particularly those who plan to sell the

property or refinance the loan within a couple of years, the cost of

the loan over the life of the loan becomes more important. To com-

pare loans and find the best bargains, take the following steps:

1. Start with the amount the bank charges you upfront in

loan origination fees, points, and other fees.

When performing these calculations, include all points, but

realize that not all points are created equal. Lenders can

charge

discount points, defined by some states as the legal

cost associated with reducing the interest rate for a bor-

rower. Lenders can also charge points as a fee (for exam-

ple,

origination points) that don’t reduce the borrower’s

interest rate.

2. Multiply the monthly payment times the number of

months you plan to pay on the loan.

3. Add the two amounts to determine your total payment.

4. Total the amount of each payment that goes toward

paying the principal of the loan.

Your lender can tell you how much of each payment goes

toward principal.

5. Subtract the total you determined in Step 4 from the total

in Step 3.

The result is the total amount you can expect to pay for the

loan over the life of the loan.

To save yourself some time performing these calculations, check

out the mortgage payment calculator on our Mortgage Myths Web

site at (

www.themortgagemyths.com).

Say that you’re considering two loans, each for $100,000. You plan

on using the loan to buy and renovate a home over two years and

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then sell it and pay off the remaining principal on the loan. You

have a choice between a 30-year, fixed-rate mortgage at 6 percent

or a 30-year, interest-only loan at 5 percent. Look at the 6-percent,

fixed-rate mortgage first:

Loan origination fee and discount points: $1,000.00

Monthly payment of $599.55

× 24 months: $14,389.20

Total payments (fees plus monthly payments): $15,389.20

Total paid toward principal: $2,531.75

Total cost of loan (payments minus $12,857.45

principal paid):

Here are the numbers for the 30-year, interest-only loan at 5 percent:

Loan origination fee and discount points: $1,000.00

Monthly payment of $416.67

× 24 months: $10,000.08

Total payments: $11,000.08

Total paid toward principal: $0.00

Total cost of loan: $11,000.08

As you can see, even though you’re not paying down the principal

on the interest-only loan, over the life of the loan, you pay about

$1,700 less. In addition, the interest-only loan has much lower

monthly payments, freeing up cash to use for renovations and

other investments.

As a general rule for

quick flips (buying and selling a property in

less than a year’s time), opt for loans with low (or no) closing

costs, low (or no) discount points, and low interest rates. Avoid

any loans that have early-payment penalties.

Don’t forget to account for cash flow and tax benefits that may be

available. A lender may charge you $3,000 in points, but if you can

write off a portion of that mortgage interest on your taxes, it may

end up costing you less than $3,000. Also, always remember that

having access to financing is often more important than the cost of

that financing. Crunch the numbers to get the lowest-cost loan

available, but don’t beat yourself up if you have to pay more than

average — as long as you can walk away with a decent profit and a

positive cash flow.

One more, very important word of caution: Always factor in a

margin of error to account for the unexpected.

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Chapter 7

Navigating the Loan

Application and Processing

In This Chapter

䊳 Filling out a loan application

䊳 Tracking your paperwork through the approval process

䊳 Gathering ’round the closing table

䊳 Getting a loan to finance investment-based residential property

ssuming you own the home you live in, you’ve already filled

out at least one loan application and have been through one

closing. Whether you did everything correctly is another question,

but at least you have a general sense of how the process works.

As the buyer of a residential property and the borrower, you have

the most papers to sign — papers dealing not only with the prop-

erty you’re buying but also with the loan you’re taking out to

finance the purchase. Faced with mountains of documents to sign,

borrowers (even seasoned investors) often give the paperwork a

cursory check at most before signing on the dotted line. This care-

lessness can be a big mistake, however, leaving you open to sign-

ing up for something you never really agreed to.

In this chapter, we review the closing process in greater detail and

show you how to avoid many of the traps that ensnare even the

savviest real estate investors.

Completing Your Loan Application

Filling out a loan application isn’t exactly rocket science, but it

does call for some careful attention to detail. The application

requires specific and accurate financial details that enable your

loan originator (broker or loan officer) and your lender to properly

evaluate your current financial situation and your ability to make

payments and repay the loan. In addition, the lender provides you

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with specific information, by way of lender disclosures, about the

loan program and its costs.

In the following sections, we show you how to complete the loan

application, review the various disclosures, supply the additional

documentation your lender needs to process your application, and

sign a release of information, so your lender can confirm the infor-

mation you supply.

Walking through the parts

of the loan application

In order to be able to accurately complete the loan application,

you first need a good grasp on what the form comprises.

Everything in your loan application package revolves around the

Uniform Residential Loan Application — a five-page, fill-in-the-blank

form that requests all sorts of information about the property

you’re buying and your financial situation. Although your loan orig-

inator actually prepares the form for you, go through the process

yourself first so that you can gather the necessary information

ahead of time and see for yourself what the lender looks at to

determine whether you qualify for the loan.

The Uniform Residential Loan Application is commonly referred to

as the

FNMA (Fannie Mae) 1003 application or simply the Ten-Oh-

Three.

