For most house flippers, hard money financing will make or break a deal. Unfortunately, we don’t all have tons of cash sitting around to fund flips. This makes screening and selecting a quality lender extremely important to investors. As such, I want to use this article to explain what to look for when selecting a hard money lender.
Hard money lenders approve loans based on the quality of the deal – not the borrower’s financial profile. Accordingly, before making a decision, house flippers should review a potential lender’s loan-to-value, target properties, loan repayment requirements, interest rates, and investor support.
In the rest of the article, I’ll cover the main considerations when selecting a hard money lender. Specifically, I’ll dive into the following topics:
- What Do Hard Money Lenders Do?
- Consideration 1: The Hard Money Lender’s LTV
- Consideration 2: The Lender’s Target Property Type
- Consideration 3: The Lender’s Target Location
- Consideration 4: Loan Repayment Requirements
- Consideration 5: Interest Rates
- Consideration 6: Support the Hard Money Lender Provides
- Final Thoughts
What Do Hard Money Lenders Do?
Before discussing selecting a hard money lender, I want to first provide an overview of this financing source. People frequently – and incorrectly – assume hard money loans are so named because they’re hard to get. The opposite is true. Borrowers can typically receive hard money loans more easily than conventional mortgages.
Rather, lenders provide hard money loans primarily against the hard asset – the property. With a traditional mortgage, lenders base their lending criteria largely on the borrower’s “soft assets.” That is, lenders assess a borrower’s income, credit score, debt-to-income ratio, and other personal financial information to make a loan decision. Basically, lenders want to confirm you can make your monthly debt service payments. If you’ve applied for a home mortgage before, you understand the cumbersome nature of this soft asset review process for borrowers.
On the other hand, hard money lenders base their decision on the quality of the deal itself – not the borrower’s personal financial profile. Generally speaking, these lenders provide loans for distressed properties that would not qualify for traditional financing. Real estate investors – often using fix & flip strategies – use these loans to purchase and rehab properties to bring them to traditional mortgage lending standards. As a result, hard money lenders look at the future value of these distressed properties, known as the after-rehab value (ARV). Lenders assess a deal’s ARV, and they base the amount they’ll lend off of that future value. As long as borrowers don’t have bankruptcies or judgments, their credit doesn’t impact hard money lending decisions.
The reason hard money lenders can focus solely on the deal – rather than the broader borrower profile – comes down to equity. With a traditional mortgage, lenders frequently provide 100% LTV (VA loans) to 96.5% LTV (FHA loans) terms. As such, if the borrower defaults and they need to foreclose and sell the property, they’ll likely lose money – not enough equity exists in the property.
Hard Money Loan Requirements
Hard money lenders typically provide far lower LTV terms. While each lender differs, we offer 70% LTV terms – based on the property’s ARV. This means that, if hard money lenders need to foreclose on a completed property, they’ll likely recoup their funds, as far more equity exists in the property.
But, as stated, hard money lenders base their LTV calculations on the ARV, or future value. Whereas habitable properties back traditional loans, distressed properties back hard money loans. This means that hard money lenders assume far more risk. More precisely, they assume the risk that A) the borrower fails to rehab the property as planned, and B) that market price comes in significantly below the projected ARV.
If a borrower fails to rehab a property and the hard money lender needs to foreclose, the lender now owns a distressed property – not the fully rehabbed property. This means that, to recoup funds, the lender needs to either continue the rehab or sell the property to another fix & flip investor, as it won’t qualify for traditional financing.
Less risk exists for the second scenario, that is, market price coming in significantly below the projected ARV. And, this directly results from the lower LTV. By lending 70% LTV based on the ARV, the actual sale price would need to drop more than 30% from the ARV for the borrower to not cover his or her loan. This provides hard money lenders a significant buffer against market volatility, assuming the borrower completes the rehab as planned.
