Debt Financing and How Loans Actually Work

Jan 31, 2019
real-estate-investing

Book: Real Estate by the Numbers: A Complete Reference Guide to Deal Analysis Authors: J Scott and Dave Meyer Chapters: 28-30

← Capital Stacks and Equity Financing | Debt Metrics: LTV, LTC, DSCR, and the Loan Constant →

Most people buy real estate with a loan. That’s just the reality of how this works. But “getting a mortgage” covers a lot of ground. There are many types of debt, many ways loans can be structured, and a surprising amount of math behind what looks like a simple monthly payment.

These three chapters break all of that down. Chapter 28 covers what debt financing is and its pros and cons. Chapter 29 runs through the main types of loans. Chapter 30 gets into how loans actually work at the math level. Let’s go.

What Is Debt Financing?

Debt financing is just borrowing money. You get a loan from a lender, you use it to fund a deal, and you repay it over time with interest. The lender makes money through that interest. You get access to capital you wouldn’t otherwise have.

The big difference between debt and equity: debt does not give the lender any ownership in the deal. The bank doesn’t own your property. They have a legal right to take it if you stop making payments, but as long as you pay, they have no say in how you run the investment.

Debt is at the bottom of the capital stack (from the last post) because it gets paid first. That makes it lower risk for the lender. In exchange, the lender’s upside is capped. They earn the agreed-upon interest and nothing more, even if your property doubles in value.

Is Debt Bad?

Some people in the personal finance world are very anti-debt. And for consumer debt like credit cards, that’s reasonable. But debt used to fund an income-producing investment is a different thing.

The question isn’t “is this debt?” The question is: “Does this debt help my returns or hurt them?” We’ll get into that math in later posts. For now, the key is knowing that debt can be a useful tool when it’s the right type, at the right cost, used the right way.

Pros and Cons of Debt Financing

Pros:

You keep full ownership. The lender has no stake in the deal.
The terms are clear up front. You know exactly what you owe and when.
The cost is defined. You can calculate your interest expense in advance.

Cons:

All the risk is yours. If the deal goes badly, you still owe the full amount.
It pulls cash out of your pocket every month. Loan payments are required whether or not the property is performing.
It limits future borrowing. Once one lender has a first lien on a property, getting a second loan on the same asset is harder.
Most lenders cap at 75-80 percent of the deal. You’ll almost always need some equity too.

Types of Loans

Here’s a rundown of the most common loan types real estate investors encounter.

Conventional Loans

These are standard mortgages from banks, credit unions, or private lenders. Usually fixed or adjustable rate. Thirty-year terms are the most common, but fifteen and twenty years are also common. The shorter the term, the higher the payment but the less total interest you pay.

Best for: personal homes, traditional rentals, short-term rentals, BRRRR deals.

FHA Loans

These are government-backed mortgages through the Federal Housing Administration. They allow smaller down payments, as low as 3.5 percent. In exchange, you pay mortgage insurance premiums, which add up over time.

Key thing to know: FHA loans are only for owner-occupied properties. You can’t use them on a straight rental. But if you’re house hacking or buying your own home, they can help you get started with less cash.

Portfolio Loans

A portfolio loan is one the bank keeps on its own books instead of selling on the secondary market. Because it doesn’t get sold, the bank can set its own terms. That usually means more flexibility: looser credit requirements, properties in poor condition, self-employed borrowers.

The trade-off: portfolio loans typically come with higher interest rates or fees to compensate for the extra risk the bank is taking.

Hard-Money Loans

Hard-money loans come from private companies or individuals, not banks. The “hard” refers to the hard asset (the property) being used as collateral. The lender cares more about the property value than your credit score.

These loans close fast and are flexible, but they come with high interest rates and short terms. They’re designed for deals where you intend to sell or refinance quickly, like a house flip or BRRRR project. Getting stuck on a hard-money loan for a long time can eat your profits fast.

Private Loans

Private loans are between two individuals or private entities. Could be a friend, a family member, or a private lender in your community. They can be structured in almost any way both parties agree on.

Always get a proper contract, even when borrowing from people you trust. This protects both of you.

Crowdfunding

Multiple investors each put in a smaller amount to pool together financing. Online platforms have made this much more accessible over the past few years. It’s becoming a real alternative to banks and hard-money lenders.