To download the form, visit www.efanniemae.com/sf/

formsdocs/forms/1003.jsp

and click the link for the desired

version — the blank form or an interactive version you can type

your own entries into.

The form consists of ten sections:

⻬ I. Type of Mortgage and Terms of Loan: Basic information

about the loan, including the type (FHA, VA, Conventional,

Rural), total loan amount, interest rate,

term (number of

months), and amortization type. Your loan originator can

supply this information. Refer to Chapter 6 for details about

amortization.

⻬ II. Property Information and Purpose of Loan: Description of

the property (including its location) and how you plan to use

it: as a primary residence, secondary residence, or investment

property. This section also covers whether the loan is for new

construction or refinance, how the title will be held, and the

source of the down payment and any closing costs.

⻬ III. Borrower Information: General information about you,

including your name, address, previous address, Social

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Security Number, marital status, number of children (if any),

and so on.

⻬ IV. Employment Information: Information about your and any

coborrower’s employment, including names and addresses of

the most recent three employers, dates of employment, and

monthly gross income. The lender wants to know the past two

to five years’ history.

⻬ V. Monthly Income and Combined Housing Expense

Information:

Information about monthly income including

base pay, bonuses, overtime, commissions, dividends and

interest, and rental income, along with housing expenses that

include any monthly rent, existing home loan payment (princi-

pal and interest), property taxes, mortgage insurance, home-

owners’ association fees, and so forth.

⻬ VI. Assets and Liabilities: The value of what you own (assets)

and how much you owe (liabilities). Assets include balances

in checking and savings accounts, stocks and bonds, the cur-

rent cash value of any life insurance policies, vested interest

in retirement funds, the value of any real estate you own, and

so on. Liabilities include any current loans you have, credit

card debt, alimony or child support payments, and job-related

expenses (including child care).

⻬ VII. Details of Transaction: Overview of the financial aspects

of this particular loan, itemizing the costs and sources of

financing. Costs include the purchase price, cost of alterations

and improvements, cost of land (if purchased separately),

refinance costs (debts to be paid off through the refinance),

closing costs, cost of mortgage insurance, and so on. Sources

of financing include the loan itself, closing costs paid for by

the seller (if any), cash from the borrower, and other sources.

You may need to consult your loan officer and others involved

in the transaction to gather all the information you need.

⻬ VIII. Declarations: Yes/no questions for you and your co-

borrower (if applicable) to determine whether past or present

situations may affect your ability to make payments and pay

the loan. Questions include whether you have any outstand-

ing judgments, whether you’ve declared bankruptcy or

suffered foreclosure, whether you’re obligated to pay child

support or alimony, and so on.

⻬ IX. Acknowledgement and Agreement: Here is where you

sign, acknowledging that the information in this loan applica-

tion is correct to the best of your knowledge and that you and

any coborrower are knowingly entering into this agreement

with the lender.

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⻬ X. Information for Government Monitoring Purposes:

Information that enables the government to track statistics on

mortgages and homeownership relating to race and ethnicity.

The information also enables the government to enforce any

antidiscrimination rules and regulations.

As an investor, you know that the more prepared you are, the more

quickly you get things done. The same is true with financing. By

having all the necessary information at your fingertips, you can

work with your lender (or loan officer) to complete your loan

application in a matter of minutes.

Although you may be tempted to fudge the facts on the Uniform

Residential Loan Application, don’t do it (or allow anyone else to

do it for you). Lying on a loan application is all too common, but

it’s also a felony. The rules are ultimately meant to protect you. If

your net assets are too small to qualify for the loan, for example,

then having your application rejected protects you from a poten-

tial financial nightmare. See lenders as your partners, not your ene-

mies. For more about dodging the real estate and mortgage fraud

bullet, turn to Chapter 2 for more info.

Reviewing the lender’s disclosures

In the Declarations section of the 1003 (see the previous section),

you and any coborrower must answer several disclosure questions

as a way of “coming clean” about your current financial situation.

Your lender also must commit to a certain level of transparency

regarding its practices and the loan you’re applying for. For example,

by law, a lender can’t play some cruel game of bait-and-switch on

you by dangling an attractive set of numbers during the application

process and then sticking you with a real stinker of a loan at closing.

Be sure to examine the lender’s disclosures carefully before signing

on the dotted line, as explained in the following sections. At the

closing, make sure the lender adheres to whatever those disclo-

sures stipulate. (For more about closing, skip ahead to the section

entitled “Navigating the Closing.”)

Program disclosures

Regardless of the loan program, be sure you fully understand the

program disclosures (the terms of the loan agreement) before you

sign anything. If you don’t understand how a particular type of

loan works, keep asking your mortgage expert questions until you

fully understand what you’re getting yourself into.

