How to Financially Prepare For Your First Investment Property - Real Estate Investing .org (2024)

I bought my first property in 2009; I was 24 years old. I stumbled into it totally unprepared andI had no idea what I was doing.

We learned a lot of hard lessons those first two years.

I almost didn’t qualify for the loan and almost lost the deal because of it.

Then, once we did close, I barely had enough money to do the basics – like evict my first tenant, repair leaks, or fix the heater. Somehow, I managed to get through the first year and things started to get easier.

I didn’t know about analyzing investment property, property management, or how to budget for my business.

I realize now that the key is to have a strong financial base BEFORE investing. It’s better to figure it out beforehand and not struggle through every problem as it pops up.

Financially Preparing For Your First Property

The key to buying property is to be able to get a loan. For any loan, there are three variables to consider: your debt, income, and cash needed to finance. By manipulating these inputs, you can influence the output – your loan.

1. You need a solid income both through wages and what’s generated from the property.
2. You need to keep debts low to qualify.
3. You need to have enough cash to cover the down payment, closing costs, and basic repairs and maintenance.

1. Manipulate Your Income to Qualify for Real Estate Loans

When I say manipulate your income to buy investments,I do not mean you should fake any numbers and make false statements. Manipulate means to handle or control in a skill fashion – by understanding that variables that determine your loans, you can start planning ahead to make yourself look good to the lender.

The first thing to consider is your source of income. Lenders like to look back 2 years in general, and the way you earn your income will significantly impact what you qualify for.

Employee With a Full-Time Job:

A wage earner with a W2 can qualify very easily for loans. Generally, a bank looks for 6 months of solid earnings and then you can qualify for a loan. Easy, right?

But, what if your wages aren’t enough to qualify? There are only a few ways to manipulate this – one way is to get a second job, and the other way is to work overtime.

Unfortunately, your mortgage broker will need to see a long history of this to use it to help you qualify – often around 2 years worth. They want to make sure you can regularly earn this much and that the high earnings are not just an anomaly.

Self Employed or Business Owner:

This is where it’s really interesting and really difficult.

Working for yourself, you have probably learned how to deduct everything under the sun and you probably know how to avoid paying most, if not all of your taxes. Unfortunately, when you want to qualify to buy that investment property, the banks look at the income you claimed on those tax returns. So, writing off every random expense to keep those taxes low will actually hurt your odds of qualifying for a loan on your investment property.

That’s the trade-off: pay taxes and qualify or avoid taxes and don’t qualify.

You should consult with your CPA on what is the best strategy for you, but many years ago I chose to run my business 100% in line with the law and never “fudged” the numbers to reduce my tax liability. This has helped me grow very fast because every year my income grows.

2. Manipulating Your Debt

This one is probably the thing you have the most control over. It’s hard to increase your income but it’s easy to rebalance loans, pay some off, etc.

The conventional wisdom says we should pay off the loans with the highest monthly payment in order to qualify for a house…but conventional wisdom is often wrong.

Instead, I’ve used a different approach:

I try to pay off the debts that have the lowest monthly payment to total debt ratio.

In the chart, there are a number of debts and their associated monthly payment. You’ll also see a ratio on the side and you calculate it by taking the debt and dividing it by the monthly payment

The ratio can also be read “How many dollars I need to spend in order to reduce my monthly payment by $1.”

Simply look at it and see which ones make sense to pay first. Should I pay the $12,000 and reduce my monthly burden by $225 or should I pay $2,500 to reduce it by $125? By looking at the ratio, you can see that paying the $2,500 first makes the most sense because for every 20 dollars you spend to pay down debt, you reduce your debt burden by $1. That’s a lot better than any of the other debts.

You can see how powerful this ratio is. It really helps you take your debt-to-income ratio under control and you can manipulate it as required to qualify for the loan on that new rental property!

You not only need to manage your debtbut manage your finances. It is important to avoid making these financial mistakes.I particularly like #2, 5, & 10 that Jeff Rose lays out in his article. Credit cards, cars, and recurring payments will really sink your debt-to-income ratio.

