Investing With Other People's Money, Part 1

Investing With Other People’s Money, Part 1If you have ever traded stocks on credit, you know that it’s a tough way to get rich. Things work differently in real estate, which is why hundreds of thousands of investors use credit to get started with their first property and then to reach their investment goals much faster than they could with any other investment.

In stocks, borrowing money from a broker to purchase is called buying on margin. To trade on margin, you need an initial investment in a margin account of at least $2,000, though some brokerages require more. Once the account is opened and operational, you can only borrow up to 50 percent of the purchase price of a stock. This portion of the purchase price that you deposit is known as the initial margin. Some brokerages require you to deposit more than 50 percent of the purchase price.

Life on the Margin

When you sell the stock in a margin account, the proceeds go to your broker against the repayment of the loan until it is fully paid, not to you. Also, there is also a restriction called the maintenance margin, which is the minimum account balance you must maintain before your broker will force you to deposit more funds or sell stock to pay down your loan. Marginable securities in the account are collateral. You’ll also have to pay the interest on your loan and the interest charges are applied to your account. As debt increases, the interest charges increase, and so on.other people's money

Therefore, buying on margin is not a good idea for a multi-year investment. The longer you hold an investment, the greater the return you need to break even. If you hold an investment on margin for a long period of time, the odds of making a profit are slim to nil.

Trading stock on margin is a good way to make someone else rich. Real estate operates in the reverse. It’s a great way to make money on somebody else’s dime. When you borrow money for a real estate investment, you pay it back on a predetermined payment schedule just like any other loan. You keep the profits.

The difference is in the collateral. The value of stocks fluctuates daily. Lenders appraise real estate before they lend money on it so that they have a good idea of what it would be worth it they had to foreclose.

CashHow to Leverage Borrowed Money in Real Estate

Perhaps you’ve heard that most investors pay all cash. That’s not true, though the percentage is growing as more institutional investors enter real estate. In August 2012, nearly one out of four investors said they planned to use all cash on their next purchase and the balance would use some form of financing. By June 2013 the percentage had increased to 37 percent, but the majority of investor money is still borrowed.

Consider how the ability to leverage your investment with other peoples’ money helps.

Frank has $100,000 to invest. He can choose to use that $100,000 to buy a house that will produce $1,000 per month in income or $12,000 per year. This equates to a 12 percent return-on-investment.

Frank could also instead use that $100,000 as a 20 percent down payment on FIVE similar homes, each listed at $100,000. With an $80,000 mortgage on each, the cash flow would be approximately $300 each month per house, which is $1,500 per month each or $18,000 per year. This works out to an 18 percent return-on-investment, or 50 percent better than buying just one home.

Financing Options for Investors

Qualified Mortgages

A new federal regulation known as the QM Rule took effect in January 2014, defining the requirement for mortgages to become qualified, which means they will incur lower risk for lenders and lower mortgage rates for borrowers. Lenders have an incentive to make QM loans in the form of legal protection from the government against borrower lawsuits. Requirements include:

  • No Excessive Upfront Points and Fees
  • No Toxic Loan Features like Interest-only Loans
  • Limits on Debt-to-Income Ratios.

Mortgages from Portfolio Lenders

Qualified mortgages are the most common type of mortgage used by homebuyers and generally provide the lowest interest rates that you can get. Most are resold by the originating lender to be turned into mortgage-backed securities, which are sold to large institutional investors on Wall Street. They require an appraisal and the borrower must meet strict guideline on credit, income and ability to repay the loan. However, some banks and credit unions have the ability accept more or all of the risk of a loan, which them a portfolio lender. Because the money is their own, they are able to provide more flexible loan terms and qualifying standards. This means that they are able to make loans available at any terms acceptable to them. Often times a portfolio lender will have funds available with less restrictive qualifications than a conventional lender. However, the interest rate paid by the borrower will be significantly higher than those offered by qualified mortgages.

FHA logoFHA Loans

The Federal Housing Administration (FHA) insures mortgages for banks in order to make housing affordable to those who don’t have sufficient savings for a down payment. FHA loans are designed only for homeowners who are going to live in the property – so you cannot use an FHA-backed loan to buy a pure investment property. However – you can take advantage of the exception to the rule that allows the FHA-financed home to have up to four separate units. In other words – if you plan to live in one of the units, you could buy a duplex, triplex, or four-plex.

The benefit of the FHA loan is the low-down payment requirement: currently just 3.5 percent. However, every blessing comes with a curse. While the low down payments the FHA offers is great, the FHA also requires an additional payment, called “Private Mortgage Insurance.” This “PMI” insurance protects the lender and is required when the down payment on an FHA loan is less than 20 percent. The extra PMI payment can make your monthly payment slightly higher, thus reducing your cash flow. In recent years, the FHA has had an extraordinary level of delinquencies. To remain solvent, it has raised PMI requirements and made other changes to raise money. Unless its fortunes improve, the FHA will make additional changes in the future that will make its loans more expensive.

Join us in 2 days to see the rest of your options, and to read some of our conclusions, as well. You can also contact us, in the interim, if you have further questions.

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