For example, some loan programs are straightforward. If you’re

taking out a 30-year mortgage at 7.5 percent interest, the lender

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has very little to disclose about the program itself. On the other

hand, more-complicated loan programs may require that the

lender provide an additional disclosure. With adjustable rate mort-

gage (ARM) programs, for example, the lender must notify you of

the index it uses, the margin associated with the loan, and how and

when the lender calculates changes to your interest rate. For more

about ARMs, including the roles that the index and margin play,

check out Chapter 5.

The disclosure may also contain a hypothetical example showing a

brief history of changes and how your rate may have changed

under that program if you had a loan with those terms. (For more

about ARMs, including the roles that the index and margin play,

head to Chapter 5.)

Good Faith Estimate

For all loan types, your lender is required by law to provide you

with a ballpark figure of all the costs associated with this loan in

the form of a

Good Faith Estimate (or GFE, in industry lingo). The

GFE provides a complete breakdown of all the costs associated

with the loan you’re applying for, including the loan origination fee,

appraisal fee, and underwriting fee. Only by comparing GFEs can

you get a good feel of what’s normal and what’s excessive in the

market. Although the lender must supply the GFE to you within

three days of receiving your application, most lenders offer the

GFE prior to the application.

Ask for the GFE in advance, so you don’t waste time applying for a

loan you have no intention of following through on. In fact, obtain a

GFE from at least three lenders so you can compare the programs

and their costs. Watch for

junk fees (unfair charges), as discussed

in Chapter 6. If any of the costs on the GFE look out of the ordinary,

ask about it.

Truth In Lending statement

The Truth-In-Lending disclosure (TIL) gives you a reflection of the

true cost of the loan, including the interest rate and fees. In short,

the TIL makes it easier for you to comparison-shop for loans.

One of the key items on the TIL is the

annual percentage rate

(APR),

as discussed in Chapter 6. The APR shows you how much

interest you’re really paying on a loan if you include the upfront

costs in your calculations. For example, say you’re comparing the

following two loans:

⻬ $100,000 30-year fixed rate loan at 7 percent interest with

finance costs of $5,000

⻬ $100,000 30-year fixed rate loan at 8 percent interest with

finance costs of $4,000

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With numbers like these tossed about, comparison-shopping

becomes almost impossible. At first glance, the second loan may

seem like the better deal, costing $1,000 less upfront, but if you

look at the APR, you get a different picture:

⻬ The first loan has an APR of 7.52 percent and costs you

$251,485 over the life of the loan.

⻬ The second loan has an APR of 8.44 percent and costs you

$274,723 over the life of the loan, or $23,238 more than loan one.

The TIL also discloses any late-payment fees associated with the

loan, whether the loan has any early-payment penalties, and the

proposed payment schedule. If the loan is an ARM loan, it may illus-

trate what will happen to the payments as the rate starts to change.

The TIL is a great tool for taking a quick look at which loan among

several is the best deal, but it doesn’t provide enough information

to evaluate specific costs associated with a particular loan. Use it

in tandem with the GFE.

Real Estate Settlement Procedures Act (RESPA)

RESPA standardizes closings for residential real estate transactions

in order to clamp down on any funny business that may occur at

closing. According to the act, all closings must use a HUD-1 form to

disclose the costs of the loan and show where all the disbursed

funds are going.

Take a copy of your GFE to the closing to compare the fees dis-

closed on it with the fees actually being charged according to the

HUD-1. This practice is one of the best ways to catch any discrep-

ancies between what your loan originator told you and what it’s

actually charging you.

RESPA also controls certain actions of settlement providers such

as the closing agent, and service providers (including the title

insurance provider, credit company, and appraiser) to prevent

them from working together against the best interests of the con-

sumer (as in the case of price-gouging or kickbacks). Section 8 of

RESPA has two important components:

⻬ The first part prevents a lender from overcharging for settle-

ment services and keeping the difference. For example, if the

appraisal costs $400, the lender can’t charge you $600 and

pocket the extra $200.

⻬ The second part prevents lenders and service providers from

accepting or offering kickbacks for referral business — for

example, a lender can’t refer a specific appraiser and then

accept part of the appraiser’s fee as a reward.

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RESPA’s provisions cover all aspects of services, companies, and

individuals, including title companies, attorneys, and real estate

agents.

HOEPA — Section 32

The Home Ownership and Equity Protection Act (HOEPA) is an

amendment to the

Truth In Lending Act (TILA) to protect homeown-

ers from paying excessive fees and interest. HOEPA is part of TILA

but stands alone in its application; Congress passed these two sep-

arate acts:

⻬ TILA covers all residential loan transactions (one- to four-

family units), whether they’re owner-occupied or investment

properties. It doesn’t apply to commercial loan transactions.

⻬ HOEPA, also referred to as “Section 32” or “high-rate, high-fee

loan disclosures,” applies to residential owner-occupied

dwellings for purchases and refinances. It includes one- to

four-family owner-occupied properties (which could be a

multiunit investment property in which one unit is occupied

by the investor). It also applies to anyone you sell the property

to. HOEPA doesn’t apply to pure investment properties or

commercial loan transactions, but you should always be aware

of it so you know what’s considered fair in terms of fees.

