If you are a real estate investor, you most likely need cash to finance your deals. One option is a hard money loan. Is a hard money loan the best solution, or is there a better option?
What is a hard money loan?
Unlike traditional mortgage financing, a hard money loan is a loan that is based primarily on the underlying value of the asset, namely the property. A traditional mortgage lender will look at your credit score, income, and debt to income ratio.
Hard money lenders only care about the “as is” value of the collateral, i.e. the property being financed. Very rarely do they look at other factors.
How much can you borrow?
Some people believe that you can borrow 100% of the purchase price with a hard money loan. This is definitely not the case. There is one exception to this. A hard money lender will loan up to 70% of the value of the property. The loan is usually around 65% of value.
If you can find a property that is priced at 65% of market value, a hard money lender may lend you 100% of the purchase price. Needless to say, those kinds of deals are extremely difficult to find.
Who are the hard money lenders?
Hard money lenders are usually investment funds that are run by an investment manager. He or she manages the fund on behalf of investors. As such, the investors expect a fixed return on their investment.
Unlike private money, which we will discuss later, hard money lenders have rigid standards that are designed to maximize the return on investment.
What are the costs of a hard money loan?
The interest rate of a hard money loan can be between 10 and 15% per annum. This is significantly higher than a traditional first mortgage.
Hard money lenders can charge between 3 and 5% of the loan in origination fees. Some lenders may waive the fee if you have a good track record with them.
Closing costs on a hard money loan are comparable to a standard bank mortgage.
Why is the interest rate so high?
This is the obvious question. There are primarily 2 reasons;
1) No fixed loan period.
When you take out a hard money loan, it can be paid off at any time without penalty. The hard money lender incurs costs underwriting the loan. Not only does the lender have to recoup the costs but he must turn a profit that satisfies the expectations of its investors.
2) Less stringent underwriting standards.
Because the hard money lenders only look at the value of the underlying collateral, the risk of loan default is higher. Therefore the interest rate has to be higher to compensate for the additional risk.
Hard money lenders, like banks, are in the business of risk management. They are constantly looking for the best return on investment with the lowest possible risk.
Assume for a moment that you are looking to buy a property, renovate it, and resell it. The hard money lender is going to look at 4 variables before they approve the loan.
1) Skin in the game.
The lender wants to know how much of your own money you are putting into the deal. The more you have at risk, the less likely you are to default on the loan.
Is this your first deal, or have you done this many times before? It makes a difference to the lender.
3) Track record.
The lender will not only look at your experience but also at your success rate. How much profit did you make on your last deal? How long did it take for you to complete the renovations? Were the payments made on time?
4) Ability to pay.
If you are a new client, and this is your first deal, the hard money lender may look at your income to verify that you have the ability to make the monthly payments and repay the loan.
Keep in mind that the last thing the lender wants to do is foreclose on the loan. Foreclosures are expensive and time consuming for the lender. During the foreclosure period, the lender receives no payments and the return on investment suffers. In the end, the lender will likely get his money back but once all the costs of foreclosure are deducted, he will be lucky to break even.
Is a hard money loan right for you?
Because of the high interest rate, hard money loans are usually short term in nature. They are definitely not suited to long term mortgages. Hard money borrowers fall into 2 categories.
1) Real estate investors with multiple mortgages.
If you are a real estate investor that owns 4 properties with mortgages on each property, it is almost impossible to get approved for a traditional first mortgage by a bank. There are ways around this but that is the topic for another discussion.
2) Buyers who need funds for renovation.
Suppose you bought a property and paid cash. However, you need funds to complete the renovations. You could go to a bank and get a small first mortgage but that is time-consuming and expensive when the costs are amortized over a short period of time.
You will pay a higher rate with a hard money lender, but if you only need the cash for a short period of time, say 3 months or less, the actual financing costs will not be that much more. Because the underwriting standards are lower, the loan will likely be approved quickly.
FHA 203k Loan
If you bought a property to flip and you do not have enough cash to cover the cost of renovations, one option is an FHA 203k loan. This type of mortgage allows you to build the renovation costs into the mortgage. FHA will look at the “as is” value and compare it to the market value of the renovated property and finance a percentage of the difference. For more information on 203k loans, go here.
Depending on your circumstances, there are more attractive options. If you are buying a property with the intention of holding it over the long term, a traditional first mortgage is the best option.
However, if you are either a real estate wholesaler or flipper, there are a couple of other options that you might consider.
The difference between hard money and private money is that private money usually comes from an individual such as a friend, family member, or even the seller himself.
If the seller holds the property free and clear, you might submit an offer where the seller will hold the first mortgage for a fixed period of time at a slightly higher interest rate. In this environment of low interest rates, a seller might find that very attractive.
Suppose that you purchased a property to wholesale and you have already found a buyer. You only need a loan for a few days or maybe even just a few hours to close the buy side of the deal before the sale of the property is closed to the end buyer. This used to be called a bridge loan. It is now referred to as a transaction loan.
You can obtain a transaction loan provided that you have a signed contract from the seller and a signed contract from the end buyer. The transaction lender will loan you the cash to close the deal but you will still be required to make a down payment of 10 to 20%. The transaction lender will usually charge between 2 and 3% of the loan value.
The Bottom Line
Regardless of which financing option you choose, it all comes down to making the numbers work. Not only do the numbers have to make financial sense, but the risks have to be factored in. Make sure that you have a sufficient cushion built in to be able to handle any unforeseen problems that may occur.