To Qualify for Loans on Your Investment Properties, Controlling Debt is More Important Than Earning More Income

What? Let me explain.

Let’s say a person earns $4,000 per month and has a monthly debt of $1000. This person is looking for a loan for $150,000 on a house.

Let’s say the bank allows for a maximum of 35% debt to income ratio or a monthly debt of $1,400. That leaves only $400 for a loan.

A 4%, 30 year loan for $150,000 is $716/month. This person is $316 short of qualifying.

There are two ways to solve this. Earn more, or pay off debt:

Paying Off Debt:

• Max Debt – $1400
• Current Debt – $1000
• Loan – $716
• Amount to pay off – $316

Earning More

• Max Debt – $1400
• Current Debt – $1000
• Loan – $716
• Debt with Loan – $1716
• $1716 / (0.35) = $4903
• Income Required to qualify = $4,903

We can either pay off $316 of debt or earn $903 more per month to qualify. Each dollar of debt of worth nearly 3 dollars of income.

Cash Required

How do you manipulate the cash required to purchase? Different loan programs have different closing costs and down payment requirements:

• For conventional financing, you will need 20% + closing costs.
• Commercial financing will require 20-30% + closing costs. That’s a lot, but they don’t use your personal debt-to-income ratio to determine eligibility.
• FHA is as low as 3.5% but has some extra inspection requirements. Only good properties will qualify, not fixer-uppers.
• VA can be 0% and has a higher debt-to-income ratio which makes it easier to purchase. It is similar to the FHA with its inspections
• There are other loans out there too, like USDA that may be available on a case by case basis.
• I always count an extra $5,000 for closing costs just to be safe. VA and FHA can be more (unless you’re a disabled vet then it’s waived).

Shop around and find out what loan programs you may be able to take advantage of in your area. Each one may have different down payment requirements and will help you adjust this number.

Let’s take the numbers above and see if changing loan programhelps.

• Max Debt Traditional (.35)- $1400
• Current Debt – $1000
• Loan – $716
• Amount to pay off – $316
• Max Debt Alternate Program (.40) – $1600
• Amount to pay off – $116

By changing programs you may have a much easier time qualifying for that loan.

Paying Down Debt

What got you into this problem in the first place is your willingness to buy things you can’t afford or don’t need. It’s fine to have flashy toys and new things, but only if you can afford them.

Once you pay off your debt, you are likely to just do it again if you don’t make permanent changes to your lifestyle. Here are a few quick and easy changes.

Ask Before You Buy

Before I buy things, I always ask myself – “Do I want this or do I need this?”

If it’s a necessity, then I never hesitate to buy it. If I want it, then I decide if I want to pay for it or not. Simply by pausing to ask this question, we have easily cut thousands of dollars in expenses a year.

By pausing for just one second, it eliminates all impulse purchases.

Never Make a Big Purchase in 1 Day

Never find the product and purchase it on the same day.

If there is something that you need then shop around for it and always think about it for at least one day.

Never fall for ‘today only’ sales tricks. If that store doesn’t have it on sale tomorrow, you could probably purchase it online for the same price or cheaper anyhow.

By giving yourself a night to think about it, you may think of alternatives, find a better deal, or even just decide you don’t need it after all.

Clear debt by Creating a Monthly Budget (and Stick to it)

Write down all your mandatory expenses each month, then subtractit from your income to find out what’s left over. Subtract an additional portion for unknown or unplanned expenses such as vehicle maintenance or birthdays and holidays.

Don’t forget to include a portion of your budgetfor personal and “fun” expenses if there is enough.Just like a diet should allow for a cookie now and again, a budget should include some spending on yourself. It helps gives you something to look forward to and helps avoid those impulse buys.

Now that you have your budget, stick to it. If you want to purchase something, do not borrow against next month’s surplus. Instead, save your money this money, and then save it next month before buying the item. I’ve actually seen people spend their entire year’s discretionary money in the first couple months.

