Most people believe the only way to finance buying a new house is by using a traditional mortgage – unless, of course, the potential buyer is sitting on a mountain of traditional good, cold cash.
However, as any real estate investment expert will tell you, there are several non-traditional ways that people can secure the financing they need to purchase their next property.
In fact, savvy real estate investors have been using these financing methods for years, and have profited handsomely by avoiding the traditional mortgage route altogether.
These non-traditional, non-conventional methods are known as “creative financing.”
What is Creative Financing?
Creative financing is the term used to describe “new or unusual ways of legally getting money to finance something such as a home, project, or business.”
In real estate, it is the use of non-traditional or non-conventional methods to obtain funding for a real estate transaction – such as using seller financing, lease options, or owner financing – rather than the traditional method of a bank mortgage.
The aim of creative financing is to find unique and innovative ways to structure a transaction in order to make it work for both the buyer and the seller, and to access financing that may not be available through more traditional channels.
According to the National Association of Realtors, in September, 2022, nearly a quarter (23%) of all home purchases were all-cash sales. Furthermore, according to U.S. government Census data, only 42% (around 51.5 million in total) of households have mortgages – around 51.5 million American households.
Many entrepreneurial real estate investors are more likely to opt for one of creative financing solutions to their next project than having to take out a traditional mortgage. While obviously mortgages are still very common, the 30-year, fixed-rate route is not a one-size-fits-all model.
Creative financing is just that – creative. It allows savvy investors to choose and use innovative, alternative financing methods, as they look for the best fit for their planned exit strategy.
Creative Financing vs. Traditional Financing by Mortgage
Typical real estate transactions in the U.S. and elsewhere follow the same concrete steps:
- A prospective home buyer finds a house they want to buy
- The home buyer applies for a traditional mortgage, and
- Once the mortgage is approved, they close the deal.
As we have described previously, this may not suit every property investment – hence, the rise in popularity of creative financing.
That doesn’t mean there is no place whatsoever for the traditional mortgage. Sometimes, successful real estate investors will use a combination of traditional loans and creative financing to allow them to purchase the real estate they’re looking for.
Creative Financing is Not Just for Real Estate Investors
And remember, creative financing is not just for real estate investors. Prospective home buyers with credit issues could also benefit.
For example, if you’ve decided you’re ready to buy a home, but traditional banks are accusing you of being a less than perfect candidate, such as a low credit score or you can’t afford the 20% down payment, one of the following methods could well be your solution.
Let’s look at these non-traditional creative financing methods and techniques that real estate investors will turn to for securing and then closing on their next investment property.
Creative Financing Methods & Techniques
Going straight down the traditional mortgage route may seem the most straightforward option for most property deals, but this common approach does not always guarantee the best loan terms.
Creative financing methods can offer choice and flexibility for today’s investors (and, perhaps, the typical home buyer).
There are many unique and diverse ways to finance real estate transactions – here are the ten most common creative financing methods and techniques currently in use today:
|1. Cash-Out Refinance||6. Self-Directed IRA|
|2. Home Equity Line Of Credit (HELOC)||7. Hard Money|
|3. Personal Loan||8. FHA Loans|
|4. Seller Financing||9. Crowdfunding|
|5. Lease Option||10. Cross Collateral|
1. Cash-Out Refinance
A cash-out refinance is a type of mortgage refinance in which the borrower takes out a new loan that is larger than their existing mortgage loan and uses the difference between the two loans to receive cash.
2. Home Equity Line of Credit
A Home Equity Line of Credit (HELOC) is a type of loan that allows homeowners to borrow money using the equity in their home as collateral. The lender establishes a credit limit, and the borrower can borrow up to that limit as needed, similar to a credit card.
The borrower must only make interest payments on the amount borrowed until the loan term ends, after which the borrower must repay the principal and the interest. HELOCs typically have variable interest rates, meaning the interest rate can change over time.
You can find a list of the best HELOC lenders for 2023 here.
3. Personal Loan
A personal loan doesn’t offer the same great tax benefits as a refinance or HELOC, you aren’t required to put up your house as collateral. In some cases, you aren’t even required to put up any collateral at all.
With a repayment term much shorter than a mortgage loan (around 5-7 years), you pay a lot less interest over the long term.