Under this regulation, lenders must warn borrowers if APRs exceed

10 percent of the comparable Treasury yield (which means

Treasury securities having a similar period of maturity, such as 30

years), or if the deal’s total points and fees exceed 8 percent of the

loan amount.

Most lenders don’t offer loans that fall under Section 32, including

to investors, so this regulation usually isn’t an issue. Just be aware

of these restrictions and limitations to make sure you’re working

with a lender who plays by the rules.

Supplying the requested

documentation

In order to review your loan application, your lender needs some

supporting documentation that verifies the information you sup-

plied. Gather the following documents:

⻬ Federal tax returns (with all attachments and schedules) for

the past two years

⻬ W-2s from the past two years

⻬ 30-days’ worth of paycheck stubs

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⻬ List of real estate owned, complete with income and expenses

⻬ Any and all supporting documentation for assets and liabili-

ties listed on the Uniform Residential Loan Application (bank

statements, credit card statements, divorce decree, retirement

earnings statements, and so on)

Make a copy of each document in the list and place them neatly in

a folder labeled with your name and contact information. You can

then hand the entire package (the copies, not the originals) over to

your loan originator at your next meeting.

Signing a release of information

Providing your loan originator with a loan application package is

like submitting a resume for a job — it paints a picture of you on

paper, but it may not be an accurate portrait. To make sure the

information is factual, your loan originator needs to verify it in the

real world, usually by checking independent sources such as

employers, banks, and even providers of government benefits.

Most lenders require that you sign a

borrow authorization form,

which gives them permission to check your credit and independ-

ently verify any information you provide for this transaction.

Before you sign the release, read it carefully to make sure it covers

only this transaction. You don’t want to give anyone carte blanche

to poke around in your financial affairs whenever they want.

Additionally you may be asked to sign an IRS Form 4506 or 8821 for

verifying tax return information. These forms are standard, but make

sure you don’t sign blank ones — make the lender fill out the years

covered, or else it can go get your tax returns from six years ago.

Following the Loan

Processing Trail

After you supply your prospective lender with a completed loan

application and supporting documentation, all you can really do is

wait. During this time, you may be wondering what the lender is

doing, whether you need to be doing something, and how this

whole loan application process is going to unfold.

To prevent anxiety from overtaking you, the following sections lead

you through the course of a processing and keep you posted on

the possible outcomes.

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Getting up to speed on

the underwriting process

You may be under the illusion that right now an accountant is comb-

ing through your loan application and supporting documents for

proof that you’re worthy of a loan. The fact is that nowadays com-

puters actually do the initial screening. The information you provide

is entered into an

automated underwriting (AU) system, which per-

forms a preliminary evaluation and spits out the conditions and doc-

umentation requirements of the loan.

The AU system can’t deny your loan application. It can only place

your application in one of the following three categories:

⻬ Accept/Eligible: This category is the best; it means that

you’re approved for the loan, subject to certain conditions.

Those conditions show up on the

findings report and must be

part of the file for final approval. The loan officer or processor

obtains the necessary documents as requested and then sub-

mits the complete file to the underwriter to review for accu-

racy. The file is already approved at this point, so they’re only

looking to make sure you’ve submitted and signed each of the

required supporting documents and disclosures.

⻬ Accept/Ineligible: This category indicates that the loan is

approved but is ineligible for purchase in the

conforming

market

(Fannie Mae or Freddie Mac). For example, it may be a

jumbo loan, where the loan amount is outside the upper limit

of what Fannie and Freddie can purchase. Many investors still

use AU systems and approve/buy these loans anyway.

⻬ Refer: This category is also typically known as a dead deal. An

underwriter still has to review the file before it can be denied,

but loan files that fall in this category don’t come with the same

lender guarantees against loan losses, so the lender has no

incentive to take on the additional risk of approval. Unless the

loan can be repackaged and resubmitted to obtain a different

AU result, the deal is likely DOA.

Don’t let a dead deal get you down. Even if you can’t obtain a loan

from traditional sources, you can usually find other means of

financing your investments, as we explain in Part IV.

Obtaining an appraisal or AVM

One of the first things any lender wants to know is whether the

property you’re buying is worth the money you’re borrowing to

pay for it. Actually, it wants to make sure the property is worth

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more than the money you’re borrowing so that if anything prevents

you from paying back the loan, the lender has something of suffi-

cient value to sell and recoup its investment.

To assess the value of a property, the lender orders an appraisal,

Automated Valuation Model (AVM) report, or both and usually

charges you for it as a part of the cost of processing your loan.

This appraisal isn’t something you order — the lender wants to be

in charge of picking an objective appraiser.

Expect to pay the full price for an appraisal, even if the property

was recently appraised. Old appraisals can’t be recertified no

matter how recent they may be.

Appraisers generally take one of the following three approaches

when performing an appraisal:

⻬ Sales comparison: This most-common form of appraisal for

residential properties compares the property to similar,

recently sold properties in the same vicinity. The appraiser

can then adjust her estimate by accounting for differences

between the comparable homes and depreciation.

