Financially Prepare For Your First Investment Property
Cutting Debt is More Important than Earning More
I bought my first property in 2009. It really was an accident that I even got into a multi-family property, but that's a story for another time. I look back though and I realize how lucky I was to just stumble onto the easiest possible way to get started in real estate.
Getting a second property for me was more like everyone else trying to get their first. I had already done it, it couldn't really be that easy, could it?
I spent more than two years preparing myself financially for my next step in real estate. I built up experience as a landlord, showed profit on my property, and saved a lot of cash.
Finally in early 2012 I made my next purchase and the rest is history.
The Goal for Real Estate Investing is in Millions
I've heard that the first million is the hardest million. It's true I think. I don't have a million dollars in cash but I'm working on it. It's pretty hard to get there. It was also hard to buy my first million dollars worth of real estate.
I want to keep moving myself up the pyramid of millions. Getting to a million in assets is pretty easy actually. If you have a million worth of investment real estate with mortgages, you probably have a net worth around 200-250k. The goal is then to get to a million net worth, which may be around $4 million total assets. So on and so forth.
OK, great advice Eric. You are talking millions and I don't even have ONE. Well, I think this applies to getting investment property too. Your first property is the hardest. After that, it's much easier to get 2, then 5 then 10. Once you know the system and how it works, it's easy to keep going and keep getting more investments.
Financially Preparing For Your First Property
I talk about millions because even such a loft goal of earning a million is broken down into smaller and smaller pieces with the simple asset, in this case investment property, as the building block.
Once you learn how to place one block down, you just need to keep placing more in a line until you have a foundation. Keep putting those blocks down one a time and you have built yourself to where you never thought you could be.
Alright, let's take a look at how we build our total assets.
You can see that your total assets are made up of your equity and your mortgage - essentially the entire market value of your property. To get this property though, there are three variables we need to consider: your debt, income, and cash needed to finance. By manipulating these inputs, you can influence the output - your property.
Everyone is always talking about their credit score so where does my FICO score come into this?
A low credit score will disqualify you from purchasing a property. 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 you debts, it is just another factor to consider when manipulating your debts.
Related: Should I Invest In Real Estate?
Manipulate Your Income to Qualify for Real Estate Loans
Just to clear the air, Manipulate means to handle or control in a skill fashion. When I say manipulate your income to buy investments, I do not mean you should fake any numbers. By understanding how you qualify for loans you can target those areas for change.
Banks and mortgage brokers look back two years on your tax returns. Depending how you earn your money will depend on how much you can influence this variable and you need to start planning it years in advance. Remember, they look at your tax returns, so even if you have done something for 2 years, it may only reflect on one full tax return and partially on another tax return.
Let's say you have some type of income beginning in March 2014. It's now March 2016 so I've done the job for 2 full years. My 2015 returns will show a full year of income but the 2014 returns will only show a partial year of the income.
The bank will likely AVERAGE the two together, thus dropping your income down. It's not fair, but just the way they generally operate.
Employee With a Full Time Job:
There are only a few ways to manipulate this number. One way is to get a second job, and the other way is to work overtime. Your mortgage broker will most likely want to see a very long history of either of these, basically 2 years tax returns.
You could also get a side-hustle. Money expert and blogger Stefanie O'Connell wrote an interesting article on earning side money. She lists a ton of ways to earn some extra money. If you start earning some extra cash that is more to put toward getting your finances right so you can start investing sooner!
You may only earn $500 or $1000 but if you do it consistently for a couple years and then claim it on your taxes (as you are legally required to do) you will be able to use this income to really affect your debt-to-income ratio.
Related: Can I Start a Successful Business?
Self Employed or Business Owner:
You are more likely to hurt your ability to qualify than to help it. Working for yourself, you have learned how to deduct everything under the sun and you probably know how to avoid so much in taxes. Unfortunately, when you want to qualify to buy that investment property, the banks look at the income you claimed. Writing off every expense will save you taxes, but hurt you because you won't qualify for the loan on that new investment.
Make sure you write off your correct and accurate business expenses, not all the extra stuff you know you can get away with. Don't be afraid to pay some taxes. Paying taxes will allow you to grow, not constrict you. Remember, the goal is to invest and gain passive income, not self employed income.
Manipulating Your Debt
This one is probably the thing you have the most control over. Since the goal is to reduce our monthly debt payments in order to qualify for the most amount of loans, we need to pay off the debt with the highest monthly payments, right?
That is one way to do it, but I recommend paying off the most monthly payments with the least amount of money. What? How do you do that?
Well, look at the chart. There are a number of debts and their associated monthly payment. You'll also see a ratio on the side. You get this ratio by taking the debt and dividing it by the payment.
It can 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 $5,800 and reduce my monthly burden by $350 or should I pay $23,000 to reduce it by $372. Obviously pay that $5,800 first! You spend the least amount of money and reduce your debt by the most.
You actually spend $16.6 for every $1 in monthly reduction compared to $61.8 for every $1 in reduction on the other loan.
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.
Related: I earned over $18,000 in February.
Alright I promised I'd throw it in for you. 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.
Start the learning process by signing up for my email list and also checking out the entire website for more resources
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.
To Qualify for Loans on Your Investment Properties, Controlling Debt is More Important Than Earning More Income
What? Let me explain.
Let's saying 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
- 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.
There are two pieces to this: How much cash you have, and how much cash you need. Both are important, but first I'll talk for a second about savings. In real estate, it is unbelievably essential to have cash available at all times. Not only will you have sudden repairs that pop-up, but you will also find deals that suddenly present themselves. You need to become an expert at saving money, paying down debt, and NOT spending your savings on things you don't need.
There are some good tips to paying down debt on moneyrebound.com. It's ironic in some ways that I'm linking you to a page about being realistic and not cutting every single pleasurable activity in your life. The goal is to be a financially free investor - you need to be smart but to get there you don't need to be a Spartan.
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 25-30% + 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 it's 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 programs 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.
It's time for you to create a plan and start preparing for your investing future. If you'd like, email me and we can go over it together. You can also find some more resources and articles to read on the blog.
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