Property investors can use several types of investment property loans for financing their property acquisitions.
In terms of rate structure, there are two major categories of investment property loans (mortgages), those with a fixed interest rate over the term of the loan (fixed-rate mortgages) and those with variable rate over the term of the loan (variable-rate or adjustable-rate mortgages, abbreviated respectively as VRMs and ARMs).
The different dimensions of the various types of investment property loans need to be carefully evaluated by the investor in order to choose the particular type and structure that is most likely to maximize the return of the investment given the expected cash flow profile of the property over the holding period.
In terms of amortization schedule, investors can use self-liquidating loans, balloon mortgages or interest-only property loans. Self-liquidating investment property loans fully amortize a loan with the principal fully paid over the term of the loan, while balloon mortgages amortize the loan only partially, thus leaving a significant outstanding balance at the maturity of the loan, which is repaid as a balloon payment (hence the term balloon mortgage). In the case of interest-only mortgages, the investor pays only interest over the term of the loan (which is usually short) with the full loan amount due upon maturity of the loan.
In terms of the collateral used, property investors can use blanket mortgages, which use more than one property as collateral, as opposed to conventional mortgages where only the property acquired is the collateral. Blanket mortgages are the best means for achieving 100% financing of an investment property acquisition using borrowed funds. The reason for this is that blanket mortgages allow the borrower to achieve the best loan terms by lowering the loan to value (LTV) ratio and, therefore, the risk of the loan. Blanket mortgages help reduce significantly the LTV because the loan is compared against the combined value of all properties used as collateral for the loan. Blanket mortgages can help the investor maximize the return of an investment, since when there is positive leverage, the higher the percentage of the purchase price that is financed through borrowing the higher the rate of return on the investment.
Wraparound mortgages, which are often used when an existing first mortgage is combined with seller financing for a significant part of the build-up equity in the property, can also be used by investors for financing their property acquisitions. The new wraparound mortgage offers a higher interest rate than the existing mortgage, thus making it attractive to the seller.
Bridging loans may also be used for very short-term financing for solving temporary cash shortfall when buying a property. Two typical examples of the use of bridging loans is the purchase of one investment property while in the process of selling another one, and when trying to acquire with no money down properties discounted significantly below market value. Bridging loans are more risky for the lender and as such they involve higher interest rates than conventional loans.
Bridging loans, under certain circumstances, can complement conventional investment property loans (mortgages) as a means of achieving 100% financing of property acquisitions. In fact, in the pre-crisis environment, bridging loans helped many investors achieve 100% financing of acquisitions of properties that were sold at prices significantly below market value. When buying such properties, the investor still needs to put some equity, as the maximum LTV a bank allows for investment property loans is typically calculated using the acquisition price and not the market value of the property. In such a case, the bridging loan can provide the investor with the cash for the equity needed to purchase the property.
Before the financial crisis there were lending institutions allowing same-day remortgages on the basis of market value, which allowed the buyer to actually get a refinancing loan that would cover the full purchase price (which was discounted significantly from market value), thus providing the cash for repaying the bridging loan. During the crisis same-day remortgages were cancelled. Now, most financial institutions will not provide remortages or refinancing no sooner than 12 months from acquisition.
In order to choose the type of loan in terms of amortization structure (self-liquidating, balloon or interest-only) that will maximize the internal rate of return of a property investment, the investor needs to evaluate the benefits of reducing the mortgage payments in the early years of the holding period by repaying as little principal as possible, against the increased overall interest charges since these will be calculated on a higher remaining balance. The cash flow implications of the different mortgage schedules need to be evaluated by incorporating the respective annual payments and the payment of the remaining balance at the end of the holding period in the particular discounted cash flow profile of the property under consideration