⻬ Income approach: This method is used for income-producing

properties, such as rental units. The appraiser compares simi-

lar properties in the same market to determine how much

income the appraised property is likely to generate.

⻬ Cost approach: This method is commonly used to establish

the value of a unique property or properties in areas where

few comparisons are available. The appraiser determines the

value of the land and

improvements (the building on the land)

and then subtracts for depreciation.

An appraisal that uses the income approach is likely to cost a little

more than a market-comparison appraisal, but not a whole lot

more. If the lender tries to charge you hundreds of dollars more

than you’d be paying for a standard appraisal (for a typical owner-

occupied residential dwelling), find out why.

Having the property inspected

Whenever you make an offer on a property, make the offer contin-

gent upon the property passing inspection, and then have the

home professionally inspected. (This action is more for your pro-

tection than the lender’s. Lenders usually don’t require an inspec-

tion, even on government-secured loans.) This contingency

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ensures that you don’t get stuck holding the bag on any of the

following big-ticket items:

⻬ Damaged foundation or other structural anomalies

⻬ Electrical wiring problems

⻬ Broken sewer lines, poor plumbing, or aging septic systems,

especially if the house has been vacant for some time

⻬ Leaking, nonfunctioning, or nonexistent gas lines

⻬ Poorly functioning furnace or central air conditioning units

⻬ Leaking or ramshackle roof

⻬ Termite damage

⻬ Health hazards such as lead-based paint, toxic mold, radon

gas, asbestos, and hazardous insulation

In the following sections, we show you how to track down a profes-

sional home inspector and ensure that you obtain a thorough

inspection.

Hiring a qualified home inspector

If you decide to hire an inspector, you can crack open the phone

book and find listings for dozens of home inspectors in just about

any area of the country. Finding a qualified home inspector, how-

ever, is a challenge. So where do you start? Ask the following indi-

viduals for referrals:

⻬ Your real estate agent or other real estate professionals you

know:

By networking with homeowners, investors, and col-

leagues, real estate professionals know the best service

providers in the area. Ask them for references to the best

inspectors. If one inspector’s name pops up on several lists,

you’ve probably found a winner.

⻬ The National Association of Certified Home Inspectors

(NACHI) Web site:

NACHI is a nonprofit agency that works

toward educating and ensuring the quality of home inspec-

tors. Its Web site at

www.nachi.org features an online referral

service that you can search to find certified home inspectors

in your area. Make sure the inspector you hire is NACHI-

certified — meaning the member has performed at least 250

inspections and passed two written proficiency exams.

⻬ Friends, family members, and colleagues: Gather referrals

from people you know and trust. Using an inspector who’s done

a satisfactory job for someone you know usually delivers better

results than choosing someone blindly.

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⻬ Your town’s building inspection department: Most towns have

building inspectors who examine buildings as they’re being

constructed or renovated to ensure that they adhere to the

local building codes. In some cases, you can hire the town’s

building inspectors to perform your inspection for you. They

tend to be more thorough, and they’re well versed on local

building codes. The inspectors often show up as a team that

typically includes a plumber, an electrician, a heating and air

conditioning specialist, a builder, and someone who specializes

in zoning. You get a thorough inspection and a complete write-

up for about the same price as you’d pay a private inspector.

⻬ Better Business Bureau (BBB): Although the BBB has a policy

of not recommending certain businesses, it does offer a tool

that enables you to search for BBB-certified businesses in

your area. Start your search at

welcome.bbb.org, where you

can enter your ZIP code to skip to the Web site for the nearest

BBB. You can then click the Find an Accredited BBB Business

to start your search.

When you have a few leads, contact your candidates and ask them

the following questions:

⻬ Are you certified, licensed, and insured? Certification and

licensing ensure that the inspector has the basic qualifica-

tions for the job. Insurance covers any serious defects he may

overlook.

⻬ How long have you been a home inspector? Length of serv-

ice is often, but not always, a good indication of experience

and expertise. Someone who’s been in the business for 10

years probably has more experience than a person who’s just

getting started.

⻬ How many homes have you inspected? “One or two” isn’t the

answer you’re looking for. A busy home inspector is usually

busy because she’s good.

⻬ What did you do before becoming a home inspector?

Someone who’s a retired carpenter or home builder is proba-

bly a better candidate than, say, a burned-out English teacher.

⻬ Do you have references I can call? If the inspector has a

good track record, people don’t hesitate to provide positive

references.

⻬ Do you recommend remedies or simply identify problems?

Look for an inspector who’s had experience in construction.

Someone who not only points out problems but also recom-

mends repairs and renovations is a good choice.

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⻬ How much do you charge? Most inspectors charge a flat fee

of a few hundred bucks — more or less depending on the size

of the home and the complexity of the inspection. As you

interview candidates, you can get a pretty good idea of the

going rate for a typical home inspection in your area.

After you gather answers and information from all your candidates,

make a decision. Sit down with your list and identify the inspector

who has the best experience and credentials of the bunch but

doesn’t charge an exorbitant fee.