Seller Financing

Sometimes the seller of a property is willing to act as the lender. If the seller owns the property free and clear, they can essentially loan you the purchase price, you make payments to them, and they earn interest. Good for buyers who have trouble qualifying for bank loans. Good for sellers who want a higher price and a steady income stream.

Lines of Credit

A line of credit is different from a term loan. Instead of borrowing a fixed amount upfront, you get access to a pool of money that you can draw from and repay as needed.

HELOC (Home Equity Line of Credit): You use the equity in your home as collateral to secure a line of credit. Because of that collateral, the interest rates are usually low, similar to mortgage rates. Very common for funding rehabs or down payments on other properties. The risk: if you don’t make payments, the bank can foreclose on your house.

Business Line of Credit: For established businesses with revenue. Not for startups.

Personal Line of Credit: Unsecured, so harder to qualify for and higher rates. Useful for short-term cash flow issues, not long-term investing.

Revolving Debt (Credit Cards)

The highest interest rates of any debt type. Fine for short-term expenses you’ll pay off in a month or two. Otherwise, avoid using credit cards to fund real estate investments.

How a Loan Actually Works: The Anatomy

Chapter 30 gets into the math, and it’s worth knowing even if you use a calculator for everything. Understanding what’s happening behind the scenes helps you make better decisions.

Principal and Interest

Every loan payment has two parts:

Principal: The amount you borrowed. Paying this down reduces what you owe.
Interest: The lender’s profit. This doesn’t reduce your balance.

The goal as a borrower: pay as little interest as possible. That means getting a lower rate, a shorter term, or both.

Here’s an example from the book. Julia buys a $400,000 property, puts 20 percent down, and gets a 30-year conventional mortgage at 5 percent.

Loan amount (principal): $320,000
Monthly payment: about $1,718
Total paid over 30 years: about $618,000
Total interest paid: about $298,000

That means Julia pays nearly double her original loan amount over 30 years. The bank earns $298,000 as its profit. This isn’t a scandal, it’s just how loans work. The question is whether the investment returns justify that cost.

Amortization

Here’s something that trips a lot of people up. Even though Julia’s monthly payment is the same every month, what’s inside that payment changes constantly.

In month one, most of her $1,718 goes to interest. Only a small amount goes to principal. That’s because interest is calculated on the remaining balance, and at the start, the balance is highest.

As she keeps paying, the balance goes down, the interest charge goes down, and more of each payment goes toward principal. By the last few years of the loan, almost all of her payment is going to principal.

This is the amortization curve. Early in a loan, you’re mostly paying the bank. Later, you’re mostly paying yourself (building equity).

Why does this matter? Because paying down principal builds equity. Paying interest doesn’t. If Julia sells her property after five years, she’ll have built up equity from both her original down payment and the principal she’s paid off over those five years.

Balloon Loans (Partial Amortization)

Not every loan is fully paid off by the end. A partially amortized loan works like a regular loan for a while, but at a certain date, the remaining balance is due all at once. That lump sum is called a balloon payment.

These are common in commercial real estate. For example, a loan might be amortized over 30 years (low monthly payments) but have a maturity date of 10 years. You make 10 years of payments, then owe the remaining principal balance in one shot.

Why would anyone want this?

Two reasons:

Lower monthly payments. You’re acting as if you have a 30-year loan, but you’re only borrowing for 10 years. Cash flow is much better in the early years.
Less total interest. You pay off the loan in 10 years instead of 30, so you pay far less interest overall.

The risk: If you can’t make the balloon payment when it comes due (either because you can’t refinance or the market has dropped), you’re in serious trouble. Many investors plan to refinance before the balloon hits, but that depends on interest rates and the market cooperating.

Interest-only loans are an extreme version of this. Every payment is pure interest. The principal never goes down. When the loan matures, you owe the full original balance. Very low monthly payments, but the balloon is the entire loan amount. These are used when cash flow in the early stages matters a lot.

Here’s the Thing

Understanding how loans work is not just academic. It directly affects what deals you can fund, how much they cost, and what your returns look like. Knowing the difference between a fixed-rate 30-year conventional loan and a hard-money balloon loan changes how you analyze deals.

The next posts build on this foundation. We’ll look at the key metrics lenders and investors use to evaluate debt, and then show how borrowing money can either boost or drag down your returns.