4. Seller Financing
Ever hear an investor talk about buying something “on terms”? They are referring to seller financing, a type of real estate transaction in which the actual seller provides all or part of the financing for the purchase of their property.
Instead of the buyer obtaining a mortgage from a traditional lender, the seller acts as the lender. They hold the promissory note and mortgage or deed of trust for the property.
The buyer then makes their payments to the seller, who is responsible for collecting and remitting payments to the appropriate parties.
5. Lease Option
A lease option is a type of real estate agreement in which a tenant rents a property from a landlord, with the option to purchase the property at a later date. The tenant pays a higher rent than market value to the landlord, with a portion of the rent being applied towards the purchase price of the property.
The tenant also typically pays an option fee, which gives them the right to purchase the property at a specified price within a specified time period.
It is important to note that this type of agreement is not common, and it can be complex. It is highly recommended to get legal advice before signing a lease option agreement.
6. Self-Directed Individual Retirement Account (IRA)
A self-directed Individual Retirement Account (IRA) is a type of retirement account that allows the account holder to have more control over the investments within their IRA.
Unlike traditional IRAs, which are typically managed by financial institutions and have limited investment options (such as stocks, bonds, and mutual funds), self-directed IRAs allow the account holder to invest in a wide range of assets, including real estate.
By using a self-directed IRA, an individual can use their retirement funds to invest in real estate, either by purchasing a property outright, or by becoming a partner in a real estate deal.
There are specific rules and restrictions that apply to self-directed IRAs – consult with a financial advisor or a legal expert before making any investments.
7. Hard Money
A hard money loan is a type of short-term loan that is secured by real estate. Hard money loans are typically used by real estate investors to purchase and rehabilitate properties, or to bridge the gap while they secure long-term financing.
Hard money loans are typically provided by private individuals or companies, rather than traditional financial institutions. They are characterized by their high interest rates, short loan terms (around 1-5 years), and a focus on the value of the collateral (the property) rather than the borrower’s creditworthiness.
Hard money loans can be a viable option for real estate investors who need to close a deal quickly, and don’t have time to wait for traditional or other financing.
8. Federal Housing Administration (FHA) Loans
FHA loans are mortgages that are insured by the Federal Housing Administration (FHA), which is a government agency. These loans are designed to make it easier for people to purchase a home, especially for first-time homebuyers or those with limited funds for a down payment.
FHA loans have several benefits:
- They offer more flexible credit and income requirements than traditional mortgages, making them easier for many people to qualify for.
- They require a lower down payment, typically between 3.5-10% of the purchase price.
- They also allow for a higher debt-to-income ratio, which means that borrowers can have a higher percentage of their income going towards housing costs.
A relatively new creative financing option, crowdfunding in real estate refers to the use of online platforms to raise funds from a large number of individuals, known as “crowdfunders,” to invest in real estate projects.
Crowdfunding allows investors to pool their money together to invest in a property or a real estate development project, with the goal of earning a return on their investment.
There are different types of crowdfunding in real estate:
- Equity crowdfunding: Investors receive shares of the property or development project, and earn a return on their investment through rental income or capital appreciation.
- Debt crowdfunding: Investors lend money to the developer, and receive interest and principal repayment.
It is important to carefully review the crowdfunding terms and risks before investing. Additionally, not all U.S. states allow for real estate crowdfunding, and rules and regulations vary by state.
10. Cross Collateral
Cross collateralization refers to where a borrower uses more than one property as collateral for a loan. In other words, a borrower may use multiple properties as security for a single loan.
For example, a borrower may own several properties that they have not yet paid off, and they are looking to get a new loan to purchase another property.
Instead of using only the new property as collateral for the loan, the lender may require that the borrower also use the existing properties as collateral.
Cross collateralization can be beneficial to the borrower because it allows them to access a larger loan than they would be able to if they were only using one property as collateral.
However, cross collateralization can be risky if the borrower defaults on the loan – the lender may foreclose on any of the properties that were used as collateral.
Better Off Home Buyers: Creative Solutions
Creative financing can be a great solution for home buyers or real estate investors who need funds for their unique purposes. These are financing solutions that focus on finding a way to accommodate each borrower’s unique needs.
However, it’s important for borrowers to consider the drawbacks to their creative financing option before they commit to it, so they’re well aware of how the loan may change or how their payments could increase.