Attending the inspection

Although attendance isn’t mandatory, you should show up for the

inspection prepared to take notes. Your notes should include the

following:

⻬ Possible structural defects: The inspector will point out

cracked foundation walls, weak roof trusses, or shifting foot-

ings or joists. These problems can be extremely costly and

can kill a deal quickly.

⻬ List of functional defects: Examples include a furnace that no

longer functions or is leaking carbon monoxide, or a toilet that

doesn’t flush. These are critical repairs that have the most

impact on your ability to resell the property or lease it out.

⻬ List of potential environmental problems: An example

includes insulation that contains asbestos or ground on the

lot that’s been contaminated by a local industrial plant. These

can be costly to fix.

⻬ List of cosmetic defects: These include divots or dents in the

walls, peeling paint, and other defects that just look bad.

They’re less-serious stuff.

⻬ Anything else the inspector points out: These may range

from minor issues, such as a leaky faucet, to more major

issues, such as a stained ceiling that may be a sign of some-

thing more serious, but the inspector can’t gain access to the

area above the ceiling to check it out.

If you’re note-taking challenged, consider carrying a digital recorder

with you during the inspection. Just don’t forget to turn it on.

Requesting repairs

With your list of property defects in hand, highlight the ones you

expect the seller to repair and then have your agent present the

list to the seller or seller’s agent. The seller agrees to make all

repairs, refuses to make all repairs, or agrees to make only some of

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the repairs. It’s up to you to decide whether you want to move for-

ward with the deal.

For any repairs you’re willing to take on and other renovations to

improve the property, obtain estimates from independent contrac-

tors to determine approximate costs. Get three bids from licensed

professionals, including the time estimated to complete the work,

as well as the lead time needed to schedule the work.

Don’t get your inspector involved in providing estimates or doing

any repairs or renovations to a property. This creates a conflict of

interest, which is prohibited on government-insured loans.

For additional details on how to determine whether a property is

likely to be a profitable investment, check out Ralph and Joe’s

Flipping Houses For Dummies (Wiley) and Real Estate Investing For

Dummies,

2nd edition, by Eric Tyson and Robert S. Griswold (Wiley).

When you’re estimating the costs of repairs and renovations, keep

in mind that as soon as you take possession of the property (at

closing), you’re responsible for the holding costs on the property

when repairs are being done. (

Holding costs are the expenses you

incur when the property is just sitting there — they include the

monthly mortgage payments, insurance, property taxes, and utili-

ties.) By planning your repairs and renovations prior to closing

and lining up contractors to begin work as soon as possible after

closing, you can slash your holding costs.

Testing the water

You may not need to test the water as a condition for obtaining

loan approval, but if the system is served by a well, get the water

tested for your own protection. Your county health department or

an independent lab can perform the required tests, but you need

to collect the water:

1. Get a clean bottle from the lab or your county health

department.

2. Go to the water faucet farthest from the well source.

3. Let the water run for at least five minutes.

4. Fill the bottle and label it as instructed.

5. Have the sample tested right away.

The lab usually returns the results within a couple of days and

lets you know the chemical makeup, including minerals

and any detectable E. coli in the water.

If the property is serviced by a community well, request

maintenance records.

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I, Chip, usually steer clear of properties serviced by community

wells. I also avoid properties on which the well is located in a

crawl space or basement. These pose financing risks, and any

eventual buyer will be limited in financing options.

Having the septic system inspected

If the property relies on a septic system, have a qualified septic

contractor inspect the field, saturation levels, and estimated

remaining life of the system. These systems can be very costly to

replace.

Also, research the pumping records with the owner and the county

(usually the county health department), and check with the county

on the age of the system and its maintenance history. The county

should have records of when the system was installed and a pump

card that shows when it was last pumped out.

If the system is more than 10 years old, we highly recommend that

you have a qualified professional perform a

perk test. This test

makes sure the septic field is draining properly and isn’t saturated

(a situation that indicates a short remaining life).

Obtaining a survey

Your lender will request a survey on the property, regardless of the

size of the parcel, even if it’s a

platted lot (a lot with boundaries

shown on a map). To insure the transaction, the title company

requires a survey or certification of an existing survey. Surveys

come in two types:

⻬ Boundary survey: This type illustrates where the property

lines are and is usually sufficient for a platted lot, because the

parcel’s boundaries have already been recorded.

⻬ Stake survey: With this type the surveyor actually goes out

and places or finds metal boundary stakes to certify the

actual boundary lines of the parcel. The stake survey is

slightly more expensive, but it’s the better choice for water-

front property, irregular parcels, and properties with a

metes-

and-bounds description

(commonly found in a deed).

Walk the property with the owner to be sure you know where the

boundary lines are, and ask questions about any easements or

encroachments that may exist. If the owner/seller has a copy of the

previous survey, obtain a copy so the surveyor can recertify it

instead of performing a new survey — you may save a few bucks.

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Navigating the Closing

Although the closing (or settlement) is the final step in the real

estate transaction, it can feel a little anticlimactic. You and the

other participants in the transaction have completed your work.

