Based on an interview with Srdjian Gavrilovek, an investment banker in Atlanta, GA.
Lenders only make money when they lend money. Therefore, they want to lend as much money as possible. However, there are qualifying criteria that borrowers must meet. Some loans will require high credit scores and a lot of income, while other loans will allow for a lower credit score and less income. For the average buyer, government-insured loans like FHA or VA may be easier to obtain. But, in general, your mortgage lender will require you to meet certain underwriting requirements for your loan.
There are four C’s of credit. 1 – your Credit History, 2 – Cash Flow; as in, what is your ability to repay the debt; 3 – Collateral – such as what item(s) you are going to secure the loan on. (the collateral will help determine how much money you can borrow)
4 -Character, comes down to stability. Someone who has been in your job for 10 or 20 years is considered lower risk than someone who started work last month. Ideally, they will have some assets in retirement accounts, brokerage accounts, or cash accounts.
But this is less and less considered in today’s world of automated scoring systems that spit out responses very quickly.
Let’s tackle these four C’s one by one. Credit History – In today’s world, that’s the first thing to focus on. A good credit history will allow you to apply for the best deals. It will allow you to obtain declared income or loans without documents, obtain better interest rates, higher loan-to-value offers, etc. Understanding how credit history works is probably the first thing you can do to help your career as an investor.
In the state of Georgia, we are entitled to two free credit reports per year that can be obtained from any of the credit bureaus. The free ones do not provide the credit score.
I would definitely urge anyone to spend $33 to get a “triple melt” report once every six months and see what their average score is. http://www.equifax.com is a very useful website that newbies can go to to learn a bit more about how the scoring system works and what will increase or decrease their score.
I have looked at literally thousands of credit files in my career as a lender. I have noticed many errors. One of the most common mistakes I’ve seen is charging $30 for a phone bill, gas company, or medical bill. When you move, be sure to leave forwarding addresses and get these final bills, because a $30 charge with perfect credit can lower your score by 50 points and can drastically impact the type of loan you qualify for.
The cash flow is going to translate into what they call the debt/income ratio. Debt to income ratio is basically all of your debts added together, every car payment you have, every credit card payment you have, mortgages you have, and every item in your credit file.
Things that will be counted against you that will not be on your credit file are government contract obligations or court-ordered payments, such as child support.
If the lender is doing its job right, it should include property taxes and insurance and count them in your debt-to-income ratio because that’s part of the actual cost.
To calculate your own cash flow or debt-to-income ratio, check your credit file. There will be three columns in your credit file. High credit, current balance and minimum payment.
High credit on credit cards would be your credit card limit, current balance would be what you owe to that specific lender, and minimum payment is what that lender reports as your minimum obligation.
Most lenders today will go up to 50% of your gross debt to income ratio, as long as all your debts, including the loan you are applying for, do not exceed 50% of your monthly gross income.
There are exceptions to that when you are buying residential real estate. If you’re actually going to live in the house and have excellent credit, the ratio can stretch.
If you are already investing in real estate and have a variety of homes; Let’s say you have four rental houses. Let’s say those rental house rents add up to $2,000 per month. What does that mean to you when you are applying for credit? Rentals are generally never taken at face value.
Let’s say you are receiving $2,000 a month in rent for your properties. There are several things that your lender will ask you to verify. The first thing is to find out if you have just started receiving these rentals. Many lenders will not allow you to use new rental income. At a minimum, we are going to need leases on each property along with checks to show that rent is actually being collected.
I strongly recommend that you collect your rents in the form of a check so that you can show a canceled check as proof of payment. If you get it in cash, make a deposit separately from other deposits. I have seen many clients who get cash from their tenants and put some in their pocket for everyday expenses. When I check your bank statements, I can’t find a consistent pattern of that rent being deposited. Therefore, I cannot prove that they are actually receiving rent for that property.
Leasing is great, but if you have a lease with a bad guy who isn’t paying you, it won’t help the bank or you. A copy of the lease agreement along with the last three checks you received on that property would be the basic minimum that will be considered to count this as income.
Collateral: There are two ways to look at credit and two ways to borrow: secured and unsecured. Unsecured loans are increasingly becoming the purview of credit card companies. Banks aren’t really in the market for unsecured loans because they’re not that profitable. There is not much incentive for banks to grant unsecured loans.
When you use a rental property as collateral, depending on the strength of your credit, you can get a loan of 80% to 90% of the value. Generally, for buyers with good credit, the 90% is not a problem in their real estate investment. When it comes to multi-family homes, many people want to own them in their company name. This means that you should look for loans that are for your business. Commercial loans are an entirely different product and these offers are evaluated for loans differently than single family homes.
Regardless of where your credit is now and how much cash you have, it’s clear that having access to good sources of financing is the key to a successful investment business.
While seller financing and other creative options may allow you to buy a property without cash or credit, professional investors know that good credit and cash are king. If you want long-term success as a professional investor, you owe it to yourself to take the necessary steps to build your access to good sources of financing.