It’s no secret that a strong credit score makes it easier to purchase a home. Buying your own home allows you to stop renting, build wealth, and enjoy the stability and control that comes with your own “forever” home.
However, what is less often talked about is how strong credit can help you become a successful real estate investor. There are many real estate investing strategies, each of which can be quite profitable. What they all have in common is that they each generally require a strong credit score. If you have good credit (or are working towards it), you’ll be able to use a range of strategies to build wealth through real estate.
1. Flipping Houses Through Use of Hard Money Loans
Flipping houses is one of the most popular real estate investing strategies. In a nutshell, flipping involves purchasing a home, and selling it for more than you bought it for, a relatively short time later. In most cases, “flippers”, as they’re popularly known, purchase a home which is priced under market, often because it needs upgrades and repairs.
The flipper then works with contractors and other construction professionals, to upgrade the home, and get it ready for sale to a new buyer. Most flippers aim to sell the home within 2 to 5 months after purchase, though it is hardly uncommon for the process to take longer.
Flips can be purchased using a variety of strategies. Sometimes, flippers send mail to homeowners, offering to buy their properties. In other instances, they knock on doors, run ads on Facebook, or work through local realtors. Whatever strategies flippers use, they work to find houses which they can upgrade and sell fairly quickly.
As with all real estate strategies, there’s one very important question: Money. Assuming you’re able to find deals, how do you go about funding them, so that you can purchase, rehab and flip houses?
One approach is to put up your own money, and use that to purchase and fix houses. Of course, unless you’ve got a nice chunk of change in the bank, this can be quite difficult to pull off.
You could try obtaining a standard mortgage loan, as offered by banks like Chase, Wells Fargo and many others. However, there are a few problems with this.
For one, properties which are good candidates for a flip often need serious work. It is quite common for a potential flip property to need a new roof, upgraded electrical systems, and perhaps have city code violations (like an illegal garage). In most cases, traditional banks won’t lend money on properties with so many problems.
Also, flipping is a competitive business. When a home that’s ripe for a flip hits the market, especially in a hot neighborhood, you’ll usually see multiple flippers (or other investors) making offers.
Even if you’re finding deals off market (let’s say through mailing homeowners), those sellers have usually recieved mailers and other offers from other investors. For you to stand out, and effectively compete for a deal, you probably need to be able to close quickly and simply.
How Hard Money Loans Can Help You Get Ahead
This is where hard money lenders come in. A hard money lender offers loans with a higher interest rate than traditional mortgages, but fewer conditions, and a shorter closing period.
Remember that house we mentioned, with roof issues, electrical problems, and city code violations? Unlike traditional mortgage lenders, hard money lenders will fund these sorts of deals, as long as you have a realistic plan in place to correct these issues, and ultimately sell the property.
Having a track record of prior success certainly helps. If you haven’t flipped a home before, you might try partnering with someone who has flipped several houses before, and have them guide you through the process. Or, a hard money lender might offer you a loan for a higher rate, until you’ve proven yourself to be reliable. Either way, hard money is often a better option for closing properties which have significant issues.
Hard money lenders also allow for a much shorter closing period on loans. When you purchase a home, you’re required to verify that title on the home is correct (that is, no one else has a claim of ownership on the house), that there are no environmental issues, and meet other conditions. Traditional bank lenders often take a while to meet all of these conditions.
For this reason, most house escrows tend to last for a period of 30 days, sometimes as long as 60 days. However, hard money lenders are often willing to allow an escrow of as little as 7 days. They quickly move to verify title, research other relevant issues, and fund the deal.
Sellers obviously prefer a shorter closing period, as this reduces uncertainty, and allows them to move faster. If you’re competing for a property with multiple offers (as mentioned earlier) this gives you a clear advantage, compared to other buyers.
What does credit have to do with all of this? Like traditional mortgage lenders, hard money lenders have credit score requirements. While some hard money lenders will make a deal with a FICO score as low as 620, most require a FICO score of at least 660 or higher.
