Newer investors to real estate are often asking us about hard money loans. Commonly used by professional investors to purchase real estate, hard money loans are quite different from your traditional mortgages and can be advantageous to your real estate investing career if utilized correctly.
Traditional mortgages are underwritten by federally backed lending institutions and are often backed or insured by the government, such as the Federal Housing Administration (FHA) or U.S. Department of Veterans Affairs (VA). Traditional mortgages have strict underwriting standards and lenders will underwrite your purchase based on their analysis of your ability to pay back the loan through careful screening of your income, credit score, and other personal variables. These mortgages are tailored towards borrowers with good credit scores and may take anywhere from 30 days to several months to process. Loans backed by FHA or VA may take additional time to close and pass inspections compared to a conventional loan.
On the other hand, hard money loans are financed by private entities, often a company or individual, rather than a bank. We call them hard money loans because the underwriting parameters are primarily tied to the value of the hard assets that the loan is being taken out to purchase. This allows hard money lenders to approve loans quickly and provide financing for not only the upfront purchase price but also most remodeling costs if a home needs to be rehabbed. In addition, credit scores, income and other personal information are less important considerations for hard money lenders. Instead a hard money lender looks at real estate specific metrics such as ARV, LTC and DSCR to determine the loan you qualify for. The loan term is much shorter than a traditional mortgage, often maturing between 6-18 months with extensions as needed.
When should you use hard money?
The most common reason people will use hard money loans is to purchase real estate. This is a loan vehicle that is used for a short time period and is refinanced when the property is resold or converted into a rental property.
A common real estate investment strategy is referred to as the “BRRR” method, an abbreviation for Buy – Repair – Rent – Refinance. Real estate investors take out a hard money loan to fund the purchase and repair costs and refinance the loan with a conventional or rental property loan when the property is ready to rent. In the hard money world, rental property loans are typically referred to as “buy and hold” loans.
For those who invest in real estate to fix and flip properties, a “fix and flip” hard money loan can also offer a number of benefits to help facilitate the process.
Here are a few reasons that you would choose a hard money loan rather than a traditional loan in your financing:
- Speed. In real estate investments, time can often be a major factor in taking advantage of good opportunities. A traditional loan process takes longer to obtain and in a competitive process, financing contingencies will often lose you the deal. Hard money lenders can close deals within a week, allowing you to offer a quick close to the seller or even compete with cash buyers.
- Flexibility. You can obtain a hard money loan for investment properties that may not be able to pass the inspections necessary for a traditional mortgage. This can be a major benefit in cases of complete renovation, where the property will not pass inspection now but will be rehabbed to the point that a traditional mortgage can be financed later.
- Short Term. Traditional financing options are usually terms of 15, 20, or 30 years. In cases where the loan is only intended to help the investor in the short term, a hard money loan option may be ideal. This is often the case for a fix and flip or a rental property that needs major upfront renovations.
- Low Credit Score. Traditional financing options are often not available for someone with a low credit score. Personal financial information may be overlooked with a hard money loan because the debt is secured by hard assets rather than your projected ability to make monthly payments.
- Down Payment. While most hard money lenders will require some down payment, particularly for new investors, hard money lenders are underwriting to metrics like the ARV. If you find an investment opportunity with a very attractive discount to the ARV, you could be in a situation where a hard money lender will finance your purchase and rehab costs at little to no money down.
- High Debt to Income Ratio. As noted above, if you have a high debt to income ratio, it may be overlooked in the process of applying for a hard money loan but will often be a cause for denial in a traditional loan application.
What does your hard money loan cover?
A hard money loan is not the best choice of financing for a property that you purchase as a permanent residence. However, you might consider using a hard money loan to rehab a residence and then refinance when the property meets the criteria for a traditional loan. Because hard money loans are often granted at a higher interest rate than standard federally backed loans due to the shorter term, if you're looking for a mortgage to purchase a home that you are living in, there may be more cost-effective ways to finance the purchase of your home. Some traditional mortgage lenders we would recommend include:
[Traditional mortgage click-outs]
Hard money loans usually have a shorter timeline for full repayment. This makes them the ideal solution for someone who wants to purchase a property to renovate and sell. They also make an excellent bridge loan for an investor who wants to purchase and rehab a property that will not pass the inspections for a traditional loan as-is. The bridge loan allows you to purchase and renovate before refinancing with a more traditional loan option.
What do all of the ratios mean?
In real estate, there are many terms that may seem confusing to the novice or new investor. But the ratios are important to understand because they have a direct bearing on possible financial implications of your purchase and investment.
Here are a few of the ratios that are important to understand:
- ARV. ARV stands for the after repair value. This is the projected estimate of what the property will be worth after it has been renovated. You can calculate the ARV by comparing that property to comps in the surrounding area. In finding comps, you will need to consider the differences in age, architecture, property size and condition of the home in your evaluation. Ideally, you should look for properties with the same configuration and condition to base your ARV estimates on.
- LTC. LTC stands for Loan to Cost, which compares the total loan amount to the cost of the overall project. You can estimate your down payment by subtracting the LTC from 100%.
- LTV. LTV stands for loan to value. This compares the total loan amount to the total value of the property after completion.
- Points. At closing, mortgage points may be paid to the lender in order to bring down the interest rate of the loan. Mortgage points may also need to be paid to cover closing costs and other fees.
- DSCR. The DSCR, or debt service coverage ratio, assesses the operating income of a business or property in regard to its ability to pay for the debt servicing fees. The DSCR is most commonly used for buy and hold loans rather than fix and flip loans.
What are the typical hard money terms?
All loans can carry their own specific terms and it is important that you thoroughly understand every financing agreement you enter. In general, hard money loans will include the following terms.
- Term. These loans are set in 6, 12, or 18-month terms. In contrast, traditional mortgages are set in 15, 20, and 30-year terms. Most loans will also provide flexibility for 6-month extensions after the original term expires.
- Interest Rate. Hard money loans have higher interest rates than traditional loans due to the shorter term. Most hard money loan rates will range between 6-12% APR and vary depending on your prior real estate experience and the financial metrics discussed above.
- ARV. Up to 75%.
- LTC. 90% of purchase price and up to 100% of renovation costs. Some lenders offer no money down options.
- Loan Size. $50,000 and up
- Intended for Investors. Buyers who want to own and live in a property for an extended time frame usually opt for traditional financing. Hard money loans are intended for investors who are flipping a property or those who are buying property to renovate and then refinance.
How do I find a good hard money lender?
There are a number of ways that you can find a reputable hard money lender in your area. Often word of mouth or recommendations can be excellent places to star. You can also contact a real estate person in your area who specializes in investment properties for a recommendation or work with an agent overall to find properties and connect you to financing options.
We’ve done the legwork for you and compiled a list of our top choices for hard money lenders in your area based on reputation, loan terms and customer service. Click here to see our list.
