Hard Money Made Easy

Hard Money Made Easy

How To Leverage Your Cash and Make More Deals!

You probably already know conventional loans and government backed loans represent the primary and the least expensive way to finance real estate purchases for first time home buyers, primary residence buyers, and investors. Although, if you have even a little experience in real estate, you already know other more expensive, but also more flexible financing options, are available to investors.

Alternative financing has grown exponentially in the last few years, driven by the fact banks require several weeks to approve a conventional loan, and impose stricter and stricter qualification criteria to their borrowers. Furthermore, conventional lenders prefer to finance owner-occupied and well-maintained properties, not run-down homes needing to be fixed and flipped. So, if you are a primary residence buyer, with good credit and income, a conventional loan may be your best bet; but if you are a rehabber who identifies a distressed property, and wants to purchase it quickly to beat the competition, a conventional loan is out of the picture. Okay, then what are your other options? A very popular and effective strategy is called hard-money loans.

What is hard money?

Hard money is private financing. Hard money lenders have access to large sums of capital coming from private individuals that loan them out in real estate. Hard money loans are asset-based loan where the funds that the borrower receives are secured by the value of the real estate asset. There are many differences between the way hard money lenders and banks evaluate the deal and structure the loans as far as qualifications, amount of the loan, length of the loan and costs. Let’s explore them a little more in depth.

Qualifications

When you apply for a conventional loan, a bank will strictly evaluate your income and credit, employment history, and cash-flow. If based on these and other lending criteria you’ll be considered a good borrower, they will lend you the money.

Hard money lenders don’t care as much about conventional lending criteria; they are more interested in the deal you are making. The most important factor for them is not your credit or income, but the value of the real estate collateralized. What is the collateral of the transaction, and what is marketability? How easily can it be refinanced or sold during the loan term? Those are common questions a hard money lender asks before lending you the money. Another important factor analyzed is the ‘capacity’ of the borrower, which means the borrower has the ability to repay the debt and has a sound exit strategy to pay off the loan before it comes to maturity. They may analyze common lending criteria, as well, but if the deal works and you have a good exit strategy in place, poorer credit will take second place.

Some people think hard money lenders want you to default on the mortgage and take the property. Even though it is true there are unscrupulous lenders out there, the majority of them are not interested in your property at all. They like to be the bank, they make their money in the lending business, and they want the short term interest to pay to their investors, not a property sitting on the market to add to their portfolio.

Costs

At the present moment conventional loans (30 year period) rates are less than 5%. Hard money loans are supported by private financing and rates are definitely higher, ranging from 12% to 20% depending on the lender. In addition to that, lenders charge from 2 to 10 points (1 points equals 1% of the total loan amount) to the amount of the loan. Even though hard money loans are expensive compared to traditional loans, it’s important to understand that interests and points are not the primary factor in many deals. For example, if you are not going to have the loan for a short period of time, the impact of a higher interest rate is greatly reduced. Real estate investors know that the return of investment plays a much more important role in their success than interest rates by themselves.

Beyond points and interest rates, which should be very clear from the beginning, there can be other fees involved when you take on a hard money loan. Some are legitimate, some aren’t, and you need to be aware of them because they can add up to the loan very quickly. Ask your lender which are the fees are applied and understand them before applying for a loan.

According to Ken Strunk at Lions Mane Investments legitimate fees are:

Loan origination fee, underwriting fee, processing fee. Almost every lender has them. They are predetermined upfront fees that can vary from lender to lender, usually from $500 to $1500. Originating a loan requires time and dedicated staff to prepare the paperwork, underwriting documents, etc…If the deal fails, the lender still need to cover these expenses.
Broker fees. If a broker helps you as an investor to find the money to make the deal connecting you to the lender, the lender normally charges one point on top of the loan as a broker referral fee.
Legal fees. When an attorney looks at the documentation, you will always charge a legal fee. Even though it’s a legitimate fee, you should be aware of the amount, as it can vary consistently.
Draw inspection fees. It means that an inspector is sent out to certify that the work has been done correctly. The primary goal of a lender is to protect the investors behind him, so it’s important the quality of the job done by your contractor is approved by the lender.
Late payment fee. If you pay late, you will be charged a penalty like on every other loan type.
Renewal fee. It’s very important to know the length of the loan. Many loans are made for a six month period. In this case, if your rehab project needs a seventh month to be completed you are going to pay a renewal fee. Some hard money lenders offer 12 months loans, so the possibility of incurring in renewal fees is more limited.
Foreclosure fee. If the loan fails and the lender needs to take legal action, you are going to pay the legal costs.

