Whether you're a first-time homebuyer, a repeat buyer or an investor, you might have reasons that you don't want to — or can't — obtain a traditional mortgage. Maybe lenders don't see you as being in ideal financial health because of a foreclosure or bankruptcy in your credit history. Or maybe you have plenty of assets in the bank but can't show sufficient monthly cash flow to convince a lender that you will be able to make the monthly payments. Or perhaps you're a small-business owner with irregular income.
Whatever the reason, there are other ways to finance large purchases such as real estate. Here are a few of the most common options.
1. Borrowing from your whole-life policy
A whole life-insurance policy is one that accumulates cash value over time as you make your regular premium payments and earn dividends and interest. It's possible to borrow against this cash value and, when you borrow from your own whole life-insurance policy, there is no loan-qualification process. While such a strategy increases your borrowing potential, it reduces the face value of the policy if not paid back.
You may not have to answer a lot of questions to borrow this money, but there are some important questions you should ask your insurance company:
- What is the interest rate on this loan?
- Will it reduce my annual dividend?
- Will my withdrawal be taxable?
- How will this loan affect my policy's death benefit?
- Could my loan eventually cause my policy to lapse?
Additionally, you should ask yourself these questions:
- Will I really repay the loan?
- What is the opportunity cost of borrowing this money? What are the consequences of a reduced death benefit for my beneficiaries?
If you have a whole-life policy that you can borrow from, don't lose sight of why you originally took out the policy. Make sure that the expected benefits of owning property outweigh the drawbacks of borrowing from your plan.
2. Seller financing
With seller financing, you bypass the bank and make mortgage payments directly to the seller. The official agreement, which defines the principal amount, interest rate, repayment schedule, consequences of default and other terms, is usually drawn up in the form of a promissory note.
- They don't own the house free and clear. Mortgage agreements commonly require the mortgage to be paid in full when the property is sold through seller financing. Homeowners carrying mortgages need to receive the full proceeds from the sale immediately.
- They don't want to become lenders. Although seller financing can provide a better rate of return than the seller could get elsewhere, the additional risk and hassle may not be worth it. However, the seller doesn't have to become a lender; he could arrange to resell the promissory note immediately to an investor in what is known as a simultaneous closing.
When the option is available, seller financing has many potential benefits for buyers. The closing process can be faster, since strict bank requirements can be bypassed, and it's also less expensive, since there is no need to pay a mortgage origination fee or other lending fees that banks commonly charge. The terms of the mortgage and the criteria you need to meet to qualify are entirely up to you and the seller, which means there's plenty of flexibility and room to negotiate.
However, if you couldn't get a loan from the bank, why should an individual want to offer you financing? You'll need to be prepared to answer this question and prove that you're a worthy borrower. You should also expect to pay a higher interest rate to compensate the seller for the risk of lending to you.
3. Borrowing from a self-directed IRA
Self-directed IRAs are a tool for investing in a wide variety of nontraditional assets, one of which is mortgages. A self-directed IRA differs from the Roth or traditional IRA you may already be familiar with in that the investment options the Internal Revenue Service allows for a self-directed IRA are much broader and can to a large part be dictated by the policyholder.
You cannot purchase a home using your own self-directed IRA because of IRS rules that disallow what is called "self-dealing." But someone who is not your lineal relative or business partner can use self-directed IRA assets to lend you money to buy a house.
Daniels has also used this strategy as a borrower.
"I bought a trashed house two years ago for $100,000. I paid $50,000 and borrowed $50,000 from another investor's IRA. We agreed to split the profits. Five months later we sold the house for $182,000," she says.
David Coe, founder of Freedom Growth, a California retirement consulting firm, says: "While a bank may not be willing to loan due to poor credit or other factors with the property, private investors are stepping in to help with acquisition loans. Shorter in term, and higher in rate and down payment, these loans allow an individual to secure a property then proceed with repairing the property, their credit or both. Once repaired, they then refinance into a longer, lower-rate mortgage."
What's in it for the IRA owner? "IRA owners love these loans due to their short-term nature, the upfront fees and the high rate of return, usually in the 8 to 12% range," Coe says.
4. Rent to own/lease option
A rent-to-own arrangement, also called a lease option, lease to own or lease to buy, allows a homebuyer to rent a property for a specified initial term with an option to buy the property at the end of that term. Monthly rent payments are generally higher than market price; the surplus goes toward a future down payment. If the buyer opts not to purchase the property, the extra rent is forfeited.
Renting to own can be a good option for homeowners who aren't quite financially ready to buy but expect to be within the next three years. Perhaps they need time to amass savings or improve their credit score enough to qualify for a loan. Renting to own can also be attractive to individuals who are not sure if they will be moving in the next few years and want to keep their options open.
In rare circumstances, individuals may be able to turn a pure rental situation into a rent-to-own opportunity. That's what journalist Mary Pittman of Vero Beach, Fla., did with her house-rental agreement.
"The fact that it wasn't for sale really didn't matter to me," she said. "At the end of the lease, I told my landlord that I was looking to buy a place." She asked if he would consider selling her the property, and they were able to reach an agreement that included seller financing based on her track record of making timely rent payments for a year. The rent she had already paid didn't go toward the purchase price, as it would have in a typical rent-to-own arrangement, but the deal made sense for her.
In addition to the issues listed above, you should watch out for other potential problems with alternative financing.
Marcus McCue, a vice president at Texas-based Guardian Mortgage, says, "Unusual methods of financing a home can have some serious repercussions," including affecting retirement planning and incurring additional costs in the form of higher interest rates.
"Borrowers should at least check with a local title company or real-estate attorney when planning to finance a home with one of these alternative methods," he says. "There may be specific requirements of the state lending laws or title process that could delay or prevent the home purchase from funding." McCue further suggests consulting a financial adviser before proceeding.
But if you know you've been repeatedly turned down for a mortgage for a good reason, such as having a poor credit history or not really being able to afford a home, be honest with yourself about whether now is really the right time for you to buy.