Creative financing has enabled many investors to get into real estate even with little money and poor credit.
Not only does creative financing allow investors to purchase properties using less of their own money, but it also enables them to secure more deals. By having these tools in your toolbelt, you will be able to buy houses where a cash offer would never make sense.
In this article, we’ve covered the details about creative financing as well as the most common strategies that investors use.
What is Creative Financing?
Creative financing in real estate involves using specialized tactics to limit the amount of money you have in a deal, avoid using traditional lenders, or both. Instead of relying on cash or banks to fund their projects, creative financing investors lean heavily on other forms of leverage, such as owner financing.
Many people don’t realize it, but it is entirely feasible to purchase a house while leaving the seller’s loan in place. It is also possible to make a large amount of money from a property without ever owning it.
Most creative financing strategies focus on “terms” rather than price only. When buying on terms, the seller typically doesn’t receive the bulk of the proceeds of the sale upfront. Instead, they receive a small portion upfront, monthly payments along the way, and the remainder at a date in the future.
Here are some of the most common creative financing strategies investors use.
Buying a property subject to the existing financing is arguably the most lucrative creative financing strategy available. And the good news is that it’s relatively straightforward. In a basic subject-to transaction, you as the buyer will simply take over the seller’s loan balance and monthly payments.
By structuring a subject-to deal, you can acquire a house with essentially no money out of pocket. Assuming the spread between the home’s market rent and the loan payment is relatively large, you will be adding monthly cash flow to your finances for free.
Although a traditional subject-to transaction consists of the buyer simply taking over the seller’s loan balance and payments, you can offer the seller some cash on top of that as an extra concession. If they have a decent amount of equity in the home and it is in good shape, this will likely make sense and will allow you to close more deals.
What if the seller has a large amount of equity in their home, and you don’t want to pay them that in a lump sum? A wraparound mortgage is a great solution!
When structuring a wraparound mortgage, a new loan is created between the buyer and seller with its own principal amount, interest rate, and term length. Typically, the new loan's principal amount and monthly payment are adjusted to be larger than the values of the original loan.
This strategy gets its name because the new loan “wraps around” the existing mortgage and covers it. Because the monthly payment is at or above the original payment, the payment from the buyer first goes to pay the seller’s mortgage payment, and the seller then keeps whatever is left over.
This also applies to the principal amount. The beginning principal amount of the new loan is the purchase price of the house minus the down payment. When the buyer refinances the home or sells it, part of the proceeds go toward paying off the principal amount left due to the seller. The seller then uses those funds to repay their original loan and keeps the remainder.
What if the seller owns the house free and clear? That makes the process even simpler!
Instead of covering an original mortgage, the new loan created with the seller, called a seller carry-back, is the only debt tied to the property.
When structuring this owner-financed deal, you create a loan with the seller instead of going to a lender for the funds to purchase a house. And the seller doesn’t have to provide the funds for the purchase. They just deed you the property in exchange for a promissory note that explains how you will pay them back the principal amount with interest.
The primary terms of a seller carry back deal are purchase price, down payment, interest rate, term length, and balloon length. The good news is that, unlike a conventional lender, all of these terms are completely negotiable, so they can be adjusted to meet the needs of both parties.
The first three creative financing strategies discussed above are forms of owner financing, but lease options are slightly different. However, this tactic still involves buying on terms by paying the seller the purchase price over time instead of in a lump sum.
A lease option is a lease agreement combined with an option to purchase agreement. It allows the tenant-buyer to lease a property and buy it at a future date for an agreed-upon price.
While this might sound creative, a lease option on its own doesn’t present any notable opportunities. The beauty comes from using this strategy on the buying and selling sides of a house simultaneously. This method has been named the “sandwich lease option.”
The first step in implementing a sandwich lease option is to get an agreement with a homeowner to lease their property to you with the option to buy it in the future. Then your job is to find a tenant-buyer that wants to buy the house using the same type of agreement. The average tenant-buyer is someone that wants to buy a home but needs a year or two to get their financing in order to qualify for a loan.
The general terms of a lease option agreement are purchase price, monthly rent, option fee, and term length. The option fee is the fee paid upfront to lock in the purchase price for the length of the term and is typically subtracted from the purchase price at closing. If you plan to do a sandwich lease option, you will need to set the duration for at least two or three years to give the tenant-buyers time to qualify for a loan.
The goal when staying in the middle between the seller and the tenant-buyer is to make a profit from the difference in each of the amounts. The three ways to profit from a sandwich lease option are upfront from the option fee, during the term from the rent, and at the end from the purchase price.
