Real-estate investment has always been a lucrative option for investors. If you are going to be a first-time real estate investor, there is a lot that you need to understand about this industry before entering the market.
Before making any financial decision, one needs to be very sure. Especially if the decision is as important as investing in real estate, if you are serious about investing in real estate, taking professional guidance would be of utmost importance.
A professional, experienced, and reliable “real estate agent” would not only help you find a property worth investing but would act as a guide at every step of the property-purchase process.
The very first thing that demands your attention is financing options. If you want to purchase a property but do not have enough money in your account, no issues. Numerous financing options are available in the market. However, selecting the best option out of the pool of financing options can be quite tricky.
Another thing that you need to understand is leverage. One of the major benefits that real estate investment has over the stock market investment is the ability to earn profits on someone else’s money (financial institutions).
Besides this, if you buy a property using a loan, then your cash-on-cash returns will be much higher than paying the entire price using your own savings.
This leads to a very important question, which loan to take and from where. In this article, we would be discussing two of the most common types of real estate financing options- Residential loans and commercial loans.
Residential loans for investment properties
A residential loan is the same as what you apply while buying your first property. However, in this case, the investor has to put more money. Also, the interest rate of a residential loan is higher as compared to the loan taken for a primary residence.
The maximum payback tenure for a residential loan is 30 years. However, the option of a shorter loan term is also available. Besides this, an investor can even go for mortgage recasting.
In residential loans, the eligibility criterion is quite similar to that of a personal loan. Even the documentation is almost the same. This include,
- Letter from the employer
- Pay stubs
- Other financial documents
If possible, try to take a residential loan from an investor-focused lender. This would make the loan process easier. These people are not only familiar with the process but also take care of all the necessary paperwork.
A commercial loan is another most common financing option for real estate investment. You can use this loan to purchase any kind of rental property.
These loans are expensive as compared to other loans. Generally, they have a rate of interest and lower payment tenure. As a result, the monthly payment turns out to be higher as compared to a residential loan.
If you are planning to buy properties with five or above dwelling units, then the commercial loan would be the right option. If this is the case, then why we say that ‘commercial loan can be used for any type of rental property?’.
Firstly, you can use a commercial to buy a smaller property if you purchase it in the name of LLC and not under your name. As the property would already be in the name of LLC, you don’t have to worry about losing the title insurance, quit claiming, or the due on the sale.
Also, if you don’t have a history or W-2income to qualify for a residential loan, then also you can go for a commercial loan. Commercial loans are based on the property’s performance and not that much on the borrower’s income.
Another situation in which the applicant can opt for a commercial loan over a residential loan when they have exceeded the limit of the number of residential loans. For individuals, the maximum limit is ten, and in the case of married couples, the maximum limit is 20 (10 residential loans each). if you are done with the limit, then the commercial loan would be the only option.
Difference between Commercial and residential real estate loans
In residential loans, the deal is done between the individual borrower and financial institution. Whereas in commercial loans, the borrower is a company. Hence, it is between a company and a financial institution.
As per lender, commercial loans are riskier. Hence, the interest rates are higher as compared to residential loans.
In residential loans, the financial institution is interested in individual financial status and credit score. Whereas, in commercial loans, besides a good credit score, lenders are more interested in the applicant’s business plan.
For them, the property’s performance is more important than the applicant’s own income. They need all the important details regarding the property, like the type of maintenance, who will be responsible for utility bills, etc.
For a better understanding of these two real-estate financing options, we have covered a head-to-head comparison.
Almost all national lenders and major banks deal with residential loans. Whereas, in the case of commercial loans, it is the local bank that can provide you the loan. Hence, you need to build a relationship with a bank which has its headquarter in the same city where you want to purchase the property.
This is the repayment period. In residential loans, generally, the amortization period is of 30 years. This means the borrower can pay the loan amount within 30 years. However, these loans are very much open to negotiations. Considering negotiations, the amortization period generally lies in the range of 15-40 years.
Whereas, in the case of commercial loans, this period is shorter. As a result, the monthly payment is higher in this case. Also, getting a property to cashflow becomes harder.
Fixed vs. Variable
In residential loans, the rate of interest is fixed. This means the borrower has to pay the same monthly payment throughout the loan period. Whereas, commercial loans have a variable interest rate. In this, the rate of interest is linked to a standard index.
If the index goes down, so will be the rate and vice versa. This can have both positive, as well as negative effects. If the index goes up, so would be your monthly payment. The same rules apply if the index goes up.
In residential loans, the down payment amount is negotiable. In a strong housing market, you can even get a 0-down mortgage. Well, there is just one condition, you should have a good credit score.
Also, in the residential loan, you will have to pay PMI if the ratio of your loan amount to the total current value of the property, is more than 80%.
Generally, in commercial loans, the borrower has to pay 20% of the property’s value as a down payment. The loan to value ratio is 80%. However, if the market is strong, then there are chances that the borrower can get a loan by paying 10% of the value as a down payment.
In a residential loan, the borrower can pay off the loan at any time, irrespective of the length of the loan term. No penalty would be levied to the borrower. Hence, when there is a drop in the rate of interest many a time, borrowers go for refinancing.
The situation is not the same in the case of commercial loans. A prepayment penalty is very much applicable to these loans. Prepayment penalty keeps on decreasing with each passing year of the loan payment tenure.
What is passive commercial investing?
Passive commercial investing is a kind of real estate investing in which an individual can join a commercial real estate company as a limited partner. Well, the option of becoming an owner of a commercial property is always there if the investor can arrange the capital required.
Truth is the capital needed to buy a commercial property is very high, and this is a reason that many investors avoid entering the commercial real estate market.
If you want to have a diversified portfolio in real estate investment, then you might need to rethink your strategy and start building a passive commercial real estate portfolio.
Residential and commercial real estate loans differ from each other in interest rates, tenure, prepayment options, penalties, qualifications, and penalties. Hence, the borrower needs to understand his or her investment requirements before applying for the loan.
The loan market is highly competitive. Hence, to get the best possible offer, you need to do a window shopping and select the lender who offers you the best loan terms.