Term Loans for Real Estate – A Comprehensive Guide

A term loan is a common financing method used by investors and businesses to purchase real estate. With a term loan, the borrower receives a lump sum of cash upfront and pays it back over a set period of time through fixed monthly or quarterly payments. Term loans offer many benefits for real estate investors compared to other financing options. In this comprehensive guide, we’ll explain everything you need to know about using term loans to fund real estate purchases.

What is a Term Loan?

A term loan is a type of loan where the borrower receives the full amount of the loan upfront and makes regular payments over a set term until it is fully paid off. The term length typically ranges from 1-30 years.

With a term loan, the payment amounts, interest rate, maturity date, and other terms are set in advance. The borrower pays down a portion of the principal and interest with each payment until the loan is fully amortized at the end of the term.

Term loans differ from lines of credit and other revolving loan options where the borrower can withdraw and repay funds multiple times The proceeds from a term loan are distributed once and then repaid according to the fixed schedule,

Benefits of Term Loans for Real Estate

There are several reasons why term loans are a popular choice to finance real estate purchases:

• Fixed regular payments – Borrowers have predictable fixed monthly payments over the life of the loan which helps with budgeting.

• Lower interest rates – Term loans typically have lower interest rates compared to short-term financing options like bridge loans. The longer the term, the lower the rate.

• Long repayment periods – Term loan maturity can range from 1-30 years. Longer terms have lower payments.

• Funding for purchases – The lump sum distribution provides capital to purchase or refinance real estate.

• Flexible loan uses – Term loans can finance the purchase of residential, industrial, retail, or commercial real estate.

• Ability to lock in rates – Borrowers can lock in a low fixed rate even if market rates rise later.

How Do Term Loans Work?

When applying for a term loan, the borrower specifies an amount they wish to borrow based on the real estate purchase price and their down payment amount. Here are the key steps in how a term loan works:

• The lender analyzes the borrower’s financial statements, credit score, debt-to-income ratio, and other factors to determine approval and establish terms.

• Once approved, the borrower receives the full loan amount upfront in a lump sum to use right away.

• The loan agreement specifies the interest rate, monthly payment, payment due dates, and loan maturity date.

• The borrower makes fixed monthly payments consisting of principal and interest until the loan is fully paid off by the maturity date.

• Payments are amortized so that each one pays down a portion of the principal. Earlier payments go mostly toward interest, while later payments apply more to principal.

• Prepaying the loan early may incur penalties depending on the lender. Many term loans allow prepayment without penalty.

What is a Mortgage?

In real estate, the term loan borrowers most often utilize is a mortgage. A mortgage is simply a term loan used to purchase real estate where the property acts as collateral securing the debt.

Mortgages have long repayment terms ranging from 10-30 years to keep payments affordable compared to the high cost of real estate. Banks and mortgage lenders provide qualified residential and commercial borrowers with mortgages for real estate purchase and refinancing.

Mortgages have some unique features compared to other term loans:

• The property purchased serves as collateral for the loan.
• Loans are typically fully amortized with fixed equal payments.
• Private mortgage insurance may be required for borrowers with lower down payments.
• Homeowners can usually deduct mortgage interest on tax returns.

Types of Term Loans for Real Estate

While mortgages are the most common, there are a variety of term loan programs available for real estate buyers and investors:

Mortgages

• Residential – Primary home purchase and refinance loans.
• Investment Property – Loans for non-owner occupied residential purchases.
• Commercial – Loans for office, retail, industrial property.
• USDA, FHA, and VA loans – Special programs with lower down payments.

SBA Loans

• 7(a), 504, microloans – Financing for purchasing and constructing commercial real estate.

Construction Loans

• Funds dispersed in phases to builders during construction. Converts to permanent financing after.

Land Loans

• Funds to purchase and develop vacant land before construction begins.

Home Equity Loan

• Second mortgages using equity in existing property as collateral.

What Credit Score is Needed?

The minimum credit score needed for a term loan depends on the specific program, loan purpose, and lender requirements. Here are general credit score guidelines:

• Top tier rates – 740+ credit score
• Good rates – 670-739 credit score
• Below average rates – 580-669 credit score
• Subprime financing – Below 580 credit score

Many lenders allow term loans with credit scores in the fair range (580-669), but will require a higher down payment and interest rate. For the best rates, a credit score above 740 is ideal. Bringing your score into that range can substantially lower payments.

Borrowers with poor credit below 580 may need to utilize alternative financing options or take steps to improve their credit before applying.

Term Loan Rates, Fees, and Closing Costs

The interest rate offered for your term loan depends on market rates, your credit score, loan-to-value ratio, debt-to-income ratio, and other qualifications. Fixed rate loans set your rate at closing, while adjustable rate mortgages fluctuate with an index. Expect to pay lower rates for excellent credit, low LTV, and large down payments.

Aside from interest, expect to pay loan origination fees of around 1% of the total loan amount plus closing costs. Closing costs run 2-5% of your loan and may include appraisal fees, legal fees, inspection fees, taxes, and more. The costs are usually rolled into your total loan amount.

Term Loan Qualifications

To qualify for a real estate term loan, lenders will review:

• Credit history and credit scores
• Income and employment
• Existing assets and reserves
• Debt-to-income ratio
• Loan-to-value ratio
• Property appraisal

By maintaining good credit, steady employment, low debt, and adequate reserves, you can improve your chances of approval and get better loan terms. Provide strong documentation of income, tax returns, bank statements, and assets. Your loan officer can advise on documentation needed.

How to Get a Term Loan

If you’re looking to obtain a term loan for a real estate purchase, follow these steps:

1. Check credit and improve your score

Aim for at least a 670 FICO score for approval. Pay down balances, dispute errors to boost your rating.

2. Calculate costs, loan amount, and down payment

Factor in the purchase price, rehab costs, down payment funds, and closing costs.

3. Choose a lender and get pre-approved

Apply with banks, credit unions, or mortgage lenders. Compare options.

4. Make an offer and apply for financing

Once your offer is accepted, submit full application documentation to secure financing.

5. Close on time

Finalize paperwork and fund your down payment in time for closing day.

Pros and Cons of Term Loans

Term loans offer many benefits but also some downsides to consider:

Pros

• Fixed regular payments
• Lower interest rates
• Funding for purchases
• Take advantage of low rates

Cons

• Loan maturity less than 30 years have higher payments
• Total interest costs increase with longer terms
• Prepayment penalties may apply
• Refinancing costs after interest rates fall

Alternatives to Term Loans

Term loans aren’t the only financing option. Here are a few other methods real estate investors can consider:

• Hard money loans – Short term loans from private lenders at higher rates
• Seller financing – Owner carries back a portion of the sale price
• Crowdfunding – Pool money from multiple small investors
• Lines of credit – Revolving credit to use as needed
• Bridge loans – Very short term loans that bridge a gap

However, term loans tend to offer the best combination of affordable payments, favorable rates, flexible terms, and funding. For most real estate buyers and investors, they are the ideal financing method.

The Bottom Line

A term loan provides real estate investors with an upfront lump sum of capital to put towards a purchase in exchange for fixed monthly repayments over a set period of time.

Term loans like mortgages offer many advantages for buyers who want low rates, flexible repayment periods, and predictable payments