What is Real Estate Financing
The rapid increase in housing prices and Inflations are making paying cash for a property increasingly difficult, and even buyers who are able to pay in cash choose to finance instead.
By using real estate financing wisely, investors and homeowners may receive better returns and diversify their risks.
Defining Real Estate Financing
The Concept of Leverage
Real estate financing is also known as leverage or leveraging because of the way a down payment is used. Leverage is the process of using borrowed money to make a return on an investment.
By leveraging a real estate purchase, you can claim 100% of the property, the cash flow, tax benefits, and any appreciation in property value by investing a small down payment, usually around 20% of the purchase price.
Financing
Financing has traditionally been, and will always be, an integral part of the purchase and sale of real estate. Only a handful of people have the funds to purchase properties for all cash, and those that do rarely put all of their money in one place.
Even corporate and institutional buyers of real estate use borrowed money to buy real estate. For instance, even Mark Zuckerberg, the co-founder, and CEO of Facebook and a billionaire, whose net worth was estimated to exceed $80 billion did not pay cash while purchasing his home. He just financed his California home with a 30-year mortgage with an interest rate of 1.05%.
So, why do these people (investors) finance? What are the benefits of financing? How can we utilize real estate financing in the most effective and profitable way possible? Let us know some of the benefits of financing real estate.
Understanding the Time Value of Money
In order to understand real estate financing, it is important that you understand the time value of money. Due to inflation, a dollar today is generally worth less in the future. Thus, while real estate values may increase, an all-cash investment and purchase may not be economically feasible in a long term, because the investor’s cash may be utilized in more effective ways.
Benefits of Using Financing
Let’s say there’s a property worth $100,000. You bought it using all of your cash for $100,000. If the property were to increase in value 10% over 12 months, it would now be worth $110,000. Your return on investment would be 10% annually (of course, you would actually net less because you would incur costs in selling the property).
If you purchased the same property using $10,000 of your own cash and $90,000 in borrowed money, a 10 % increase in value would still result in $10,000 of increased equity, and your return on cash is 100%. Of course, the borrowed money isn’t free; you would have to incur loan costs and interest payments in borrowing money.
However, by renting the property and collecting the monthly rent in the meantime, you would offset the interest expense of the loan. Also, you could purchase 10 properties with 10% down and 90% financing, which would increase your overall profit by more than threefold. Be careful of the risks involved too.
Read More: How to Buy Your First Real Estate Investment Property?
How Financing Affects the Real Estate Market
Financing plays a huge role in real estate sales; it also affects its values. The higher the interest rate, the larger your monthly payment, and the lower the interest rate, the lower the monthly payment.
On the contrary, the lower the interest rate, the larger the mortgage loan you can afford to pay. Consequently, the larger the mortgage one can afford, the more the seller can afford and ask for in the sales prices.
People with all hand-in cash are more concerned with price whereas people with less cash are usually more concerned with their payment than the total amount of the purchase price or loan amount.
When interest rates are low, housing prices tend to increase, as people can afford a higher monthly payment. On the contrary, when interest rates are higher, people cannot afford as much higher payments, generally driving real estate prices down.
Since most buyers borrow (or finance) most of the purchase price, the prices of houses are directly affected by financing.
Lower Interest Rate >> Lower Monthly Payment >> Larger Mortgage Loan >> Increase in Housing (Real Estate) prices as Sales Rises.
Higher Interest Rate >> Higher Monthly Payment >> Lesser Mortgage Loan >> Real Estate Sales Dries Up
How Real Estate Investors Use Financing
Generally, there are two ways for purchasing real estate. You can either pay all in cash or finance the real estate by making a small payment and borrowing the rest of the money in the form of a loan to pay the purchase price.
Investors rarely do use all cash to purchase properties, and when they do, it is on a short-term basis. Instead, they usually refinance the property to get their cash back or sell the property for cash.
Real estate financing is also known as leverage because of the way a down payment is used. Investors use mortgage loans to increase their leverage. The more money an investor can borrow, the more he or she can leverage the investment.
By leveraging a real estate purchase, investors can claim 100% of the cash flow, tax benefits, and any appreciation in property value by investing a small down payment, usually around 20% of the purchase price.
When Is Cash Better Than Financing?
Using all cash to purchase a property may be better than financing in two particular situations.
The first situation is a short-term deal, that is, you intend to sell the house shortly after you buy it (known as “flipping”). When you have the cash to close quickly, you can generally get a tremendous discount on the price of a house. In this case, financing may delay the transaction long enough to lose an opportunity. The real estate agent is more likely to recommend to his or her client a purchase offer that is full payment in cash rather than waiting for bank financing. Cash also allows you to purchase properties at a larger discount.
The second case is one in which you can use your retirement account. You can use the cash in your IRA or SEP to purchase real estate, and the income from the property is tax-deferred.
Key takeaways
- Real estate financing is used by investors and homeowners to control 100% of a property while making a small down payment.
- Financing real estate is also an investing strategy used to generate higher returns compared to purchasing a property for cash.
- Interest rates affect property values.
- Financing affects the value of a property to an investor.
- Investors use financing to leverage their investments.
