Concept #1: Difference Between Consumer and Commercial Banking
It’s critical to note that consumer and commercial bankers don’t play by the same rules. Consumer bankers deal with 90% of the population that comes in and out of the bank, handling personal home loans, car loans, boat loans, etc. Commercial bankers, on the other hand, deal with businesses.
Generally, consumer banking has different standards from commercial banking, especially when it comes to buying a house. In fact, a consumer banker will not loan you money for a commercial venture like rental property—you’ll have to talk to a commercial banker.
In consumer banking, there are also a lot more rules and hoops to jump though. Unless you are moving out of a home you occupy and buying a new primary residence, you’ll need to talk with a commercial banker. I’ve been told by a banker that I trust that in consumer banking, you can have up to 4 personal 30-year home loans at a significantly lower interest rate than that of a commercial banking home loan. Another important distinction is that consumer lending is federally backed and guaranteed. With the government involved, there are definitely incentives (such as lower interest rates), but they come at the price of lots of paperwork and red tape. For these reasons, consumer lending tends to be difficult. Additionally, consumer banking underwriters will require an incredible amount of effort and work from you as the borrower.
In commercial banking, you’ll receive a shorter loan term, but you’ll also experience more flexibility on the kind of deal you can get. You also won’t have to worry about the same headaches and underwriting that you would in consumer banking. Commercial banks will assume that their bankers know what they’re doing, so they will give those bankers a lot more freedom and discernment to carry out what they think is good business. In turn, commercial bankers will typically assume that their customers are a little more savvy and can understand the rules of the bank as good customers should.
Consumer banking on a primary residence has certain legal protections in place, like protection against bankruptcy, etc. In commercial banking, you won’t have any of that. If you default on a property, you’ll have to stand good for it. In short, commercial banking is a lot less forgiving, but it’s a lot easier to deal with and needs to be a part of your risk assessment if you’re getting involved in real estate.
Concept #2: The Importance of the Term of Your Loan
When evaluating the terms of a loan, it’s crucial to negotiate the best terms possible. The length of time from origination to maturity is the term of your loan (during this period, a bank will “lock” your interest rate so that it won’t change with the market). Note that this is different from your amortization rate. The amortization rate is the period that the loan will pay down to zero, including all interest charged by the bank. Whenever the loan matures, you’ll have to go through the entire process again and pay whatever the interest rate is at the time of the new lock. What you risk is renewing at a higher rate, which will affect your cash flow.
When you first start borrowing money, it’s likely that the bank will try to give you a 1-year lock. While this lock isn’t ideal, it’s pretty typical for new borrowers. If you can, however, I would advise you to negotiate for a 3-year lock.
Once you get more established in the rental property industry, bankers are more likely to give you a 3 or 5-year lock. It’s important that whatever loan you choose does not have prepayment penalties. Prepayment penalties are dangerous because they may make terminating the loan too costly to sell a property if need be. The holy grail of rental property is getting a 10-year lock with no prepayment penalties, but such locks are rare and a lot more difficult to get. When you lock the loan over a longer period of time, you protect your cash flow against higher interest rates and save any renewal fees that would’ve occured for a shorter period, thus lowering your overall risk factors. Typically, the longer you lock the loan, the better the loan is.
Remember, you must pay the same interest rate for however long your lock is unless you want to go back into your loan and refinance the deal. If interest rates fall considerably during the term of your loan and you have a good relationship with your banker, you can request that he or she float your interest rates down (this is called a rate modification). The banker has no formal obligation to float your interest rates down, but he or she may consider doing so to prevent you from loan shopping at other banks. There will be some paperwork and a fee involved, but if you have a banker who will do that for you, you’re in a great banking relationship.
Concept #3: Additional Loan Products
Not all loan products are equal. There are some alternative loan products that are off the beaten path. The most popular of these is probably what’s called a swap.
A swap will give you today’s interest rate for 10 or 20 years (if you like today’s interest rate), but can be very expensive to get out of. The prepayment penalties of a swap can be significant. If you sign up for a swap, it can be a very good product, especially if you fear higher interest rates in the future, but you have to know that you are essentially stuck within that swap.
Let’s break this idea down a little more. Say you buy a rental house over a 20-year period. The riskiest period for you as a buyer is when you have the least equity. Even if you put 20% down, your greatest risk is the first day your note starts. So, if you amortize the house for 20 years and can lock down a 10-year period in one note, your risk assessment will change completely at the end of those 10 years. First, the property has probably appreciated a minimum of 3-5% per year. Second, you’ve retired a ton of principle in the property. And third, your rent rates have probably gone up, so your debt coverage ratio looks better. For all these reasons, it’s a great idea to try and lock for a longer term using a swap.
Swaps can also protect you from potential economic distress. Although banks can call notes at any time (with just cause), they are less likely to call a longer loan, especially if the loan is performing and you are within all loan covenants. If you have a year-to-year loan, on the other hand, it could be much more difficult to renew your note if there’s an economic downturn or if your loan is performing marginally.
One of the worst things about swaps, unfortunately, is that if you want to sell your properties 3 or 5 years in, you’re stuck in the property you already have for the duration of the swap. The prepayment penalties will be too high, thus making a profitable deal more difficult for you as a seller.
Concept #4: Using Collateral
Collateral is an asset the bank uses to secure their interest in a loan and offset their risk of losing money. It’s totally reasonable for a bank to ask for collateral because they’re risking their investors’ capital. The problem occurs when the bank asks for too much collateral. Most banks will ask for as much collateral as they can get to secure their position and avoid risk.
For you as the borrower, it’s critical to avoid tying up any additional collateral into your loan. If you’re going to buy a rental house, that house should stand good for the loan. You shouldn’t have to tie up any additional collateral in order to make the loan. For example, if I’m buying a duplex for $300,000 and putting 20% down ($60,000), that duplex should stand as the collateral for that loan. I shouldn’t have to pledge any additional collateral, such as a savings account, certificate of deposit, investment account, additional property, etc. to secure the loan.
If a banker asks you to use additional collateral, I would advise you to politely say no and explain that you have a personal rule not to pledge additional assets when a deal has the ability to stand on its own. If your banker insists on additional collateral, I would go find another bank, especially if you have good credit and your paperwork is in order.