Real estate investments are an effective way to grow wealth. Properties usually provide significant returns, especially if you turn them into rental houses, apartments, and commercial establishments to earn passive income. However, only 12% of Americans bought properties in 2022, despite 23% stating that it’s the best way to build wealth.
But why is that so? Investing in real estate is expensive, primarily if you rely on a single income stream. You must pay with cash or mortgage the property to acquire one, not to mention the taxes and costs required to build and maintain it. Even loans entail staggering down payments, amortizations, and interest rates—making it more challenging to finance a property.
If you’re considering buying a property but don’t know how to finance it, this investment guide can help you plan your purchase. Here are some popular ways to finance real estate investments to help you make informed decisions before investing.
Why Invest in Real Estate?
Real estate investment refers to buying a property to generate returns over time. The average return on investment (ROI) from residential properties is 10.6%, while commercial properties usually earn around 9.5%, making real estate a popular and effective way to build wealth.
However, investing in real estate has risks. Housing markets are , with movements that depend on rapidly changing like interest rates and government policies. Moreover, renting out property for passive income is risky since tenants may fail to pay rent or damage the property, impacting its value.
7 Ways to Finance Real Estate Investments
Understanding your choices can help you acquire property with ideal terms and maximize its value. So, knowing these financing options you can leverage can help you build wealth with real estate.
1. Cash purchase
The most straightforward way to purchase a property is to buy it upfront with cash. It’s also one of the most cost-effective approaches since you’ll save on processing fees, interest rates, and other associated charges. You can even negotiate with sellers for better deals, especially since they won’t have to wait for decades for their ROI.
However, paying with cash means you’ll spend a significant amount upfront, exposing your finances to market fluctuations. You may also miss out on other investment opportunities with little capital left to set aside. As such, only purchase with cash if you’re generating a considerable income and have substantial savings dedicated to it.
2. Bank financing
You may also acquire a mortgage loan from a bank to purchase a property. Banks heavily screen borrowers’ credit and financial capabilities, so this approach provides access to a large amount of capital since they’ve already assessed the default risks. Moreover, some mortgage interests are tax-deductible, reducing your financial burden.
That said, bank financing can also be risky. Your finances are subject to fluctuating interest rates, which may cause you to default. Additionally, strict application requirements may prevent you from leveraging this financing approach, especially if your credit score fails to meet the bank’s criteria.
3. Owner financing
Instead of financing through banks, some property developers provide in-house options wherein they act as lenders and finance the property on your behalf. Developers usually offer owner financing to people investing in a condo. These properties often entail high down payments and interest fees. Sellers may also provide negotiable payment terms and schedules to attract investors toward this option.
Unfortunately, owner financing entails risk for both sellers and borrowers. Some sellers offer less favorable interest rates and down payments than traditional banks provide. Meanwhile, property developers carry the risk of borrowers defaulting or failing to make payments, resulting in income loss or repossession.
Some property owners offer rent-to-own options, involving tenants renting a property to purchase it in the future. It’s an excellent way to build equity in the property through rent, which is especially helpful for investors without enough funds for a significant upfront down payment. Some rental contracts even allow tenants to sublet, providing an opportunity to earn passive income or hasten equity growth.
Being careful when entering rent-to-own agreements is essential. Some contracts are highly stringent or have high purchasing fees to mitigate risks and maximize revenue. So, ensure that the terms are fair for both parties. It’s also best to understand your payment obligations and responsibilities clearly to avoid legal issues.
5. Government-backed loans
The government also provides loans to help citizens acquire real estate properties. For instance, the Federal Housing Administration offers government-insured mortgages to low and moderate-income families. Borrowers can loan roughly 95% of the property value—a staggering amount, especially compared to banks that typically require at least 20%.
However, FHA limits the amount of money you can borrow depending on your location, given that they’re lending taxpayer money. Of course, low-cost areas have lower limits, which may restrict investors seeking to make money there. Meanwhile, unique regions with higher property and construction prices (e.g., Alaska, Hawaii) have higher limits.
6. Real estate partnership
Consider partnering with relatives, friends, or colleagues and pooling resources to acquire a property collectively. This approach is especially beneficial for people willing to share risk to mitigate individual losses and manage the property together. It also allows you to partner with investors of different expertise. Doing so can elevate your collective investment strategy and decision-making.
However, real estate partnership comes with complex legal and financial considerations, especially since multiple people own a single property. Partners are also susceptible to conflicts stemming from differences in management style, investment goals, and economic situations. So, pick people you can harmoniously work with and have similar objectives.
7. Real Estate Investment Trust
Do you want to invest without having to manage real estate? Consider doing so through a Real Estate Investment Trust (REIT)—a company owning, operating, and investing in income-generating properties. REITs employ real estate professionals who oversee the entire management operation. They also deliver higher returns thanks to and diverse property and market portfolios.
But, one thing to note when choosing this option is that your investments are subject to market fluctuations and other risks that affect ROI over time. REITs also charge upfront costs, sales commissions, and professional fees, significantly lowering your investment’s value.
Build Wealth with Real Estate Investments
Various financing options exist for investors looking to build wealth with real estate properties. However, while each may sound good, weighing the pros and cons before deciding is crucial. Your starting capital, credit history, and financial capacity can significantly influence your chosen option. So, take time to reflect on your situation.
The right financing option affects your prospective investment’s success. If you need help, a financial advisor may guide you through the process and familiarize you with critical real estate terms for more informed decision-making. Ultimately, strategic planning helps you maximize this highly lucrative and rewarding venture.
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