I did not choose my creative financing toolbox. My creative financing toolbox chose me.
My business partner and I began full-time real estate investing right out of college with no assets, no regular job, and little consistent income. But we still wanted to buy, sell, and eventually keep properties.
So, we were forced to look beyond the traditional path of walking into a bank and applying for a loan. We learned to use creative tools, such as seller financing, private loans, self-directed IRA loans, lease options, and more.
Ironically, after almost 14 years of investing in real estate, we still choose to use creative financing to purchase real estate. Just this year we’ve used seller financing, private loans, and self-directed IRA loans to make several purchases.
We can get bank loans now, and occasionally, we do when it makes sense. But creative financing is still our preferred source to finance investment real estate.
In this article, I’ll tell you why we prefer creative financing, and I’ll open our toolbox to share 5 of our favorite creative financing tools (a.k.a. the power tools). My hope is that you’ll add some of them to your own creative financing toolbox so that you can build more wealth and create more passive income for yourself.
Why You Need a Creative Financing Toolbox
Building your real estate investing portfolio is like crafting a custom home. You need a set of reliable and flexible tools in order to build a solid structure.
Like a hammer, traditional bank financing is a common tool that everyone knows how to use. And there’s nothing wrong with a hammer. If you have a nail, it sure is handy.
But I’m here to tell you that depending only upon bank financing for real estate investing is a handicap. It’s like building a house with one tool. It will limit your business over the long run.
Other investors with a larger toolbox that also includes creative financing will have a natural advantage against you. They will build their real estate portfolio faster, more consistently, and with a better long-term result.
Related: How to Use Owner Financing to Create Wealth And Grow Your Portfolio
There are multiple reasons why this is true. I’ll explain just a few here.
Real Estate Cycles
Real estate markets go up and down, often in 7-10 year cycles. The best real estate deals are found during the down cycles. Think about 2008-2009 when blood was in the streets and good real estate deals were plentiful.
But guess what? Down cycles are when banks lend the least money. Even if you recognize good deals, your ability to buy them will be limited if you can’t borrow money. On the other hand, creative financing smooths out the curves of these cycles and works during up and down times.
For example, in the downturn of 2009, we were able to obtain plentiful private financing from individuals who were scared of the stock market and sick of tiny bank CD rates. At this time when banks would not loan money against investment real estate, our private lenders felt very secure with tangible real estate that produced rent far in excess of their interest payment.
At the same time, many sellers couldn’t get rid of their properties. They were much more open to seller financing during the down cycle than they would have been before. So, rather than working against us, the down real estate cycle actually improved our ability to finance deals creatively.
Do you know how you can tell that a bank is in control of your lending relationship? Because their army of attorneys wrote the enormous book of papers you sign at a loan closing. You get the privilege of signing the papers as-is, or you can take a hike!
That big stack of papers is all about transferring risk. The attorneys working for the bank essentially transfer as much risk as possible from the bank to you. The risk equation may be out of balance in the bank’s favor, but the terms are not negotiable.
On the other hand, everything is negotiable with creative financing. It’s possible to find win-win agreements with sellers, private individuals, or small businesses who are willing to finance to you. These agreements can reduce your personal risk and still satisfy the needs of the other party.
Lack of Control
Success in real estate investing depends upon consistently being able to acquire funding for new deals. But the application and approval process for bank financing is largely outside of your control. Today you may be able to get seven loans, but tomorrow the policy may change to five. And the changes do not always make sense.
On the other hand, creative financing is limited only by your ability to find good deals and to prove yourself to the individuals providing the financing. With your hustle and intelligence unleashed by creative financing, the potential upside of your investing business is virtually unlimited.
Lack of Speed
Ignoring all of the other problems above, bank loans are just too slow. For the best investment acquisitions, you must move very quickly. But bank loans require drawn out application processes, appraisals, and multiple layers of approval.