Most hard money loans are for a period of just 1 to 2 years, after which you either sell the property or refinance (we’ll talk more about that later). While the interest rates on hard money loans can vary considerably, most carry interest rates of as little as 6.5%, to as much as 12% (or higher).
With a 650 FICO score, you’ll pay a higher interest rate, as compared to having a FICO of 720 or higher. How much higher?
A casual survey of hard money lenders which we conducted recently, found that with a 650 FICO score, you’ll pay between 8.75% to 11.5% interest, for a fix and flip loan. With a 720 FICO, you pay as little as 6.75 %, and as much as 9%.
All other things equal, if we have two flippers with a 720 FICO score, the one with a strong track record is likely to pay closer to 6.75% while someone who is new to flips will pay closer to 9%. However, it’s also clear that being an experienced flipper with relatively weak credit (a 650 FICO score), is worse off than someone who has strong credit (i.e. a 720), and little flipping experience.
Thus, credit matters a lot. Every dollar you save on interest payments is an extra dollar of profit, which you can put towards your next flip. Clearly, strong credit helps you to grow your home flipping business more quickly.
2. The BRRR Strategy (Buy, Rehab, Rent, Refinance, Repeat)
Flipping also has it’s disadvantages. First, let’s think about taxes.
In most cases, flipping a home involves paying income tax of between 10% to 37%, i.e. standard income tax rates. Most real estate investments (including the BRRR strategy, which we’re reviewing here), only involve paying capital gains (taxed at a much lower rate of 10% to 20%).
Also, flips leave you quite vulnerable to market conditions. What if the housing market starts slowing down, while you’re in the middle of completing a very involved flip? You could lose money on the deal. Just ask anyone who tried to flip from 2007 to 2009.
Flips might also cause you to leave money on the table. Let’s assume you purchase a house that needs repairs, in a popular neighborhood, where home values are consistently improving. You’ll make a nice, quick profit when you sell the home, let’s say 4 or 6 months after you purchased it.
What might the value of the home be in 3 years, or 5 years, or 10 years? While real estate markets certainly fluctuate, in the right locations, a property can appreciate considerably over the long run. If you held on to it, imagine how much more the property would be worth, and what sort of return you might see.
This is where the BRRRR strategy comes in. With BRRRR (which stands for buy, rehab, rent, refinance repeat), your goal is to purchase an undervalued property which needs some work, fix it up, and rent out the property.
You then refinance your existing mortgage (pulling out most of your down payment and rehab costs), and repeat the strategy with another property. This allows you to grow your portfolio. Let’s take a closer look at how this works.
Selecting A Property, & Completing Rehab
Assume you find a property which needs new flooring, paint, bathroom fixtures, kitchen appliances, and refinishing of the kitchen cabinets. This is a relatively simple rehab job.
Let’s also suppose you’re able to purchase this property for $200,000. However, once the house is upgraded, it will be worth $250,000 (a 25% increase in value). Adding value through improvement of a property is known as forced appreciation, since you’re not depending on market conditions to improve the value of your property. You’re doing it yourself, by making the property more desirable.
Suppose that upgrading the property costs you $13,000. Let’s also assume that this house will rent for $1400 per month, once it is fully upgraded.
Understanding Your Finances
Say you’re able to obtain a 30 year fixed rate mortgage, at an interest rate of 4.3%. As with most investment properties, you’re required to offer a 25% down payment – for a $200,000 house, that is $50,000. That means you’re taking on a mortgage of $150,000.
With a term of 30 years, you’re paying $742 per month on the mortgage (principal and interest). Counting property taxes and insurance (let’s assume that costs $270 per month), this adds up to $1002 per month. Let’s assume that other standard expenses, such as routine maintenance and small repairs, adds up to $50 per month. This means your total monthly expenses are $1052 per month.
You’re also spending $13,000 to rehab the house – let’s assume you pay cash for that, rather than taking out a construction loan. Let’s also mark off $5,000 in closing costs.
