Why a 7 year loan?

Question

Hi - I have spoken to two bankers.  The first is with a major bank who was talking about a 20 year mortgage.  The second, a local smaller bank, without an application and over the phone, mentioned a 7 year 'abundance of caution' loan.

We paid cash (borrowed from ourselves.)  The purchase price was very low for the area ($26K, normal would be 60-95's for half of this SFH in decent condition.)  There is not a loan in place.  The property is owned through an LLC.

We have turned it from a SFH back to to the duplex it used to be, and are adding two small apartments by subdividing and adding bath/kitchens.  We are planning to get an appraisal soon after finishing the bathrooms and then asking him to estimate the value of the 4 units in its future finished state.   One apartment is ready to rent and being advertised.
 
I'm O.K. with the 20 year loan, but the 7 year makes no sense to me.  Is it something to consider?  I am only familiar with loans on primary residence houses, not investments.

Thanks for your thoughts.

Jon Holdman · Answer

Around here a conversion from SFR to a duplex would be fairly painless in most areas.  Converting to a fourplex would be much more difficult.  That's because many areas with SFRs are actually zoned for duplexes while very few are zoned for quads.  Did you go through the planning and zoning process to get your plans approved?

I'd agree with the others.  I doubt the seven year loan means seven year amortization.  Its a balloon.  You'll need to have a plan in place to deal with the balloon when it hits.

Sounds like you're wanting to use a new appraisal.  You may need to own it for a year before you'll be able to do the refinance with a new appraisal.  What did the banker have to say in this regard?

David Beard · Answer

Yes, I think you do want a 20-30 yr ARM, because you are guaranteed the loan for 20-30 years, as long as you make the payments.  With a balloon note, in 5-7 years you will have to ask (beg) the bank to refinance your note, or find another bank to refinance the note.  You will have to pay prevailing market rates at that time, regardless of how high the've risen.  It's conceivable that the bank will not refinance your note for numerous reasons related to the lending environment, their financial condition, their appetite for your specific type of loan, or the location of the property.  Also, if the value of the property deteriorates, you could be forced to bring cash to reduce the loan balance before they will agree to refinance.

ARMs are much better, and they almost always have a lifetime interest rate capped at 5 to 6% above the initial note rate, providing you a defined limit on how high your future payment might rise to.  You can get a 5/1 ARM, for example, that will have a a fixed rate for the first 5 years, then begin to reset after that (constrained by the annual and lifetime limits on how much the rate can change).  They often have an annual maximum rate change of 2%.

Always chose a 5/1 ARM over a 5-year balloon, or a 7/1 ARM over a 7-year balloon, if the initial note rate is similar.  It's less clear if you're comparing a 7 yr fixed rate balloon to a 3/1 ARM that only locks in the rate for the first 3 years.  Then it will depend on your targeted holding period for the asset.  Also, ARMs sometimes have higher initial rates to compensate for the risk the bank takes in locking in the max rate that it can receive on the note, and other risks of guaranteeing financing for 20-30 years.

Chris Martin · Answer

Regarding ...adding two small apartments by subdividing and adding bath/kitchens..." and later, regarding the guy in charge of permits/inspections "He told me under which conditions they give permits and require inspections and it wasn't our situation." This is the first instance I've ever heard of where adding new electrical and plumbing installations did not require a permit.

Jon Holdman I think we needed the CO to allow a "legal" tenancy. The bank only cared about the lease (which required a CO before tenants could sign/occupy) and I don't think the bank ever saw the CO.

Jon Holdman · Answer

Appraisal, yes. But they will usually order this and make you pay for it.  In that regard, take the time to meet with the appraiser.  Have your own good comps and offer them to the appraiser.  And have lists of what you did and hand those over, too.  Walk through the property with the appraiser and point out what you did to it.

I've actually never been asked for a CO.  That may depend on the area.  But ILCs (Improvement Location Certificates, sort of a mini-survey) are commonly requested.  Like the appraisal, though, that's something that's done as part of the process, not something you hand over up front.

In some areas, you'll need pest control certifications.  More common in areas where there is some specific problem like termites.

I see what you're saying about borrowed from yourself.  You borrowed from a 401k (I think) to fund the deal.  That means there are no liens attached to the property.  So, the refi will be a cash out refi.  That will be a little tougher than a rate and term, but not impossible.

Honestly, I'd keep searching for a lender.  You may be able to get a 15 year fixed commercial real estate loan.  We have a lender here who will do those on single families.  Not sure about quads, though.

If you want to separate this into two duplexes, you might look into "party wall agreements".  What you're really doing is creating condos.  But an HOA would add another level of complexity.  In our area, duplexes are sometimes split into two separate properties using a simpler "party wall agreement".  That dictates how the shared part of the property is handled and become attached to the deed.  I've never done one, so I'm not sure on the details.  Your city would be the place to start.  Sounds like they're pretty easy to work with.  That's a big plus!  I'm amazed you can do this much work without permits.

Kerry M. · Answer

Thank you, Bryan Hancock.  So if it refers to the term, not amortization, then could I ask, what would be my numbers if the appraisal value is 130?  Would they lend 70-80% of the value after repairs number of 130, on a 15-20 year period, with a due date at 3-7 years with a balloon payment?  So I don't know what's normal, but could someone take the most likely scenario and tell me what the monthly repayment would be?  I know how to use bankrate.com's calculator but not when the amortization and term are different.
Jon Holdman, thank you.  I am using your list to assemble documents now.  Even if they ask for something new, I'll have most of it ready.  
I told the head guy at the county who issues permits about our plans and he said we don't need them.  They have county-approved businesses who will do inspections if requested but it is not required.  He told me under which conditions they give permits and require inspections and it wasn't our situation.
When I first started blogging here six months ago you asked about the borrowing from ourselves.  It was one of our first hurdles.  You also told me to talk to a real accountant, which I since have and that was really good advice. 
The only funds we had to use to make the cash deal was by a regular, non real estate installment loan against part of the value of our retirement account, through the people who manage the retirement accounts for the company my husband works for.  We pay monthly on a 5 year term to repay the money borrowed from retirement.  I called them and asked them the questions you asked me at that time.  I don't remember all the answers but we followed their rules.
Chris Martin - what is "CO"?  I've called the appraiser and am waiting for him to call back.
Ben Leybovich - Thank you.  I will remember to ask about including a cap.  I don't think I want an ARM, if I can choose.  A balloon would be better if it were 7 years down the road.  Thank you for your offer.