By the time you finish the first step of your traditional bank application, I will have already used creative financing to close the deal. For example, we recently closed a deal in three days. We would have been lucky to get a return call from the bank by the time we already bought the property!
The Basics of Creative Financing
Luckily, adding creative financing tools to your toolbox is not rocket science. You probably already know the basics. If you have used a promissory note, a mortgage, a deed of trust, or a lease, you understand the fundamentals of how creative financing works.
But there is still a learning curve to understand the nuances and the unique applications of these tools. Almost daily in the Biggerpockets Forums, a newbie investor complains that a local closing attorney or title company refuses to close their creative financing deal or says that what they’re doing is illegal.
While I can empathize with the situation, my hunch is that most new investors really don’t understand the tool themselves. It’s like this closing attorney sees a small child climbing up to turn on a power saw. The attorney may not know how to use the power saw either, but he knows enough to scream “stop!” before the child cuts off his finger!
So, the goal of my explanations below is to make you more familiar with five of the most common and useful creative financing tools. I will share diagrams and examples that will explain how the tools are used. Once you get the basics, you can then study them more in depth from sources like Brandon Turner’s No Money Down book, the creative financing forum here on BiggerPockets, or my favorite teachers like John Schaub.
I’ll begin to unpack these creative financing tools by explaining the tool you’re probably all familiar with, traditional bank financing.
A Picture of a Traditionally Financed Closing
If you’re going to be able to understand creative financing and explain it to a skeptical attorney, real estate agent, or seller, you need to first understand each piece of a typical transaction.
The diagram above shows the relationship between all of the parties of a typical closing. There are four primary entities involved:
- The Buyer (you, if purchasing an investment)
- The Bank (lender)
- The Closing Agent (an attorney or title company)
In this example, a purchase and sale agreement was signed at some point before closing between the buyer and seller. The price was $50,000. Also before closing, a loan commitment agreement was made between the buyer and the bank. The loan was $40,000, and the buyer provided $10,000 or 20% as a down payment.
The closing attorney or title company uses these pre-closing agreements to oversee the closing transaction (a.k.a. escrow) to ensure the other three parties are treated fairly per the terms of their contracts. The items actually exchanged between the parties include:
- Money — from the bank to the buyer (a loan)
- Two contracts, a promissory note, and a mortgage (or deed of trust in some states) — from the buyer to the bank
- A deed — from the seller to the buyer
- Money — from the buyer to the seller
For those of you already investing, this may seem basic. But it’s important to start here before doing transactions that are a little more creative because these creative tools use the same basic format.
Now I’ll unpack my 5 favorite creative financing power tools from my toolbox.
Power Tool #1: Seller Financing
In the picture above, did you notice the main difference between a seller financing transaction and a transaction with a bank loan? Obvious, right? There is no bank!
Related: How to Use Owner Financing to Create Wealth And Grow Your Portfolio
In fact, technically, there is not even a loan. As you can see, the seller never gives the buyer any money like a bank would. Instead, the seller just agrees to let the buyer pay the purchase price over time with monthly installments (i.e. an installment sale).
In exchange for this financing arrangement, the seller (not a bank) receives the promissory note and mortgage as security.
The beauty of this arrangement is that there are only two parties — the buyer and the seller. The seller does not have loan committees, underwriters, or Fannie Mae-conforming rules.
You make an offer to the seller, the two of you negotiate, and if it makes sense for both parties, you move forward.
But how common is seller financing, really? Well, Ben Leybovich, a well-known creative financing writer here on BP who I respect, once wrote that seller financing is rare and usually only used on ugly pig properties. While I normally nod my head at Ben’s articles, I shook my head and chuckled at this one. Maybe Ben has been looking under the wrong rocks.
It’s true that seller financing is not as common or as easy to obtain as more traditional tools. It’s also true that seller financing does not make a bad deal magically turn into gold. But don’t let its difficulty dissuade you from its ultimate value.
Seller financing is…