Buying a home is expected to be easier in 2015, thanks to some new mortgage guidelines that are making the rounds. Lower down payment requirements from Fannie Mae and Freddie Mac and mortgage insurance premium cuts on FHA loans should open the door for more first-time buyers but there are some borrowers who may still face obstacles in getting a home loan.
If you’re ready to become a home owner but you’re having trouble qualifying for a traditional mortgage, you shouldn’t assume that you’re shut out of the market altogether. There are a few ways to finance a home purchase that don’t involve taking out a big loan from the bank if you’re willing to think outside the box.
1. Buy on contract
When you’re financially able to afford a home but your credit is a barrier to getting a loan, buying on contract may be the answer. When you buy a house on contract, you make monthly payments to the seller or to a finance company on the seller’s behalf. The seller holds on to the title until you’ve paid the agreed-upon purchase price in full.
Buying on contract is similar to a lease-to-own arrangement but with some slight differences. When you lease-to-own, you typically pay your regular rent payment plus a few hundred dollars extra, which is held in escrow as your down payment. After you make a certain number of payments, you’d go through the bank to get a loan to finance the rest. If you decide not to buy, the homeowner gets to keep everything you’ve paid in.
In a contract for deed scenario, the seller is essentially financing the home to you so the bank never gets involved. That’s a definite plus if your credit is less than stellar. You may also have a bit more leeway with the down payment, since some sellers may be willing to accept less than the standard 20 percent down. The biggest downside with this kind of arrangement is that it’s up to the seller to determine what kind of interest rate you’ll pay, so it can be a more expensive way to buy compared to a traditional home loan.
2. Take out a margin loan
If you started investing early and you’ve earned some decent returns over the years, you could leverage those investments into a new home. Brokerages will allow you to take out what’s known as a margin loan, which basically means you’re borrowing against the value of your portfolio. Typically, you can borrow up to half of what your investments are worth and they serve as your collateral for the loan, instead of the property itself.
Like anything else, margin loans have their pros and cons. On the positive side, you won’t pay any closing costs, you’re not required to have your new home appraised beforehand and you won’t get hit with a prepayment penalty if you pay the loan off early. There’s no set repayment schedule, although it’s generally recommended that you at least make payments towards the interest each month.
As far as the downsides go, you’ll miss out on the mortgage interest deduction that homeowners usually get. You can, however, deduct the interest you pay on the margin loan. The interest rates tend be higher than what you’d get with a traditional mortgage and if your portfolio loses too much value, you may have to deposit cash into your brokerage account to make up for the difference. Weighing the risks against the convenience can help you decide if a margin loan is the wisest choice.
3. Tap friends and family
Paying for a home with cash may seem impossible but it’s not that far-fetched if you’ve got someone who’s willing to spot you the money. Taking out a loan from your parents or a friend allows you to sidestep all the paperwork and headaches that go along with getting financing through the bank and you don’t have to worry about how your credit rating measures up.
Obviously, borrowing a large sum of money from someone you know has the potential to negatively impact your relationship so it’s essential that you agree on the loan terms before anything changes hands. Drawing up a formal contract or at the very least, signing a promissory note gives the person you’re borrowing from a tangible guarantee that you’re planning to make good on the loan. It’s also smart to put how much you’re paying and what the interest rate is in writing so there’s no chance of it being disputed later on.
As long as the money is deemed a loan and not a gift, there shouldn’t be any tax implications for the lender. You will, however, miss out on the tax deduction that goes along with paying the mortgage interest which could mean a larger tax bill.
What you don’t want to do
If you’re tempted to drain your 401k or another retirement account to purchase your dream property, it’s time for a reality check. Even though you wouldn’t be paying interest on a loan to a bank, cleaning out your nest egg will still cost you a pretty penny.
Not only will the IRS charge you a 10% early withdrawal penalty for taking money out of your retirement account before age 59 1/2, but you’ll also have to pay income tax on the distribution at your regular rate, which can eat up a huge chunk of your savings.
The other issue with raiding your retirement account is that you can’t replace your savings. Sure, you can begin making new contributions but you’re losing out on the potential earnings you could have enjoyed if you had left the money alone. Paying cash for a home is certainly appealing but not if it ends up costing you the kind of retirement you’re hoping for.
The Bottom Line
When you’re on the hunt for ways to finance a home, you want to leave no stone unturned. Each of the three options we’ve suggested can make home ownership possible when getting a traditional mortgage just isn’t in the cards.