Opinions?  What about paying to separate the property into two 2-units?  I've been told it costs $3,000.  Double the cost of the refi, double taxes but would allow me to pay down the principal greatly if I sold one side while keeping the other half of the property.  I don't see people doing that buy don't know why.  Would that give me flexibility to sell half so I'm not carrying so much debt?  What would be the sequence of appraiser-cash out refi-sale-paydown?

Ben Leybovich · Answer

Kerry,

I agree with Jon Holdman.  Make sure you have the proper permitting to put 4 units into the structure.  The property is in the LLC, which is why a 30-year residential is not going to happen.  As to 7 years, this is likely an ARM.  3,5,7 year ARMs are typical on a 20 or 15-year amortizations.  What an ARM does is that the interest rate on your loan resets at the specified periods and the payment is recalibrated based on the new interest and the balance at those times.  So, you do have to be careful because your payment at the adjustment could be higher than at the origination if the interest rate is much higher.

There is something you can do.  Most commercial lenders will negotiate caps on their loans.  For instance, in exchange for 2 points, they will guarantee that the interest will not adjust by any more than say 2%.  At times of high interest rates, doing this might mean that you miss out on a lower rate.  However, in 2013 the only way interest rates are going is up, which makes this a strategy that has value.

Once you know the worst case scenario % rate, you can throw a bit of cash flow at the mortgage to positively amortize it to arrive at a balance which will guarantee that your monthly payment stays even keel.  And if the rates are lower at the time of the adjustment, your payments will be lower.  This is a good safety play.  I do this all the time on notes for properties that I will be keeping for a long time.  Feel free to get back with me.  Good luck!

Chris Martin · Answer

In addition to Jon's Typically a lender is going to want to see... list, add a property appraisal, Certificate of Occupancy (a.k.a. CO from my prior post), and leases. These I would consider typical.

Jon Holdman · Answer

What do you mean when you say "borrowed from yourselves"?

Did you get permits for these renovations?  In my area, any renovations that involved adding units would have also required approval by the planning and zoning commission in addition to approval from the building department.  That's more than just being sure you're in compliance with zoning.  The last time I had to do this, they stamped and signed copies of my plans.  I don't know if unpermitted or unapproved additions will keep you from getting financing, but it can cause you problems with the city, including them potentially evicting your tenants.

Typically a lender is going to want to see:
- paycheck stubs for three months
- bank and brokerage statements for 2-3 months
- two years tax returns, they will make you sign a form giving them permission to request these from the IRS
- if you've opened any new credit accounts in the last year or two you may  have to write letters explaining why and what you bought
- HUD-1 settlement statement from when you bought the house
- Insurance policy

And who knows what else.  There's often something new and different every time.  The lender should tell you early in the process what they want to see.  But expect them to ask for additional stuff all through the process.

Watch out for running up your credit cards you're using for the rehab.  Ideally, keep the peak balance to under 30% of the credit limit (i.e, under 30% utilization).  Under 50% at the worst.  Above that and it starts hurting your credit score even more.

If you're wanting money to pay off the credit cards, you're doing a "cash out refi".  If you're just paying off loans that are already attached to the property, its a "rate and term" refi.  That's easier than a cash out.

Kerry M. · Answer

Thank you Jon Klaus, Pat L., Chris Martin and Jon Holdman for your replies.  
It is a relief to find that you all aren't alarmed at the financing terms; that the two loans mentioned might be close to the same terms but not understood by me very exactly.    I need to get closer to it.  I don't know what my plan would be for a balloon loan.  We are willing to sell one side of the duplex if needed.   Another question for you, as I prepare for asking for a bank loan, which documents do I need?  I am working with an accountant but there is so much to learn, I'm trying to find out the answers before asking him.  I am ordering books recommended here so that we can learn quickly.  I appreciate so much bigger pockets.
As far as the zoning, I made calls before starting the project to the county and spoke also to the state regulatory agency.  I have a copy of the county zoning and had a lawyer (family member) confirm that we were in compliance.  They list multifamily as 1-4 units.  We are zoned Residential and Commercial.  There is still an address on file with the county for the other half of the duplex.
It is a duplex that has not been used as a duplex for a long time, since anyone can remember.  The neighborhood is centrally located and about 100 years old but due to the geography, also isolated from the other cities' sprawl.  We were told (?) that HUD couldn't sell a duplex so they made a few walkthrough holes in the wall upstairs  to sell it.
Financing is another matter entirely.  We've done this in a straightforward way, but I need advice on how to get it right.  We bought cash (borrowed from ourselves) paid for renovations on credit cards and want to qualify for a bank loan to transfer the debt into a less expensive product.  The timing and reaching critical mass of getting the house for us was of paramount importance, is why we did it this way.  My goal is to land softly, if it is possible.

Bryan Hancock · Answer

7-year loan probably refers to the TERM and not the amortization period as others have stated.  I have never heard of a conventional lender using a 7-year amortization period.  I doubt that loan product would be very popular with borrowers given the higher debt service as others have stated.

Why a 7 year loan?

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