Use All Extra Money to Pay Off One Debt

Pay the minimums on all your debts, then use all your available money to pay off one. The hard part is choosing which debt to pay.Start by making a list of all the debts, how much you pay each month, the total balance, and the interest rate for each one. Then look at the 3 ways to choose which debt to pay.

Pay the Highest Interest Rate Debt First

If you have a credit card at 18% interest and a car payment at 4%, it might make sense to pay off the credit card first. In this example, the majority of your monthly payment for the credit card will go straight to interest and you will barely pay the principal down. The car, on the other hand, will have monthly payments that significantly reduce the principal balance and only a small amount each month goes toward interest.

Pay the Lowest Balance Debt First

If you can quickly pay off one loan, you will immediately free up some extra money, which you can then use to pay your next debt. Also, you will be able to see quick results and feel good that your efforts are beginning to work. Just seeing your number of monthly bills to pay drop from 10 to 9 can have a huge psychological effect.

Pay the Debt With The Lowest Balance to Payment Ratio

Take the total debt and divide by the total monthly payment to get the ratio. If you have a credit card with a balance of 2500 and a monthly payment of 45, your ratio is 55.6. A car with a remaining balance of 5500 and a monthly payment of 374 will give a ratio of 14.7.

Essentially, this ratio tells us how many dollars you need to pay in order to reduce your monthly payment by $1. For every 14.7 dollars spent toward the car, your monthly payments drop by $1 whereas you have to pay $55.6 to drop your credit card payment by $1.

In other words, paying off which debt gives you the best bang for your buck. The car is almost paid off already, so just getting to the finish line will free up a lot of money every month you can use to kill debt.

Snowball the Debt Payments

Now that you have paid off one debt, use all the savings to pay off the next debt. You’ve already set a budget for paying off debt, so instead of spending the savings, just use it toward more debt payments.

If you are spending an extra $100 per month to kill debt, and you pay off that first credit card which had a monthly payment of $35, now use that $100 + $35 to pay the next debt. As you roll down the hill of debt, you will pay more and more toward the next debt, paying each one off faster.

Use as Much of Your Savings as Possible

If your savings is earning less interest than your loans, you should use the savings to pay the debts. You may be earning 1% in a CD but your credit card is charging you 12%. Take that money from the CD and pay off the debt. You will save far more than you are earning in interest.

Don’t forget to leave some cash just in case an emergency pops up. We don’t want to have to rely upon credit cards to pay these unexpected expenses when we just got them paid off.

Be Extremely Cautious About Using Long-Term Debt to Pay Short Term Debt

Banks will encourage you to use a home equity loan to pay off your credit cards, cars, or other debts. This might make sense in some circ*mstances, but the problem is people pay off those debts but don’t make the lifestyle changes to avoid accumulating more debts. Now, they have a home loan and all the same credit card debts again to pay and the hole gets deeper.

I am going against a lot of financial expert’s advice with this one, but let’s think about this logically for a second.You have a 5-year car loan that you pay off and wrap into a 30-year home loan. A car might have a useful life of 7 years or so, but you are now paying for that car for 23 more years after you’ve stopped driving it. It just doesn’t make sense most of the time.

If you have made very serious lifestyle changes and a taking a home loan is the only way to allow you to pay off the credit cards, then it might make sense. It also might make sense if you are paying extremely high interest rates and you get a really good rate on the home loan. The important part though is that you must be dedicated to paying off the loan as quickly as possible to take advantage of the savings.

What About FICO Score?

A lot of people have great credit and wrongly believe they can qualify for a loan. As I’ve spent this entire article explaining, qualifying for a home loan is all about the debt-to-income ratio. That being said, your credit score does play a factor in your DTI ratio.

Credit score is important of course and it can disqualify you, but, if you are above the minimum threshold, it can raise or lower the cost of financing by affecting your interest rate. Since your interest payments are part of your mortgage, and your mortgage counts toward your debts, it is just another factor to consider when manipulating your debts.

Let’s say you have good credit and qualify for a 4% interest rate and someone else has poor credit and can get a 6% interest rate. For every $100,000 house value, that’s an extra $2,000/year or $166/month in payments. This really could be the difference between you qualifying and not qualifying, so it’s best to manage your FICO score.

