In real estate, creative financing is non-traditional or uncommon means of buying land or property.
For real estate students, it is important to understand how creative financing works. I’ve been teaching and preparing real estate students for many years. As a real estate professional, my job is to define and explain real estate terms easily. Most real estate students confuse creative financing with owner financing and consider them the same. However, both terms differ, and this is what I’m going to explain in this post.
Read on if you want to know more about creative financing and the door of opportunities it opens for real estate activities.
What Is Creative Financing?
Creative financing is a financing process that doesn’t involve conventional lending practices. In this type of financing, an individual or business uses specialized tactics to obtain funding for real estate purchases.
The financing technique doesn’t rely on traditional lenders like banks or credit unions to fund their real estate activities. It is an unconventional method where real estate investors buy or sell properties using less money. The main idea of this type of financing is that the investor can buy properties using a minimum amount of money or even none of their own money.
With traditional lending practices, the investor is limited to the financing options provided by traditional lenders such as banks or credit unions. The traditional financing methods involve four main components: the buyer, the seller, the lender (bank or credit union), and the closing agent. Whereas with creative financing, the options are not limited, and the investor can use various unique strategies to fund their real estate projects.
There are many creative ways in which the investor can access the funds for various activities for buying and selling properties. There are various methods of creative financing that investors can use.
Types of Creative Financing
With traditional financing methods, the investor is limited to the options available for funding their projects. In today’s ever-changing real estate market, investors must access various financing options before finalizing a deal.
Though approaching a traditional lender is straightforward, the practice doesn’t guarantee the best rates and terms. In most cases, getting the best deal requires the participants to become more creative and think of other ways to fund buying and selling properties. The following are the different types of creative financing methods available:
Owner Financing
Owner financing is creative financing in which the property owner agrees to provide partial or complete funds to purchase the property. The owner or seller acts as the lender and holds the note. The terms of this type of financial agreement can be structured according to the owner’s and buyer’s preferences.
The borrower makes regular monthly payments to the owner to pay off the loan for the pre-agreed term. These mortgages are mostly short-term, in which the borrower has to pay a lump sum at the end of the term.
Owner financing works when the owner owns the property free and clear and has no existing mortgage or lien. For owners or sellers, this is a good opportunity for those who have liquid money to provide a mortgage to a home buyer and then expect long-term recurring payments.
Pros
One of the main advantages of owner financing is that the borrower and the lender can negotiate the terms and conditions on the note according to their preference. Besides that, it is a good opportunity for the buyer who doesn’t want to go through the strict qualification process of traditional mortgages. The transactions in this type of financing are faster and less costly too.
Cons
One of the disadvantages of this type of mortgage is that the owner must pay off the existing mortgage on their property to sell it through an owner-financing arrangement. Also, owner financing is a bit difficult to find. For buyers, this financing arrangement cannot be beneficial if the buyer wants to consolidate debt.
Self-Directed IRA
Self-Directed IRA is a type of creative financing in which the lender is the self-directed IRA (Individual Retirement Account). This financing option allows individuals to use their retirement savings for making real estate investments.
Most people use their IRA funds to invest in bonds and stocks, and some might consider investing in real estate. In this type of financing, the funds must flow through an IRA. The borrower can use their or someone else’s funds to purchase a property. A custodian is involved in a self-directed IRA’s financing process and ensures that the process adheres to the International Revenue Service tax guidelines.
Pros
The financing technique offers more control to the investors along with several tax benefits. Investors can use their retirement savings and enjoy the benefits of property value appreciation and real estate investments.
Cons
There are a few drawbacks to this type of financing. For example, the borrower must have an IRA to use this type of financing; otherwise, they’ll have to set up one. An IRA involves fees, so the investor must also consider that they can pay the fees with their cash flow.
Hard Money Loan
For real estate investors, a hard money loan is the most common financing option, especially for flippers. This type of financing is mostly short-term, and its approval is less stringent than traditional mortgages. The borrower’s income doesn’t need to be verified to provide hard money. However, the interest rates are higher, and since the loans are not amortized, the monthly payments are lower.
Hard money loans, also known as private money, can be extended to investors who can’t qualify for a conventional mortgage because of low credit scores or not meeting lending standards. Overall, these loans are more expensive than traditional mortgages.
