Financially Prepare For Your First Investment Property

Financially Prepare For Your First Investment Property

I bought my first property in 2009; I was 24 years old. I stumbled into it totally unprepared and I had no idea what I was doing.

We learned a lot of hard lessons those first two years.

I almost didn’t qualify for the loan and almost lost the deal because of it.

Then, once we did close, I barely had enough money to do the basics – like evict my first tenant, repair leaks, or fix the heater. Somehow, I managed to get through the first year and things started to get easier.

I didn’t know about analyzing investment property, property management, or how to budget for my business.

I realize now that the key is to have a strong financial base BEFORE investing. It’s better to figure it out beforehand and not struggle through every problem as it pops up.

Financially Preparing For Your First Property

The key to buying property is to be able to get a loan. For any loan, there are three variables to consider: your debt, income, and cash needed to finance. By manipulating these inputs, you can influence the output – your loan.

  1. You need a solid income both through wages and what’s generated from the property.
  2. You need to keep debts low to qualify.
  3. You need to have enough cash to cover the down payment, closing costs, and basic repairs and maintenance.

1. Manipulate Your Income to Qualify for Real Estate Loans

When I say manipulate your income to buy investments, I do not mean you should fake any numbers and make false statements. Manipulate means to handle or control in a skill fashion – by understanding that variables that determine your loans, you can start planning ahead to make yourself look good to the lender.

The first thing to consider is your source of income. Lenders like to look back 2 years in general, and the way you earn your income will significantly impact what you qualify for.

Employee With a Full-Time Job:

A wage earner with a W2 can qualify very easily for loans. Generally, a bank looks for 6 months of solid earnings and then you can qualify for a loan. Easy, right?

But, what if your wages aren’t enough to qualify? There are only a few ways to manipulate this – one way is to get a second job, and the other way is to work overtime.

Unfortunately, your mortgage broker will need to see a long history of this to use it to help you qualify – often around 2 years worth. They want to make sure you can regularly earn this much and that the high earnings are not just an anomaly.

Self Employed or Business Owner:

This is where it’s really interesting and really difficult.

Working for yourself, you have probably learned how to deduct everything under the sun and you probably know how to avoid paying most, if not all of your taxes. Unfortunately, when you want to qualify to buy that investment property, the banks look at the income you claimed on those tax returns. So, writing off every random expense to keep those taxes low will actually hurt your odds of qualifying for a loan on your investment property.

That’s the trade-off: pay taxes and qualify or avoid taxes and don’t qualify.

You should consult with your CPA on what is the best strategy for you, but many years ago I chose to run my business 100% in line with the law and never “fudged” the numbers to reduce my tax liability. This has helped me grow very fast because every year my income grows.

2. Manipulating Your Debt

This one is probably the thing you have the most control over. It’s hard to increase your income but it’s easy to rebalance loans, pay some off, etc.

The conventional wisdom says we should pay off the loans with the highest monthly payment in order to qualify for a house…but conventional wisdom is often wrong.

Instead, I’ve used a different approach:

I try to pay off the debts that have the lowest monthly payment to total debt ratio.

In the chart, there are a number of debts and their associated monthly payment. You’ll also see a ratio on the side and you calculate it by taking the debt and dividing it by the monthly payment

The ratio can also be read “How many dollars I need to spend in order to reduce my monthly payment by $1.”

Simply look at it and see which ones make sense to pay first. Should I pay the $12,000 and reduce my monthly burden by $225 or should I pay $2,500 to reduce it by $125? By looking at the ratio, you can see that paying the $2,500 first makes the most sense because for every 20 dollars you spend to pay down debt, you reduce your debt burden by $1. That’s a lot better than any of the other debts.

You can see how powerful this ratio is. It really helps you take your debt-to-income ratio under control and you can manipulate it as required to qualify for the loan on that new rental property!

You not only need to manage your debt but manage your finances. It is important to avoid making these financial mistakes. I particularly like #2, 5, & 10 that Jeff Rose lays out in his article. Credit cards, cars, and recurring payments will really sink your debt-to-income ratio.

To Qualify for Loans on Your Investment Properties, Controlling Debt is More Important Than Earning More Income

What? Let me explain.

Let’s say a person earns $4,000 per month and has a monthly debt of $1000. This person is looking for a loan for $150,000 on a house.

Let’s say the bank allows for a maximum of 35% debt to income ratio or a monthly debt of $1,400. That leaves only $400 for a loan.

A 4%, 30 year loan for $150,000 is $716/month. This person is $316 short of qualifying.

There are two ways to solve this. Earn more, or pay off debt:

Paying Off Debt:

  • Max Debt – $1400
  • Current Debt – $1000
  • Loan – $716
  • Amount to pay off – $316

Earning More

  • Max Debt – $1400
  • Current Debt – $1000
  • Loan – $716
  • Debt with Loan – $1716
  • $1716 / (0.35) = $4903
  • Income Required to qualify = $4,903

We can either pay off $316 of debt or earn $903 more per month to qualify. Each dollar of debt of worth nearly 3 dollars of income.

Cash Required

How do you manipulate the cash required to purchase? Different loan programs have different closing costs and down payment requirements:

  • For conventional financing, you will need 20% + closing costs.
  • Commercial financing will require 20-30% + closing costs. That’s a lot, but they don’t use your personal debt-to-income ratio to determine eligibility.
  • FHA is as low as 3.5% but has some extra inspection requirements. Only good properties will qualify, not fixer-uppers.
  • VA can be 0% and has a higher debt-to-income ratio which makes it easier to purchase. It is similar to the FHA with its inspections
  • There are other loans out there too, like USDA that may be available on a case by case basis.
  • I always count an extra $5,000 for closing costs just to be safe. VA and FHA can be more (unless you’re a disabled vet then it’s waived).

Shop around and find out what loan programs you may be able to take advantage of in your area. Each one may have different down payment requirements and will help you adjust this number.

Let’s take the numbers above and see if changing loan program helps.

  • Max Debt Traditional (.35)- $1400
  • Current Debt – $1000
  • Loan – $716
  • Amount to pay off – $316
  • Max Debt Alternate Program (.40) –  $1600
  • Amount to pay off – $116

By changing programs you may have a much easier time qualifying for that loan.

What About FICO Score?

A lot of people have great credit and wrongly believe they can qualify for a loan. As I’ve spent this entire article explaining, qualifying for a home loan is all about the debt-to-income ratio. That being said, your credit score does play a factor in your DTI ratio.

Credit score is important of course and it can disqualify you, but, if you are above the minimum threshold, it can raise or lower the cost of financing by affecting your interest rate. Since your interest payments are part of your mortgage, and your mortgage counts toward your debts, it is just another factor to consider when manipulating your debts.

Let’s say you have good credit and qualify for a 4% interest rate and someone else has poor credit and can get a 6% interest rate. For every $100,000 house value, that’s an extra $2,000/year or $166/month in payments. This really could be the difference between you qualifying and not qualifying, so it’s best to manage your FICO score.

If you have a low credit score, read this article about boosting your FICO score.

Next Step

If you haven’t yet, you need to focus on education first then on creating a plan. If you’ve done all that, now it’s time to create your first stream of passive income.

Check out all 6 steps to becoming financially independent.

By | 2017-10-22T16:15:31+00:00 March 18th, 2016|Categories: Financial Independence|0 Comments

About the Author:

An investor that reached financial independence at the age of 30, Eric has been seen on Forbes, Trulia, WiseBread, TheStreet, and other financial publications.

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