You need to adjust your lifestyle in order to cut your debt.

So you’ve got a debt problem. Now it’s affecting your lifestyle.

As debt grows, paying the interest becomes a bigger portion of your paychecks until you are just working to pay back your debts.

Your debt affects everything in your life – from financing a car to buying property.

With your debts out of whack, you will never qualify for loans, save for retirement, or help your kids pay for college.

So here’s the thing – you don’t have a debt problem, you have a spending problem.

The majority of indebted people are solidly middle-class or higher. So, if you are in a lot of debt it is likely due to your spending and not your income. More likely than not, you need to adjust your lifestyle.

You’re terrible at saving. It’s not entirely your fault really.

Society has ingrained this consumerism into our minds so I can’t really blame anyone that falls into it.

You could cut back your expenses, but who wants to live like a hermit anyhow? Of course, you want a decent standard of living.

It’s a good thing this one trick will help you build long-term wealth AND maintain your current standard of living.

Increase Your Savings

Really, if you boil it all down, all financial advice is just a variation of one thing – save a larger percent of your income. Some suggestions include earning some side money, but most suggest living modest lifestyles, avoiding unnecessary expenses, and saving more and more of your income. The more you save and the less you spend then the better you will be in the future.

Unfortunately, few people can even save 10% of their earnings, never mind 15 or 20%. I’ve even seen some set goals as high as 50%. These goals are great and you would be far closer to retirement if you reach them but too bad you are stuck paying five thousand different things and your check on Friday is already spent before you even got it.

So, YES you should be saving, and YES you should be saving more. You should also cut back your expenses so that you are saving a good chunk of your paycheck every month and investing in it good solid investments that yield a great passive cash-flow return in the long run (no CD’s or savings accounts in my opinion).

Most Saving Advice Actually Makes you Spend More Money Every Year

Most people will earn more money next year than they earn this year. If you save 15% of your wages, then next year you will have more money to spend and you aren’t actually saving much more.

Let’s say you earn $4k each month and you’re saving 15% which is $600 then get a 3% raise so now you’re earning $4,120 and saving $618. So you got a $120 raise but you are only saving $18 extra. Following this guidance means you will now spend $102 more. Let’s throw this idea right out the window. Our goal is to save more, invest more, and retire early. Why are we spending so much more?

Once you are actually saving a decent percent of your check, how do you continuously increase that number WITHOUT cutting back?

The Trick to Saving a Larger Percent of Your Check

You need to bend the cost curve.

“What the heck does that mean?”

As I mentioned above, saving a fixed percent of your income just leads you to spend more money every year.Instead, you should save a minimum of HALF of your pay increase. In the example above, save $60 per month and take that other $60 for your personal spending.

Now of course, if you could save all of it, great. I’m only counting half because some of your pay increase should go to offset natural inflation. Plus, who wants to live a stagnant life?

Look at the chart to the right. You’ll see that if you save half of your pay raise, the percent of your wages you are saving grows every year. After 10 pay raises, you are now saving over 23% of your income.

You are saving more of your money and still have extra money to spend!

Double down – Save more and Spend Less

Let’s say each year you can cut your expenses by just 1%. With a wage of $4000 and savings at $600, that is only $34 a month you need to cut. If every year you cut an extra 1% you can see howsaving your raise and reducing your costs can stack up.

After 10 years you are saving 30% of your total income!

With this trick, you are able to save a larger and larger percent of your income without actually cutting your lifestyle at all. If you add in even modest lifestyle cutbacks, you can seriously stack the savings and quickly achieve your huge investment goals.

And honestly, none of this even takes into account that you will be investing your savings into good opportunities to generate passive income.

Dedicate Yourself to a Debt Free Lifestyle

Once you have cleared all your debt, worked on your FICO score, and prepared to make a real estate purchase, you need to maintain the lifestyle. It’s far too common for people to pay off debts then immediately get back into debt with all that spare money they have every month.

Instead, focus on investing that money to earn even more in the future.