If you are looking to buy a home, refinance, or are involved in the real estate investment industry, its important to understand the many types of loans available as each one can serve a different benefit, depending on what your looking for.
First Mortgage Loan: This is the primary loan, used by home buyers and real estate investors, to purchase property. Normally it is given by a banking institution, with specific guidelines based on the borrowers credit and the property’s appraised value, but it can also be loaned by private mortgage lenders, known as hard money lenders, who focus more on the value of the property. For standard bank mortgages, typical rates vary but normally are one to two percentage points above the federal funds rate. For hard money lenders, average rates are higher, 6-8 percentage points higher than bank rates. So as an example, if a borrower qualifies for a 4 percent interest mortgage at a bank, a hard money loan would be around 10-14 percent interest.
Why would borrowers want a hard money loan? Because the guidelines are more flexible and the funding is much faster. Many borrowers who use private mortgage lenders expect to refinance the hard money loan or sell the property within one to two years, so the benefits of hard money loans can outweigh the higher costs.
Second/Third Mortgage: These are subordinated loans to the first mortgage loan, meaning that the loans are paid only after the first is paid. This makes them riskier for lenders because there is a chance that a property might not have enough equity to cover the first and the second if it were to fall into foreclosure. Thus interest rates are higher, and get higher as each loan follows the next (third mortgage interest rate is higher than second, and so on). The benefits of a second mortgage is that borrowers can come with less money down when purchasing a property, or are able to pull money out of their property without having to pay large origination/pre-pay penalty fees to refinance their first mortgage. Second mortgages at banks are normally 4-6 percent higher than the first mortgage. With private companies, it can be 15-22 percent interest rates.
Mezzanine: Mezzanine loans are geared more towards commercial real estate owned by a corporation. They act similar to second mortgages in that they are subordinated loans, but the difference is mezzanine loans are secured by the stock of the company that owns the real estate. So in the case of non payment, the mezzanine lender takes control of the company that owns the real estate, instead of foreclosing on the real estate directly, making it easier for mezzanine lenders to not have to go through the complex foreclosure process. But because it is not directly securing their loans with the property, average mezzanine interest rates are higher than secured loans, normally hovering around 12-16% depending how the contract is structured.
Home Equity Line of Credit: Also known as HELOC, is a credit given by a bank or private lenders in which the borrower can use some or all of the balance at the borrowers discretion, such that the interest is only paid at what is currently borrowed. So instead of a full loan being advanced like a first mortgage, the borrower can use some of the loan balance while the rest is sitting in a line of credit. This is a good options for homeowners who need cash for smaller payments, like construction improvement or education. Home equity lines of credit can either be in first position (first loan) or subordinate (second, third..). The rates are not fixed and change based on the federal funds rate and are similar to the rates of traditional mortgage loans.
Construction Loans: These loans serve the purpose of building a new project, usually taken by the homeowner or builder. They work in the same way home equity line of credits work in that the lender provides an on going credit for the borrower/builder to use to build the home. Before being approved, the borrower will create a timetable of the construction project when each time funds need to be pulled from the line of credit. As funds are requested, the lender will usually send someone to check on the job’s progress. Because there is no collateral, rates are higher than standard real estate loans (about 1-2 percentage points more) and the term is typically only one year, after which it needs to be refinanced or it can be converted to a standard loan (called construction-to-permanent financing).
Other Lendings: There are alternative property lending products that range from bridge loans, which lend out to property owners in between the sell of an old property and the purchase of another, as well as loans which don’t charge any interest but have the requirement to be part owners on the property and share any appreciation made on the property.
Choosing the right loan is entirely dependent on the purpose. Are you looking to live at the property for a long time? Are you a small company planning to fix and flip properties? By comparing how these loans work and the costs, you can then make a better decision which route to take.
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