Adding this to your $50,000 down payment, the total amount you’re spending out of pocket is $68,000 (and remember, your monthly costs are $1052 per month).
Realistically, it will take 5 weeks to complete these renovations. After that, you can rent out the house for $1400 per month. Ideally, you find a quality tenant, who begins their lease 8 weeks after you purchased the home (remember, the tenant is paying $1400 per month in rent). We’ve now completed the buy, rehabilitate, and rent stages of the BRRR process.
It is now time for the refinance. Remember, after the improvements you made, this property is now worth $250,000. You can now contact a second bank, and tell them you’d like to refinance the mortgage. The second bank will pay off your original mortgage, and issue a new mortgage.
When you refinance a mortgage, the lender looks at the current value of the home, and will issue a new mortgage, based on that amount. Recall that with investment mortgages, you’re allowed to borrow 75% of the value of the home (hence why you paid a 25% down payment, when you first bought the home).
This means the lender will offer you a mortgage for $187,500. However, your original mortgage was for just $150,000. For the sake of simplicity, let’s set aside whatever payments you’ve already made on the mortgage in the past 6 months, and assume you still owe $150,000.
This means you’re paying off the mortgage, and getting back $37,500 in cash. Remember, your down payment plus rehab costs were $63,000. If we subtract $37,500 from $63,000, we get back $25,500.
That is all you have left in the deal (about 40% of the cash you put in). The refinance you just performed is known as a cash out refinance, because you’re paying off your old mortgage, and taking out cash.
You have a new 30 year mortgage, in the amount of $187,500. Cash out refinances typically come with somewhat higher interest rates than traditional purchase mortgages, because the bank is returning cash to you, and sees a bit more risk in that. Let’s assume you’re offered a cash out refinance with a 4.7% interest rate (as compared to 4.3% for the purchase mortgage).
Where You Are Now
Your mortgage payment will be $972. When you add $270 in property taxes, insurance and other expenses, your total monthly expenses are $1242. Remember, you’re collecting $1400 in month per rent, so you’re still generating $158 in income ($1896 per year).
You have built $37,000 in equity on the property (with the potential for more appreciation in the future). That is a bit more than a 17% increase than the purchase price plus rehab costs of the home. $25,500 is left in the property, and you’re earning a profit each month.
It’s now time for the repeat stage. You have $37,500 to invest in another property, and further grow your real estate portfolio. Start looking for another property, and once again complete the steps detailed earlier.
What does your credit have to do with all of this? Remember, the interest rate you pay is in large part determined by your credit score. The 4.3% purchase loan rate, and 4.7% cash out refinance rate, both assume a 720+ FICO mortgage score.
If your FICO score falls below 620 (in some cases 640), you probably won’t be able to qualify for a loan at all. Even with a middle FICO of around 680, the purchase interest rate on the purchase mortgage is around 4.6%, while the refinance mortgage rate will hit 5.0%. This means that when you refinance the property, your monthly mortgage payment increases from $972.45 to $1006.54.
That’s $34 a month or $408 per year. That is $12,240 over the 30 year life of the loan! Imagine what that money could have done if you’d reinvested back into your real estate ventures. BRRRR is a powerful strategy, but it’s even more effective when you enjoy a strong FICO score.
The Final Word
Real estate investing is the largest source of self made wealth in the United States. Clearly, you can use real estate investing to generate additional income, and build wealth. Succesful requires many attributes, including patience, persistence, and a willingness to work through setbacks. However, if you can master these attributes, you can succeed at a level never dreamed of before.
Much of success in real estate comes down to financing the right properties in a smart way. If you can purchase a property at a competitive price, and improve it through rehabilitation, there is great potential to add value, and thus build wealth.
The thing is, succesful real estate investing requires strong credit. Otherwise, you either won’t qualify for loans, or you’re leaving money on the table (by overpaying on your mortgage). Don’t let that happen. Get your credit in order before investing in real estate. You’ll be glad you did.