Pros
Hard money loans are approved quickly, and the funds are disbursed within a few days. Besides, hard money lenders understand real estate investments better than traditional lenders. With hard money loans, the borrowers are most likely to get a good deal as they can negotiate with the lender.
Cons
Hard money loans have higher interest rates which can make the loans more costly. Besides that, the loans are short-term, making it difficult for the borrower to repay the loan amount quickly.
Lease Option
A lease option allows the investors to work with the homeowners to purchase the property once the lease agreement is over. It is a lease agreement in which the tenant rents the property for a particular period, along with an option to purchase the property at the end of the term. The term is usually three or fewer years and allows the investors to build equity through monthly payments in the form of rent.
Pros
A lease option is suitable for a tenant who can’t qualify for a mortgage to purchase a property. This also allows the buyer to take some time to improve their credit.
Besides that, this is a big advantage for the tenant or buyer because the property price is agreed upon before signing the agreement. In this case, if the property value increases, they can avoid the additional costs due to the increase in the property’s purchase price after a few years.
Cons
A lease option is difficult to obtain as finding the right homeowner or landlord is not easy. Plus, lease options for a short period; usually expire after one to two years.
Subject To Transactions
Subject To transaction is a creative financing type that allows the buyer to take over the homeowner’s current mortgage and monthly payments. In this type of financing strategy, the title of the property goes to the investor, but the loan remains in the name of the seller.
This unique strategy helps the borrower purchase a real estate property with no down payment, no credit, and no money out of pocket. Thus, a subject-to-transaction involves only the buyer taking responsibility for the owner’s mortgage balance and payment.
In this transaction, the lender isn’t involved, and the buyer takes the risk without contacting the lender. The buyer simply purchases the property from the owner and starts making payments on the due mortgage. Sometimes, the lender might ask that the entire mortgage balance be paid immediately.
Pros
Subject To makes it easier to buy a property, especially for those investors who don’t have enough credit to finance a home. Besides that, the financing technique allows the buyer to gain equity quickly in the property since a portion of the mortgage has already been paid.
Since there are no loan officers or banks involved in the transaction, the financing method is cost-effective. For sellers, Subject To financing allows a quick sale of the property and avoids closing costs.
Cons
There are some risks to Subject To, such as the risk of loan acceleration. In some loan agreements, the lender has the right to accelerate the loan and demand a payoff earlier than the buyer wants. Another disadvantage is that a property purchased through Subject To financing is more difficult to insure.
Creative Financing Example
Suppose a homeowner wishes to sell their property for $375,000. The homeowner has a tenant who wishes to buy a home and is currently saving money for this purpose. Since the housing market is down, it would take several months for the homeowner to find a suitable home buyer.
On the other hand, the tenant is still gathering enough money to purchase a property. Moreover, to sell the property, the homeowner will have to remove the tenant, ending their monthly income.
In this case, the homeowner decides to offer a lease option to the tenant. In a typical lease option, the tenant has to pay 5% of the house price, which is $18,750 as an option fee. There would be an additional premium to their monthly rental amount. In exchange, the homeowner gives the option to the tenant to buy the house in two years at the current price. This would be a win-win situation for both parties.
Frequently Asked Questions
Who Should Consider Creative Financing?
Creative financing should be a good option for those businesses that want to acquire different properties with varying depreciation schedules. Besides that, fast-growing companies with multiple leases for an existing property should consider creative financing. Creative financing is also a good option for businesses with little equity or credit.
How to Make a Down Payment with Creative Financing?
If a homebuyer cannot make a down payment, they can consider a type of creative financing known as the lease option. This means the homebuyer can work with a landlord to purchase a property once the lease option has ended. The homebuyer will build equity monthly through rental payments, and the landlord generates interest on the income this way.
What to Know for the Real Estate Exam
Creative financing uses a combination of traditional tools, such as leases and other methods, to acquire a property. Investors can choose different types of creative financing options to buy or sell properties. These creative financing techniques can help investors get better deals and higher returns.
These innovative financing strategies allow individuals and investors to use alternative options to buy and sell properties. Though this type of financing carries some risks, careful consideration can help investors profit from this non-traditional financing arrangement.
I hope that you’ve now understood the concept of creative financing because of the easy-to-understand examples. If you’re willing to learn more such definitions, go through my comprehensive list of Real Estate Vocabulary.
