What Is a Hard Money Loan?
The very definition of a hard money loan derives from the fact that these loans are secured by a “hard asset.” Real estate, land, or some other physical commodity with a clearly defined value are the typical types of assets used as collateral to secure a loan. Private lenders require a tangible asset to secure financing. These asset-based loans are designed to provide an alternative to traditional lending when a borrower’s liquid assets are not substantial enough to qualify.
Even though there is collateral to back the loan, most lenders consider these asset-backed loans a greater financial risk, which is why interest rates are slightly higher. Many unforeseen circumstances during the project renovation could sway the course of the project. Natural disasters, issues with contractors showing up, materials not delivered on time, or a dip in the market might impact the borrower’s ability to repay the loan.
Many borrowers turn to hard money financing due to lack of credit history, poor credit, or perhaps they are overextended. Tying real property to the loan reduces the risk for the lender. Other borrowers find hard money loans attractive due to the expedited nature to obtain financing. Every keen investor knows how important it is to secure financing quickly to capture that great real estate deal before it’s gone.
How do Hard Money Loans work?
Hard money lenders employ different measures when lending since they lend mainly based on the collateral securing the loan. The application and underwriting process is much simpler than traditional loans and closing occurs within a much shorter timeframe.
Real estate investors needing to finance a quick flip find hard money financing an attractive option despite the fact they are more expensive. Experienced flippers understand hard money financing makes it easier to purchase a property, pay contractors to get the job done, and list it for a quick resell. Most hard money borrowers have a detailed investment plan that involves making a considerable profit, while also ensuring the lender is repaid on time.
On the other hand, if time goes by without the project completed or the property not selling, these high-interest loans could become quite expensive. Borrowers should know upfront the costs for extending a loan and evaluate the risks accordingly.
In short, hard money loans are a great option for serious investors who want to cut through the red tape and get a rehab project funded fast. Savvy investors know how to scrutinize the various loan programs, interest rates, and fees so they don’t end up paying too much for the loan.
How Can you Qualify for a Hard Money Loan?
Hard money loans are a perfect solution for borrowers when traditional lenders are not an option. While loan requirements will vary from lender to lender, basic qualifications are in some ways like those of a traditional mortgage.
1. The hard asset
The value of the property and its resale value are two primary factors a hard money lender considers when evaluating a loan. Some lenders will collateralize the loan by requiring a first lien position to ensure they are the first paid if the borrower defaults. Most private lenders will factor the loan-to-value ratios (LTV) to determine if the asset provides the means for repayment. With the average LTV at or around 65% of the appraised property value, a borrower could expect a loan in the $160K range for a property with a $250k resale value.
The after repair value (ARV) is another factor some lenders might use when determining loan funding. Experienced real estate investors know how to estimate the cost to rehab a property, the project timeframe, and can calculate what the property will sell for once the renovation is complete. Lenders will use these key metrics to determine the amount of financing and calculate risk, which in turn affects the interest rates. In some instances, the borrower will finance all or part of the rehab costs. The hard money loan becomes somewhat riskier if the lender provides the capital required for improvements, triggering a higher interest rate in some cases, for less experienced borrowers. Ultimately, it is up to the investor to decide if the loan rates are justifiable based on the profitability of the rehab project.
2. Personal finances
Despite allowing for a less stringent underwriting process, hard money lenders want to ensure the loan is secure and borrowers meet basic loan requirements. Many lenders will want to examine a borrower’s debt-to-income ratio to ascertain the probability of loan repayment. Not all hard money lenders will run a credit check, but even a credit score in the mid-600s will get most borrowers funded. Naturally, the higher the credit score, the lower the interest rates and vice versa. Credit may also establish the overall loan program a lender offers.
While a borrower’s credit score does not entirely impact the final decision on hard money financing, some lenders might want to see the borrower's previous two years of income tax returns. This gives lenders a sense of general income, and whether the borrower has a steady revenue stream to cover the monthly loan and interest payments.
Cash reserves and down payment will also be required for the approval process. The more money provided by the borrower increases the prospect of funding and likely lower the interest rates. Just like a traditional mortgage, private money loans still call for a down payment and closing costs to secure the loan. Borrowers that can show adequate cash on hand by providing at least three months of bank statements or a certified letter from the bank are likely to get funded faster. Not all hard money lenders request bank statements; however, many will require at least three months of statements.
Compiling a well-organized loan package will make lenders take notice. At a minimum, plan to include LLC documentation, purchase contract for the property, renovation plans, licensed contractor bids, draw schedules, and a project timeline. Private lenders are more confident lending to an organized investor who is prepared to begin the project once funded. They know this also increases the likelihood they will be repaid.
4. Investor Experience
Lenders are much more confident when funding real estate investors with extensive flipping experience. Investors who can share a proven and profitable track record of projects completed within suitable timelines and controlled rehab costs are attractive to private lenders. A successful series of flips puts the borrower in a stronger position to obtain the best loan terms.
Less experienced borrowers will endure greater scrutiny and likely pay higher interest rates and fees. One possible way to counter this and secure lower fees would be for the borrower to increase the down payment amount. Offering to put down between 35% to 40% might be enough for some lenders to lower rates and offer a better loan program.
5. Plan of Action
Investors who finance fix and flips should have a clear timeline for the project renovation. A successful exit strategy should also include a sales timeline and a realistic resell price. It is equally important to include the time most properties sit on the market, listing price, and final sales price when researching comparables. Creating a conservative exit plan helps establish the length of the loan required and, more importantly, provides a repayment timeframe for the lender.
Finding a Hard Money Lender to Work With
Borrowers should evaluate their financial situation before seeking financing. Some key things to determine before approaching a lender:
● The amount of funds available for a down payment.
● Rehab project time frame, which determines loan duration.
● When is the intended sell date for the property?
● Who will do the work and how much will be done by the investor?
● What is the expected profit margin?
Word of mouth is the best way to find a lender. Contact fellow investors for a referral. Someone who is new to the game should consider attending a local real estate investor meeting. Lenders often frequent these meetings, which provides the opportunity to ask preliminary questions in a non-formal setting. Not to mention, most real estate investors will readily share their lender experiences – good or bad.
For those not connected with other investors, an internet search might suffice. Reputable lenders usually supply testimonials from current and/or former clients on their website. In addition, most respected lenders will post their various loan programs, along with a list of criteria. Another indicator of a trustworthy lender is whether they share information about the company. Who are they? How long have they been in business? What is the company’s mission or attitude toward serving its clients? The more information a lender provides, the easier it is to decide if they would be a suitable fit.
Lastly, borrowers should verify the lending requirements. It is critical for investors to confirm they meet the lender's expectations when it comes to down payments, interest rates, loan duration, and penalties. Most reputable hard money lenders will clarify all terms upfront. It is important to take notes during negotiation to make sure the original terms quoted remain the same throughout the entire lending process.
Borrowers should continue to communicate often with a lender, even after the loan is secured. If a lender requires certain documentation throughout the project, furnish it as soon as possible. It also helps to keep them up to date on how the project is progressing. Establishing a great working relationship between borrower and lender makes funding the next deal much easier.