The type of mortgage that you select as a real estate investor is a key factor in determining your level of risk and the cash flow that your investment will generate. Your overall return on investment (ROI) is going to depend on multiple factors, but the type of loan is right near the top.
Here are six popular types of mortgages from an investor’s perspective.
- Fixed Rate: The “steady Eddie” mortgage. Low risk and predictable. But, not always the lowest rate. However, if you intend to hold a rental home for years, then this loan type allows you to set this major cost of ownership in stone. You do not have to worry about rate changes damaging your cash flow. It also can be refinanced if rates go down, so you have some flexibility. If rates are higher than you like but you still can get decent cash flow, you may take out a fixed rate loan with the goal of refinancing at a future date.
- Adjustable Rate (ARM): May offer lower initial rates, but the investor assumes the interest rate risk over the life of the investment. This type of loan is best if you want a low rate for a shorter planned holding period, under the length of time before the rate changes. You may also take out this type of loan if you expect rates to drop. There are five-, seven-, and 10-year ARM loans available, and one of these may fit into your investment plan and increase cash flow while planning to sell the asset before loan rates adjust.
- Interest Only: Lower your payment by paying interest only (no principal) for a pre-defined period. But be prepared for your rate to go up. If you definitely plan on some type of flip resale in a short period of time, this can be the lowest cost out of pocket for the period you need the money. A fix and flip transaction loan for the time from the purchase closing through the sale closing could be an example. There are also investors who plan for a 1031 Exchange in the near future who use interest-only loans to keep costs down and cash flow up until their plan is executed.
- Zero Down: The “gurus” preach this approach to financing which requires no down payment. This can boost the rate of return on your investment, but be aware of the risks. This type of loan almost disappeared after the crash that began in 2007.
- Balloon: A balloon mortgage is amortized over a period that is longer than the term of the loan. This can result in some savings in the monthly payment, but be prepared to refinance at the end of the term. Example: You take out a loan to buy a home, and the payment is based on a 30-year amortization, but the loan is only for five years. You must pay off the loan at the end of that five years, the balloon payment. You do save interest expense because of the 30-year amortization.
- Exotics: If you have a mortgage offer that seems too good to be true, it probably is. Most of this type of lending disappeared after the crash, but it's good to be aware in case you come across something so creative it seems impossible.
One type of loan that isn't really that "exotic" is a blanket mortgage covering a group of properties already owned by the borrower. If they've been held for years, there is equity that can be used to fund other investments. A group of these properties can be pledged as security for funding for other property purchases.
Real estate investors have choices for funding, but they are less varied than in the past. However, an aggressive investor can fund their deals in various ways and get the ROI they want. Carefully weigh your options. Sometimes loan type selection can make the difference in whether a deal can be done or not. But, if it's that close of a call, be careful to do your due diligence.