Although the BRRRR Method typically involves working with traditional lenders, it is still one of the most creative strategies real estate investors use to do more deals and increase their ROI.
“BRRRR” stands for Buy, Rehab, Rent, Refinance, and Repeat. This strategy is primarily used to buy multiple rental properties while recycling the working capital over and over again. Here are the steps:
- Buy a house at a discount that can be improved and increased in value
- Rehab the property, making any necessary repairs and updates to maximize the value and rent price
- Rent the home for market rent
- Refinance the property based on the new value and use the proceeds to replenish the capital used to purchase and rehab it.
- Use the capital pulled out of the house to buy another property and repeat the process.
Most lenders allow investors to refinance a property at 75 to 80% of the appraised value. On many deals, this is enough to pull all of the invested capital out of the house. Even if it isn’t, the amount of money left in the deal is typically very small, which results in a massive cash-on-cash return.
Benefits of Creative Financing
Creative financing offers benefits for both buyers and sellers. While it doesn’t fit every deal, knowing the benefits it provides you as an investor and how it can help sellers will help you structure and close more profitable deals.
How Creative Financing Helps Investors
The primary goal of an investor is to grow their money as quickly as possible. One metric that real estate investors use to track their success is cash-on-cash return. The only two ways to increase your cash-on-cash return are by maximizing your income or minimizing the amount of your own capital you have invested. Because you can significantly limit the amount of money you have in each deal with creative financing, you can achieve much higher returns than are possible with any other methods.
Because most creative financing strategies allow you to leave the sellers existing loan in place, they will enable you to capitalize on a lower interest rate than you could get on a new loan. Not only have interest rates risen rapidly over the last several months, but interest rates on investment property loans are generally higher than for primary residences.
Having creative financing strategies in your arsenal will ultimately allow you to do more deals. Although cash offers are simple and offer many benefits to sellers, they aren’t always the right fit. For example, most investors would not be willing to pay cash on a house in good condition where the seller was asking for near retail price. However, when buying on terms, this could be a fantastic deal!
How Creative Financing Helps Sellers
Although creative financing offers tremendous benefits for investors, it wouldn’t matter if it didn’t help sellers at the same time. The good news is that many sellers can also greatly benefit from these strategies. Knowing these benefits for sellers will significantly increase your conversion rate when presenting offers.
The first benefit is that you can generally pay a much higher price when buying on terms than if you were paying cash for a house. Most of the time, creative financing strategies are used to acquire rental properties. Since you can limit your money out of pocket with these tactics, you can still keep your cash-on-cash return high even when paying full price.
On top of giving a higher purchase price, most creative finance deals pay the seller residual income every month. When you add these monthly payments to the purchase price, the total amount they receive can be massive.
In many situations, a creative finance deal is the only way a homeowner can sell their house and not ruin their credit. Over the last couple of years, most home values have appreciated significantly. However, in economic downturns when homes go down in value, many homeowners end up with low or negative equity. To prevent them from selling at a loss or going into foreclosure, you can structure a deal where you take over their payments and loan balance.
How to Find Creative Finance Deals
You might be thinking, “All of this sounds great, but who would agree to one of these deals?” The truth is that it doesn’t work for everyone. However, there are many homeowners out there that will genuinely thank you for structuring a deal like this with them.
The tough part is that most of these homeowners are not waving their hands and saying, “Come take over my mortgage!” Most people don’t even know that is possible anyway.
As a real estate investor, it's your job to find these homeowners and offer them the solutions we’ve discussed here. The best way to find them is by using a source of nationwide property data and filtering by criteria that these types of motivated sellers are likely to fit. Here are some ideas for criteria to start with:
- Vacant properties
- Homes with low equity - Most strategies require homes with high equity, but creative financing works with little to no equity
- Houses in pre-foreclosure
- Absentee owners
- Expired listings
Get Out There and Start Making Creative Deals!
Adding these creative financing strategies to your arsenal will prepare you to do more deals and make even higher returns. Even though many sellers will turn down these deals, you will be able to help many homeowners that an investor who only pays cash wouldn’t be able to.
It is crucial to be patient and well-rounded as an investor. Instead of only looking for creative finance deals, sometimes it makes sense to make multiple offers to sellers. That way, instead of their options being yes or no, they can choose whether they want a cash or terms deal. This will significantly improve your conversion rate.
Good luck on your investing journey!