The traditional path to buying an investment property is to save money for a down payment, then get a mortgage to cover the rest. But that’s not the only path. From time to time, I get questions from the landlords who use Avail about how they can finance a rental property if they don’t have enough in the bank for a down payment.
Here are the four strategies I suggest considering.
1. Seller Financing
This involves getting a loan from the person you’re buying the property from. In some cases, if the seller is willing to lend you money, it’s easier (read: less paperwork) than getting a loan from a bank.
I’ve seen these deals work in a number of scenarios: The seller might finance either the down payment or the full purchase price. The seller might be another property investor — or they might be the property’s live-in owner.
The key to success is to ensure you agree on a fair interest rate for the loan. If you don’t have much experience in this area, it may be wise to work with your CPA and/or attorney. And regardless of how much experience you have, be sure to get the terms of the loan in writing, with signatures.
Another great financing option is to partner with someone who has enough money for a down payment. This is an effective strategy if you have a friend or family member who’s interested in getting involved in property investment, but maybe isn’t as interested in the day-to-day work of screening tenants and collecting rent payments.
In this scenario, what often happens is that one partner puts up money and the other handles all the actual work of being a landlord.
The key to success here is to agree on how to split proceeds. I recommend thinking about it in terms of aligning the risk and reward with costs and benefits. Your partner is taking on all the financial risk, but you’re putting in all the legwork of bringing in revenue via rent. Make sure the way you split proceeds reflects your contributions.
Whatever you decide makes sense, it’s best to have your terms in writing. Services like LegalZoom and Rocket Lawyer can help with drafting basic legal docs if you don't have an attorney. (Full disclosure: Rocket Lawyer is a partner of ours.) Another strategy we find effective is to form an LLC, which requires you to put together an operating agreement. That document is a great place to lay out roles and responsibilities for all parties.
3. Government Programs
The Federal Housing Administration (FHA) was founded to encourage homeownership. One of the ways it does that is by offering homebuyers the chance to buy property with just 3.5% down.
While FHA loans are specifically designed to facilitate the purchase of owner-occupied homes, it’s completely allowable to buy a two-, three- or four-unit building, live in one unit, and earn rental income from the others. In fact, this can be an incredibly cost-effective way to finance a rental property, especially if it’s your first.
FHA loan limits are different in every county, so part of the art here is making sure the loan limit where you want to buy is high enough that you can purchase a multiunit property.
4. Retirement Accounts
A lot of people who have moved jobs frequently or worked for themselves for any length of time have retirement money in an IRA. If you’ve got a self-directed IRA, you’re allowed to invest in nontraditional assets, meaning something other than stocks or mutual funds. Real estate is an approved investment category, meaning you can use money in a self-directed IRA to finance a rental property.
If you go this route, though, talk with your CPA first. Even with software that makes it easier to be a landlord, real estate is a more hands-on investment than anything in the stock market. Before you take the plunge, make sure you’re ready to invest the time and energy necessary to see a worthwhile return on investment.
Remember, Details Matter
Regardless of how you finance your rental property, be sure you’ve got adequate paperwork in place to set you up for success and steady income from the property you buy. That means investing in:
• Formal (written) agreements with a seller who has agreed to lend you money toward a property purchase.
• Legal documents like an LLC operating agreement to define who does what in a partnership (and who receives what compensation).
• Projections of expected returns from various investment types from your financial planner so you can compare potential outcomes.
Investing in real estate can be rewarding and lucrative. To get the greatest benefit for the long term, it’s best to take care of the details from the beginning.