Now you’re simply meeting to sign off on the deal you’ve all agreed

to and shuffle the money around to the appropriate recipients.

Even though the process may seem like an afterthought on a long

journey, you really need to stay on your toes to avoid any last-

minute mishaps. In the following sections, we show you how to

ensure that the closing proceeds smoothly without any glitches

that can negatively affect your bottom line.

Keeping your attorney in the loop

A good real estate attorney can keep you from spending thousands

of dollars later to clean up a mess that you can easily avoid now.

Get your attorney involved sooner rather than later in the

following ways:

⻬ Make sure your attorney reviews the purchase agreement

before you make an offer.

Consider working with your attor-

ney to develop a boilerplate purchase agreement you can use

for all of your transactions, so your attorney doesn’t have to

review it every time.

⻬ Have your attorney present during any sensitive or unusual

negotiations.

If you’re not completely comfortable with some-

thing the seller or seller’s representative is saying, consult

your attorney before giving a final response. Backing away

from something you agreed to, even verbally, can make your

attorney’s job more difficult later.

⻬ Ask your attorney to review the closing papers prior to the

closing date.

Have the company handling the closing supply

you with copies at least three days in advance.

Get your attorney involved early. She probably won’t be able to

help you after the closing; even if she can, it’ll cost you a whole lot

more than if you had corrected the errors

before you signed the

papers.

Dealing with the preliminaries

Closings usually proceed smoothly as long as you have all the

parts in place prior to closing. In the following sections, we show

you how to prepare for your next closing.

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Hiring a title company

Closing is pretty easy, at least from your perspective. In most

cases, your agent or the seller’s agent selects a title company, and

the title company does the rest — gathering all the essential paper-

work, making sure everyone shows up to the closing on time, and

then routing the closing documents around the table to make sure

everything gets signed.

The title company also provides title insurance — your only pro-

tection from future claims against the property, including old co-

owners,

lien holders (other parties that claim rights to the

property),

backside deals (private negotiated or unrecorded agree-

ments) with neighbors, and a whole host of other potential prob-

lems. Approximately a month after closing, the title company

sends you a complete policy. Store it in a safe place — in addition

to providing you with a record that you have title insurance, the

policy can earn you credit toward the next policy when you sell or

refinance the property.

Never ever purchase a property without title insurance. Without

title insurance, you can lose your entire investment overnight. One

way this can and has happened is when a scam artist sells a prop-

erty he doesn’t own. The con artist waits until the owners are on

an extended vacation and uses a phony deed to transfer the prop-

erty into his own name. He then lists and sells the property and

takes off with the cash. If you happen to have bought the place,

and you don’t have title insurance, when the rightful owners return

from vacation, you lose the property, but you still owe on that loan

you took out to buy it.

Under RESPA (Section 9), you as purchaser have the exclusive

right to select the title insurance provider. We encourage you to go

with one of the national agencies or one of their agents — someone

with a solid reputation in the marketplace. In addition, larger com-

panies have several offices, making dealings more convenient

when closing time arrives.

Request an

insured closing letter, indicating that the title company

is insured for handling the transaction. This document provides

you with the assurance that if the closing company mishandles

anything, you don’t get stuck with a bill for its mistake.

The title company disburses funds on investment properties imme-

diately upon the close of the transaction. Request a copy of each

disbursement check for your records.

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Reviewing the documents in advance

You have the right to review any closing documents at least 24

hours prior to closing (preferably three days before closing, so

your attorney has time to review them, too). As soon as you’ve

chosen a title company, contact the company and let your repre-

sentative know that you want a copy of the closing packet as soon

as possible so you have time to review the paperwork.

Check the mortgage, deed, note, HUD-1 closing statement, and all

other documents for spelling or calculation errors, and make sure

the figures on the HUD-1 match up with those on the Good Faith

Estimate. If anything looks odd, call the title company and have

your issues addressed

before closing.

Insuring the property

Several days prior to closing, meet with your insurance provider

and review coverage options for the property you’re about to pur-

chase. Let your agent know the closing date so he can prepare a

policy for you in advance of the closing.

Make sure you obtain a

policy and not just an insurance binder (a

promise to insure) — some lenders don’t accept binders.

Signing the documents

Be prepared to sign a lot of documents during closing (and no, you

can’t use a rubber stamp!) You have to provide a picture ID (such

as a driver’s license). The closing agent witnesses and notarizes

your signature many times during the closing.

Request a complete copy set of all

signed documents (not just

blank ones) and keep them in a safe place just in case you need

them in the future. In the court of real estate law, only signed docu-

ments count, so be sure you get a copy of the signed documents

showing what you and the seller agreed to.

Knowing your right of rescission . . .

or lack thereof

The right of rescission is a federal law that gives you three days to

change your mind on financial deals. It protects consumers from

high-pressure sales tactics. Commonly called the “cooling-off law,”

it also allows you to back out of refinance deals on owner-occupied

residences.

