Investment Property: Financing Equals Equity Investment

May 25, 2020

The lending terms offered by banks and other financial institutions for investment property fluctuates with the real estate market.  For example at the turn of the century, lenders were extremely competitive and aggressive with financing.  Not only were residential borrowers receiving unprecedented terms for loans but investors were also getting great deals.

After the subprime mortgage crisis occurred and home prices fell in 2006, which triggered defaults. The risk spread into mutual funds, pension funds, and corporations who owned these derivatives. The ensuing 2007 banking crisis and the 2008 financial crisis produced the worst recession, financing is much more conservative for investors as well.

For the first time investors, lenders will want to see some type of equity investment before making a loan.  This is because if a borrower can no longer make the loan payments and the lender must foreclose the equity investment helps preserve the lender's security and interest in the loan.  To illustrate this point let's consider a nice round loan amount such as a thousand dollars.

Now let's assume that a tract of land costs $10,000.  For a new investor, a lending institution may want to see an equity investment between 35 to 50% this means that you as the investor would need to invest $3,500-$5,000 before the lender would provide investment property financing.

These terms are beneficial to the bank in two ways - first if the bank has to take back the property they only have to sell it for $5,000 to recoup their cost and since the property should be worth $10,000 or more, the bank sees this deal as an acceptable risk.  Second, if you, the investor has committed a portion of your own resources to the deal you're less likely to walk away.

This example is very simplistic but helps illustrate the lending logic of a loan officer.  For normal size investment property financing deals, your equity investment may not have to be in the form of cash.  Depending on the structure of the deal you could offer additional property, life insurance policies or stocks as collateral.  The bottom line is that your loan officer will want to see your financial commitment to the deal.

Also the larger your equity investment in the property, the lower your interest rate will be because of diminished risk of loss due to foreclosure.  The amount of equity your lender may require for your investment property financing deal will depend on your credit score, financial statement, and history with the lender.  Although your stellar credit scores show that you're responsible personally, most lenders will still require a financial statement showing your assets and liabilities and a cash flow statement showing your average monthly income.  Any weaknesses in your financial statement and you can expect a higher equity investment requirement. A lender wants to know that you're not living paycheck to paycheck and can afford to make mortgage payments even if the property is vacant for a few months.

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