If you are looking to tap into real estate investing without tapping into the limited spare change you have laying in the bank, in a safe, in the freezer, or under the mattress — to each their own — then luckily for you, there are a variety of financing options available. Most of which require the best type of spending... using someone else's money.
We will be shedding light on the two most common real estate financing options: residential vs. commercial loans.
While this basic loan type is usually used for funding primary residences, a residential loan is crafty enough to be used for both business and pleasure.
Many investors use residential loans for financing smaller properties that have one to four units. They also use residential loans so that the payment installments are spaced over 30 years with a fixed interest rate. The 30 year mortgage allows flexibility on repayment that is not afforded by shorter term commercial loans. For example, if your investment property sees an uptick in vacancy rates or requires a costly emergency repair, you'll have enough monthly cash flow possible to prevent paying out of pocket just to keep the property afloat.
With that said, residential loans require more of a personal and commercial investor's backstory. Banks want documents that paint a multi-year financial history, so they can assess your risk and if you and your property are worth that risk. Be prepared to hand over pay stubs, previous tax returns, valued assets, and more.
You can use commercial loans for any type of rental property, business home, or personal home.
Commercial loans have higher interest rates, higher down payments, shorter loan terms, and therefore, higher monthly payments. So, why on Earth would you pursue a commercial loan as your financing option?
Here are the four circumstances that usually call for commercial real estate loan financing:
When investing in properties with five ore more dwelling units. Residential loans are ONLY for properties with 4 units or less. Period.
When buying a property in the name of an LLC. There are risks to buying a property under an LLC instead of your name with residential loans, especially when it comes to quitclaiming — a.k.a. transferring ownership. For starters, quitclaiming a residential loan into an LLC might trigger a due on sale clause where the bank could call your loan and make you pay the entire balance. Another problem with quitclaiming under a residential loan is that the title insurance may not transfer to the LLC. With a commercial loan, everything is already in the name of the LLC, so you don’t have to go through the quitclaim process or worry about the due on sale clause and losing title insurance.
If you do not have the W-2 income or history able to qualify for a residential loan. Whether you are a resident who doesn't have much income, or are self-employed and paying yourself dividends, it may be easier in some cases to qualify for a commercial loan because approval is based more on property performance than your personal finances.
If you've reached your limit of ten residential loans. Yes, there is a limit to your investing prowess and amount of residential loans you can take out. Individuals have a maximum of 10. Married couples are able to reach a maximum of 20, with 10 properties listed under each name. Anything above 10, must be with a commercial loan.
How They Differ
Let's see how residential vs. commercial loans compete in a toe-to-toe comparison.
Warning: financial jargon coming your way.
Generally speaking, residential loans will have the same or lower down payments, and fall under three umbrellas. 1). Conforming residential home mortgages — meaning a loan that meets the terms and conditions of Fannie Mae and Freddie Mac, and does not exceed $647,200 — that would be sold on the secondary market have 5% down payment minimums, but 3% for first time home buyers. 2). Conventional or "in-house" residential mortgages are 15% down payment. 3). In-house jumbo residential loans — meaning a loan that exceeds the conforming loan limits — have a down payment of 25%. Something to note when it comes to residential loans, if you are putting less than 20% down on a residence, there would likely be Private Mortgage Insurance (PMI).
Commercial real estate loans are less complicated at all usually a 20% down; however, if you request certain terms such as a lower interest rate or cash-out, your lender may request a larger down payment.
Qualifying for residential vs commercial loans largely depends on you and your income; whereas qualifying for a commercial loan depends on the property and how much the property generates. The more income or income potential a property has, the less important your personal income becomes on securing a commercial loan. Understanding the underwriting process and knowing what information you need to have prepared for your financing inquiry can be the deciding factor on if you will be approved for a loan or not.
You'll find residential loans at just about any major bank or national mortgage lender. On the contrary, commercial loans are usually sourced from community banks — hopefully, one you already have a relationship with.
While residential loans tend to have lower interest rates than commercial, it is not always the case. The biggest difference you will see between the two is when it comes to their fixed vs. variable interest rates. Rates for residential loans will have a fixed percentage for the duration of the loan. Meaning: your locked-in interest rate and payment will stay the same regardless of what happens to market interest rates. On the flip side, commercial loans tend to have variable rates that fluctuate along a standard index. So, if interest rates skyrocket, so will your mortgage payment.
Simply put, amortization period is the length of the loan, and an amortization schedule is the installment payments used to reduce the current balance on the loan. Residential loans tend to have an amortization period of 15 or 30 years — unless payed off sooner; whereas commercial loans are amortized over shorter periods. Those shorter periods means higher monthly payments for you.
Which Loan is Right for You?
It is easy to get lost in weighing the pros and cons between residential vs. commercial loans. All of the planning in the world cannot provide a cut and dry answer as to which of those two financing options is best suited for your real estate investment. Talking with a professional can however. The same people that help you develop a financing plan are the same ones that approve it. Flagship's team of experts know Minnesota real estate and know what it takes to make an investment succeed. Find out which loan type is right for your next venture by talking with a lender today.