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As an investor, don’t count on the right of rescission to protect

you. It doesn’t apply to the purchase agreement — after you sign

the agreement, your offer is binding. In addition, the right applies

only to owner-occupied residences, not investment properties.

Dealing with surprises

The key to dealing effectively with surprises at closing is to not

have any surprises. In the following sections, you discover some

prevention maneuvers that ensure a smooth closing.

Rate changes

Your interest-rate lock agreement is only as good as the loan offi-

cer who gave it to you. You have nothing in writing to say that the

person actually locked in the rate with an investor or that the

terms of your application didn’t change just enough to allow (or

require) the loan officer to place it with a different lender-investor

or a completely different loan program.

At least two days prior to closing, confirm your interest rate and

program with the loan officer. If you had been floating the interest

rate, he will require you to lock it in at least three days prior to

close so that he can prepare the documents. If it’s not what you

agreed upon, hold out until you’re satisfied with the rate and

terms. You won’t be able to change them after the closing.

Term changes

Confirm the terms of your loan (including index, margin, and start

rate for an ARM loan) prior to the closing. Your loan terms should

remain fixed unless something major occurred between the time of

your application and the closing, but ask anyway. You don’t want

any surprises.

Chapter 7: Navigating the Loan Application and Processing

123

Dodging disaster

How would you like to purchase a property and have it burn down the next day with-

out having insurance to cover it? I, Chip, almost had that happen to me. However,

the property actually burned down a day

before

closing. Fortunately, the previous

owners hadn’t cancelled their policy prior to close, or it would have been a real

mess. We had to wait for the property to be rebuilt before we could close on the

transaction — a delay of five months!

The moral of this story: Obtain an insurance policy before closing. Don’t leave the

property uninsured for even one minute — too many things can happen.

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If rates improved since you obtained loan approval, or the prop-

erty numbers no longer meet your expectations, you may consider

changing loan programs in order to maximize your cash flow. Just

remember that any changes you make now cancel out the rate and

terms you locked in. Even a slight change can jeopardize your lock,

giving the lender an opportunity to charge extra fees and interest,

so be careful.

Other unexpected events

Once in awhile, other events throw a wrench into the proceedings —

and they’re completely beyond your control. The seller may have a

change of heart, the title company may require additional docu-

mentation to insure the title transfer, you may have to get lien

waivers, and so on. Take it all in stride — and prepare for a delay.

We’ve had lots of closings slightly postponed while someone fixed

a glitch, so keep your schedule (and that of your contractors) a

little loose.

You’re dealing with professionals, and they’re programmed to get

any problems resolved as quickly as possible. If anything sounds

too strange or flat-out made up, simply ask your attorney to call

the title company or closing agent. That usually gets the process

back on track pretty quickly!

Financing Other Types of

Residential Properties

Most of the information in this chapter relates to financing the pur-

chase of primary residences. Variations arise, however, when

you’re financing the purchase of other types of properties, includ-

ing vacation and investment properties and vacant land. The fol-

lowing sections introduce the variables you can expect and show

you how to deal with them.

Digging up money for

vacation properties

If you’re in the market for a vacation property or second home,

expect the financing requirements to be a lot tighter, the interest rate

and costs to be higher, and the down-payment requirements to be

greater, with many lenders requiring at least 20 to 25 percent down.

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Due to the higher costs, you may want to consider purchasing a

fractional ownership, in which you share the property with several

parties. This can be a great way to invest in higher-end properties

located in expensive markets. You can usually find a loan officer

who specializes in these types of loans.

Banks and other more traditional lenders rarely handle loans for

fractional ownerships, so you have to go through a specialized

group of finance companies. Shop around carefully for one that

specializes in this type of financing, and make sure that you have a

solid agreement with the other parties involved. Make absolutely

sure that your real estate attorney reviews all the paperwork and

that you fully understand what you’re getting yourself into.

A management company often makes all the arrangements, but

make sure you understand your obligations as an owner and how

the parties plan to share the income and expenses of the rentals or

the burden of expenses when the rentals are vacant? For more

information, check out

Second Homes For Dummies by Bridget

McCrea and Stephen Spignesi (Wiley).

Financing investment properties

Lenders approach the financing of residential investment properties

(dwellings you rent out) more carefully than they do financing the

purchase of primary residences. As a result, you need to adjust

your expectations and approach to financing these properties in a

different way as well. We cover the main differences that come

with these properties in the following sections.

Options for financing residential investment properties are some-

what limited. Expect interest rates, costs, and the down-payment

requirements to all be higher. Often, lenders require a minimum of

25 percent down.

Shop around for a lender that offers several options for investment

properties, and be careful of extra fees. You should have to pay

only an additional 1.5 to 2 points above a normal owner-occupied

transaction. Check out Chapter 4 to find out how to shop around

for lenders.

Before approving a loan for any income-producing property, your

lender wants to know whether it promises a positive cash flow. Of

course, you want to know this, too, so before you even submit an

offer, perform a complete cash flow analysis of the property, as

explained in Chapter 3. Do the math before you do the deal, and if

the return on your investment is less than you’d earn by investing

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