House Hacking In Milwaukee – Part 3: Loan Types, Down Payments And Financing Basics

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Today, I will be covering everything that has to do with funding and financing real estate transactions.

One of the key advantages that you have with house hacking is that you can do it with a very low down payment.

As an investor, you are generally required to put down between 20 and 25%, depending on the property type, because you are not going to live there. If you are going to owner occupy the property, if it’s going to be your primary residence, the bank is going to offer you a variety of different loan products that all have low down payment options, so that makes it a lot easier to get started.

Another key perk of house hacking is that it is repeatable. So after one year you can go and buy another primary residence for yourself. You are going to have to move in there, but you can do it again with a very low down payment.

Next, let’s talk about interest rates because that is going to be driving your cost of financing. Because you’re owner occupying and you’re low risk, your lender is going to give you very attractive interest rates compared to a non-owner occupied investment property. Rates are very low right now, under 3%. I think I’ve seen as little as 2.75% on a 30 year fixed rate. When you go back to the early 1980s, you can see that mortgage rates have peaked out at over 18%. That’s like credit card debt. I cannot even imagine to sign a mortgage for over 18%.

Now, the reason this is important is because a low interest rate lets you buy a property with a lower monthly payment, or you can buy a more expensive property with the same monthly payment. If you want to stay on top of interest rates and other developments in the Milwaukee market, take a look at my monthly market updates.

Before you can go out and buy a house with a mortgage, you want to save up for a down payment. There’s a lot of misconceptions around down payments. I’m always shocked how many people are under the impression that they need to save up 20% in down payment.

That is not the case.

20% down payment is the gold standard, because as soon as you exceed 20% equity in a property, you are no longer required to pay PMI, and we’re going to talk about PMI. For now, just know that on average American first-time home buyers are usually putting down between 6% or 7%. So if you’re in the market for a duplex in Milwaukee and you’ve saved up say $15000 – $20,000, you’re in good shape, and there’re many options for you.

So what is PMI?

PMI stands for private mortgage insurance and it is an insurance policy that the lender takes out on your behalf to ensure the loan against the risk of you defaulting.

It covers the gap between your actual down payment and 20% equity. In the case of you defaulting, you’re not making your loan payments anymore and the lender has to file for foreclosure. The PMI and your down payment help to mitigate the losses for the lender. So the higher your down payment and the better your credit score, the lower your PMI insurance premium will be. Just to give you an idea, PMI on a Milwaukee duplex, may be somewhere between $150 and $200 per month.

The next big source of confusion are credit scores. There’s a lot of people out there that are under the impression that they need to have a perfect 850 credit score in order to apply for a mortgage, and that is not the case. If your credit is around 700, you are generally in good shape. There are a lot of loan products that will go significantly below a 700 credit score and having a higher credit score does help you with the better rate, but the gains are relatively small. So we’re talking maybe an eighth of a percent or a quarter of a percent that you can get if you have a higher credit score. So if you do the math on your monthly payment, it’s not all that big of a difference.

The other misconception is that you need to pay off all your loans, like your student loans, and get your credit score in better shape.

That is not the case.

Paying off debt is only necessary if your DTI is too high. We’re going to talk about that next.

So what is DTI you’re asking? DTI stands for debt to income ratio. It is simply a metric that lenders are using to determine your ability to take on additional debt. Generally, DTIs are acceptable in the high thirties, low 40% range, 42, 43%. Again, it depends on the loan product, which DTI is acceptable for that particular loan. Some have higher limits, some have lower limits.

How do you calculate your DTI? I’ll illustrate on a simple example.

Let’s say you want to take out a mortgage that will cost $1,500 monthly. Let’s say you have a car payment for $100 and you have some other debts for another $400. So your total monthly obligation, including your $1,500 house payment, is going to be $2,000. Let’s say your gross monthly income is $6,000. So you have $2,000 in debt service, $6,000 in income that gives you a DTI of 33%. So your DTI, your debt to income ratio is ultimately what determines how big of a mortgage you will qualify for. If your DTI is a little high, it’s not the end of the world. Your loan officer may suggest to pay off a credit card or finish the last three car payments that you have left in order to get your monthly debt service down and to get your DTI within guidelines for a certain loan product.

There is one more thing that you need to pay attention to, and that is closing costs.

So closing costs are a bunch of fees that you are going to get charged by your lender at the closing on top of the down payment. There’s a whole bunch of fees in there. There’s appraisal fees, there is document fees, there’s loan origination fees. For a typical Milwaukee duplex, it may total up to about $3000 to $4,000. It depends a little bit on the lender, but pay attention to this because it oftentimes gets overlooked and lenders that have very, very attractive interest rates sometimes have higher closing costs, so it is definitely something that you want to consider.

