11. Real Estate Lending-Part Two
My free property spreadsheet does some basic mortgage calculations for you.
Even if you’ve gone through the mortgage process for your own home, there are a few vocabulary terms you should familiarize yourself with before you pick up the phone and start shopping lenders for that investment property you want to purchase. We’ll clarify terminology for commercial loans here in Episode two of our loan series:
Leverage, Note, Paper, Loan, Debt, Financing-- These are all terms describing money you borrow from a lender that you use to buy a property.
Loan-to-Value. Size of the loan versus value of the property. Residential loans for owner occupied housing can be up to 100% LTV for VA loans and 95% for FHA loans. If you’re an investor then plan on getting a max of 75% LTV for your property. Your lender may require something lower than 75% depending on their own lending standards.
Mortgage: The document that says you are putting the title to your property up as collateral until you pay the lender back. Not to be confused with-
Promissory Note. This is the document that spells out how you’ll repay the loan, including details such as term, interest rate, amortization, principal amount, monthly payment, etc. When buyers say they keep paying a mortgage, they actually mean a promissory note.
APR - Annual Percentage Rate. The rate describes how much interest you’re paying on the principal each year.
APY- Annual Percentage Yield. The percentage of the loan principal you’ll have to pay over the year. This includes the frequency and details of compounding loan interest. The APY is always higher than the APR.
Amortization Schedule- This describes how the loan would be paid off with scheduled payments. Principal and Interest portions of the payment are different for each payment. The typical loan starts off as mostly interest payments, and slowly converts to being mostly principal payments at the end of the amortization period. A 30 year residential loan means that your loan will be completely paid off at the end of the 30 years. You could have a loan with a shorter term like 5 or 10 years but it would amortize over 15, 20, or 30 years.
Term - How long until your loan is due. Not all loans are completely paid off at the end of their term. This is especially true with commercial loans.
Balloon payment- If your amortization period is longer than your loan term, you’ll have to pay the remaining balance of the loan off at the end of the term. This is called a balloon payment. Most investors refinance into another loan or sell the property before the balloon payment is due.
Adjustable rate mortgage, or ARM. After a specified period, the loan rate will adjust based on the market rates and whatever else the lender defines to set the new APR. Usually, the initial interest rates on these loans are lower than fixed rate loans. The lender is hoping that you’ll have to refinance into a higher rate loan after the initial term is up. ARMs are usually denoted as 5/1, 5/5. 10/1, etcetera. The first number is the initial period of the loan at the advertised interest rate. After the initial period, the interest rate adjusts at the period of the second number. 5/1 is the most common.
Fixed rate mortgage. Just like it sounds, the interest rate is fixed for the term of the loan. The most common product in the residential world is a 30 year fixed mortgage. The amortization period and the loan term are the same. However, you can have shorter term fixed rate loans as well.
Hard Money Lenders - These lenders provide short-term interest only loans at high interest rates usually for only a year or less. If you want to flip houses, need a fast close, or can’t qualify for conventional lending - these are the lenders you seek out.
Prepayment Penalties- If you have a mortgage on your personal home, you probably don’t have any of these. You can pay off your home mortgage anytime without penalty. However, If you have a commercial loan the bank wants to make sure it’s going to get its return on investment if you pay the loan off early. They do that in a few ways. Usually, it’s a fee that is based on the percentage of loan that’s still outstanding when you pay it off early. After all, if you’re in the business of lending money and collecting interest is your profit, you want to make sure you’re guaranteed that profit!
Recourse or Non-Recourse- Can the bank come after your other assets if you get foreclosed on and the bank didn’t get all of its money back? Most non-residential loans under a million are this way. Once you get over the 1 million dollar loan amount you’ll get into the non-recourse territory. Here, a lender can’t come after your other assets if you default. Unless you misrepresent yourself or commit fraud, of course. Also, if you’re using a retirement account to buy properties and need lending, you’ll have to find a non-recourse lender.
Underwriting - The process the lender does to assess the amount of risk that you as a borrower represent to the bank. The more risk the higher the interest rate and crummier terms you’ll get. If the perceived risk is too high then a lender may refuse to lend to you.
Debt Service Coverage Ratio - We’ve covered this in previous episodes. But you’ll find this used in Commercial loans. The bank wants to know that you’ve got some padding in your rents over what the cost of the loan is. That way an unexpected repair, vacancies, or a pandemic won’t affect the bank collecting their money. Example: If the loan costs 10,000 a month and you collect 12,500 then your DSCR would be 1.25. Expect banks to look for 1.2 to 1.25 minimum DSCR
Residential Loan - These are loans on Owner-occupied housing or housing with 4 units or less. If you want to own your duplex in an LLC, though, you’ll have to get a commercial loan.
Commercial Loan - Anything above 4 units of multifamily or other types of commercial property like retail, office, and industrial properties.
Stabilized property- The property has held at or above a certain occupancy level, usually 80-90 percent depending on the lender, for a certain amount of time. 6 months is common. If the property is below this threshold, it is considered unstabilized and the lending terms will reflect that.
Assumable loans - The lender states that another party, usually the buyer or a property, can take over the loan that’s already in place subject to the lender underwriting the new buyer. Expect to pay a fee for this privilege.
Agency Debt - Fannie Mae or Freddie Mac loans.
Liquidity requirements - The lender wants to see you either can pay the loan for x amount of months after close, or you have a certain percentage of liquid assets remaining at closing among the sponsors. If there’s trouble with property, the bank wants to know you have enough liquid assets to pay the loan.
Guarantors - The people who put up their personal assets to repay the loan should the property be unable to do so for any reason.
Sponsors- The person/entity that’s buying the property and taking out the loan
Is your head spinning with all the new vocabulary? Listen to this again if you need to. We’ll also post the script online for your reference.