Junk fees are:

Referral fees. Because hard money lending is a business that is strongly based on referrals, some lenders factor in a referral fee. Although referrals fees are a common practice, they should be considered as marketing expenses and they should not be paid by the borrower.
Upfront inspection fees. Some lenders send their general contractor to inspect the property and confirm the rehab budget. This is a non-refundable fee, normally around 750 dollars. Considering that the property is going to be already inspected and the budget estimated by a third party appraiser, this is just redundant. The borrower should not pay the same service twice. Most lenders do not charge this fee, be aware of those who do.
Pre-payment penalties. Some lenders charge a pre-payment penalty if you pay off the loan before a certain date. The reason is they want a certain minimum return on their investment. For example if you take on a loan with a pre-payment penalty at 4 months, even if you are able to sell your property in 30 days you will still need to pay the interest for the entire 4 months period.
Loan servicing fees. This cover the cost of servicing a loan, collecting payments, keeping records, providing reports. This should be a service offered by a lender and already factored into the loan amount, but some lenders do charge an additional fee.
Loan closing fee. Some of the lenders will charge you to close your loan. In common opinion, you should not be paying if you are extinguishing your debt on time.

Loan Amount

Conventional loans lend normally 80% of the home’s value (considering a standard 20% down payment), while hard money lenders can loan up to 60-70% of the After Repair Value (ARV). Let’s say you are purchasing a home for $150 K, factoring $25 K for repairs you estimate that the market value (equal to the ARV) will jump to $250K. Considering 70% of the ARV the lender will be able to lend up to $175 K.

In the hard money lenders arena, some will offer loans that cover entirely both the purchase and the rehab price without requiring any down payment, although most of them will not. The reason is that many lenders are more prone to lend if the borrower has some ‘skin in the game’, which basically means they can cover 15-20% of the project. This is seen as a form of stronger commitment of the borrower to be successful in the deal.

Loan Length

While conventional loans have a life of up to 30 years, hard money loans are much shorter, ranging normally from 6 to 12 months depending on the lender. Hard money loans are in fact not made for long term financing. Although primarily used by ‘flippers’ who are in and out of the deal in a very short time, these loans can be compatible with other investment strategies. Let’s say a buy-and-hold investor wants to purchase a property with the goal of fixing it up and turning it into a rental, but the property is distressed and does not qualify for a conventional loan. In this situation hard money can be used as a strategy to close the deal quickly, make repairs, and then refinance the property with a conventional and less expensive loan.

Here is how it works

Hard money is a way to leverage other people’s money to increase your return on investment and rapidly grow your business. The advantages are, as we said before: rapid funding of loans, flexible term structure, possibility to get funds when the bank refuses a conventional loan. Let’s examine the same purchase of a property first ‘all cash’ and second leveraging hard money.

ALL CASH.

The purchase price of the property is $180,000 , and with $45,000 of repairs the estimated ARV is $320,000. Considering closing costs of $6000 the total cost of the deal amounts to $231,000. After 5 months the property is completely renovated and sold for $320,000. In this scenario profits will be $89, 000 (ARV minus total costs) with a return of investment of 38%.

HARD MONEY LOAN.

Instead of coming to the closing table with $231,000 you are just required a down payment of $40,000 (approximately 17 % of the purchase plus rehab cost). When the property is sold after 5 months, considering the costs of the loan, principal, interest and fees, your profits will be roughly $39,000. Because the only cash brought to the deal was the down payment $40,000 the ROI reaches 97%.

Hard money loans will allow you to enter the same deal with only $40,000 compared to the $231,000 of the previous scenario. It’s true that your profits are higher in the all cash deal, but your ROI is definitely not. Also, $231,000 will be entirely locked into the project until you sell the property, while if you choose hard money, only your down payment will be locked into the deal. This means that if you have other funds available you could invest in more deals at the same time greatly improving your ROI and multiplying your profits.
In conclusion, hard money lenders are a great resource for investors and every serious investor should have a good hard money lender as part of his team.

If you want to know more about hard money lending contact Ian Barnes at Fortitude Funding. If you have experience with hard money loans and you want to share it with us, please leave your comment, or meet us in person at Capitol Investors.

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