On top of the closing costs, you will also be responsible for the cost of the home inspection, and that, depending on how many units that property has is typically somewhere between $500 and $750.

So what about property taxes and insurance? Do you have to save up for that as well? There’s some good news here. Your lender is going to collect from you a monthly mortgage payment, and that breaks down into what we call PITI, that is principal and interest for the loan and taxes and insurance – PITI.

The lender takes the taxes and insurance payment that you make on a monthly basis and they put it in an escrow account, which is basically a savings account. When the time comes at the end of the year, where you have to pay property taxes, they’re going to take care of the property taxes on your behalf. The money is already saved up for you.

Next we’re going to cover the different loan products. The first loan I would like to talk about are FHA loans.

FHA loans have been around forever and they have a well earned reputation with first-time home buyers. The typical down payment on an FHA loan is 3.5% and they are very tolerant on the borrower’s side. You can get an FHA loan with a low credit score, and you can also get it with a quite high debt to income ratio.

Between all that flexibility and the low down payment, what are the negatives of an FHA loan?

Well, first off, you’re stuck with PMI basically for the life of the loan, so you will always have to make that additional payment every month. And then FHA loans also require an additional inspection that is done by the FHA appraiser, and if the property is a little bit older, the FHA appraiser might call for certain repairs, and that is usually just a week before closing, so a lot of sellers are apprehensive with an FHA loan because they don’t want to go through that second inspection.

Next up, VA loans. If you’re a U.S. veteran and you are eligible for VA benefits, you definitely want to check out a VA loan. They are quite tolerant on the credit score side, but the biggest benefit that most people will list first is that you can get a VA loan with zero money down. There is no PMI, so that is a major difference between the VA and the FHA loan, that you don’t have to pay PMI. But there is a 2.15% funding fee, which you have to pay at the beginning of the loan.

What is the downside of the VA loan? Just like the FHA loan, the VA wants to make sure that you’re buying a property that is in good shape, so with the VA appraisal, they’re also going to do an additional VA inspection after you’ve already done your home inspection. If they find on an older home that there are certain things that need to be repaired, they may stipulate that on the seller before they are closing on the loan.

Next on my list is a conventional mortgage, usually amortized over 30 years with a fixed interest for 30 years. It is considered the gold standard by many. Compared to a VA loan or an FHA loan, the requirements for the buyer are a little bit higher, so you need to have a better credit score and you need to have a better debt to income ratio. That also makes you look as stronger buyer in the eyes of a seller.

As far as PMI, it depends on your down payment. If you put down 20%, then you certainly don’t have to pay PMI. And as you’re going down in your down payment, all the way to 5%, some of them do 3%, you will have to pay PMI, but only until you can show that you have 20% equity and then you can drop the PMI from that point on.

Another big difference between a conventional mortgage or an FHA or VA mortgage, is that you’re not going to have an inspection by the lender. You still have your primary home inspection by a home inspector of your choice, but you do not have a secondary home inspection conducted by the lender.

With that, we are finally arriving at the world of adjustable rate mortgages or ARMs for short. So as the name is suggesting, on these loans, the interest rate can start adjusting after an initial period. For example, on a five-year ARM you have an amortization, over typically 30 years, so that’s the time the loan is being paid off, but after five years, the locked in interest rate starts to float. It can go up or it can go down depending on what the market is doing. ARMS are usually held as a portfolio loan by a local lender, which makes them quite flexible.

For example, we have a local bank here in Milwaukee, which will do a 5% down payment ARM with no PMI. From a cashflow point of view, not having to pay PMI and only having to come up with 5% down payment is very interesting for a house hacker, especially if you’re planning to refinance once you hit 20% equity.

These were the most popular mortgage products, but there are more which I am going to summarize in a category called others. For example, you’re going to have a USDA loan with 0% down for rural properties. You have WHEDA loans here in Wisconsin, which are state sponsored very low down payment programs. You have 203(b) loans for renovations. You have medical professional loans, also called doctor loans. Not every lender is going to be able to offer you every loan. It really comes down to sitting with a real estate agent who knows the market and who can understand your situation, what you are trying to accomplish, and then point you to a lender that is going to be a good fit for what you’re trying to do.

I have one last tip for you.

If you’re saving up for your down payment and you don’t have quite enough yet, there is the option to accept a gift from a family member. You will have to provide a gift letter, but most loan products will allow for a gift from a family member towards your down payment. So if you just need a little bit more for your down payment and your parents, for example, are willing to help you out, that’s absolutely an option you could consider.

Thank you very much. I’ll see you next time!

-Marcus