What to Look For When Selecting a Hard Money Lender
I made this mistake as a new investor. I found what I thought were great deals, but I couldn’t find hard money lenders willing to approve a loan. Accordingly, I learned an important lesson: every hard money lender has different loan approval requirements and target properties. Before looking for a property, confirm what a hard money lender is A) willing to approve, B) requires for documentation to approve a loan.
As the above graphic illustrates, hard money provides some great benefits in terms of speed and flexibility. But, the likely approval characteristic is somewhat misleading. Rather, I’d say that you’ll likely have your loan approved by a hard money lender whose requirements you’ve confirmed. In other words, if a hard money lender only does deals in California, it doesn’t matter how good your New York deal is – it won’t be approved.
Having said that, there are a few items I recommend reviewing before selecting a hard money lender. In the remainder of the article, I’ll outline these considerations. Bottom line, before looking for deals, you need to find a hard money lender. And, before selecting a lender, you need to do your research.
Consideration 1: The Hard Money Lender’s LTV
One of the most important aspects of any hard money lender is the loan-to-value, or LTV, they’re willing to offer. This will drive the deal’s entire financing structure. As stated above, Do Hard Money offers 70% LTV based on a property’s after-rehab value, or ARV. But, you can’t assume that all lenders will offer these same terms. As a result, you’ll want to ask potential lenders two related questions:
Question 1: What LTV do you offer?
Say, for instance, Lender A offers 60% while Lender B offers 70% LTV. On a $200k loan, that 10% difference translates to a gap of $20k. For cash-strapped investors, that sum could make the difference between moving forward with a deal or not. Alternatively, a $20k smaller hard money loan could force you to bring on another investor to make a deal happen.
Question 2: Do you base your LTV on purchase price or ARV?
But, you also need to confirm the value a lender uses to calculate LTV. While we use ARV, some lenders use a property’s purchase price to determine LTV. And, as house flips inherently involve initially distressed properties, this difference can lead to a significantly smaller loan.
For example, say a hard money lender offers 80% LTV. At face value, this seems like an awesome percentage. But, when you do some digging, you confirm that this lender calculates LTV off purchase price, not ARV. So, let’s say you can purchase a home for $100k, spend $30k on the rehab, and sell it for $200k. Based on purchase price, 80% LTV translates to an $80k loan – $50k less than the purchase and rehab costs. Alternatively, 65% LTV based on ARV would translate to a $130k loan, which would cover the purchase and rehab costs.
Though I used simple numbers, the important takeaway here is the significance of how a lender calculates its loan amounts.
Consideration 2: The Lender’s Target Property Type
Next, you’ll want to confirm a hard money lender’s target property type. That is, what do they seek in terms of the following:
Many hard money lenders choose a particular home style to work with (e.g. single-family homes, duplexes, townhouses, etc.). As mentioned, I ran into this problem when starting as a house flipper. I’d find great deals, but I kept getting turned down by hard money lenders – “Sorry, it’s just not what we’re looking for.” So, if you have a particular type of home you’d like to flip, make sure the lenders you screen will support that style.
Related to style, many lenders have home price ranges that they’re willing to approve. For instance, a particular hard money lender may only approve loans for properties with purchase prices between $100k and $200k. Alternatively, a lender may set a range based on ARV, approving loans on homes with ARVs from $300k to $500k. Naturally, you’ll want to confirm that your target property prices align with the price ranges of a potential hard money lender.
Consideration 3: The Lender’s Target Location
Most lenders also limit themselves to a particular location, so the market you choose matters. For example, smaller hard money lenders may only approve loans in a particular city or county. Mid-sized ones may opt for more state-level or regional portfolios. And, national lenders like Do Hard Money will originate loans across the entire United States.
As a real estate investor, you’ll need to assess your own target market and ensure it aligns with a potential hard money lender. Trying to secure a loan from a California lender for a property in Utah won’t make much sense. And, in some respects, you can argue that finding a smaller, local lender may make sense, as they’re likely intimately familiar with your market.
On the other hand, significant advantages exist to working with a national hard money lender like us. Due to our size, we are able to scale the support we provide far beyond what a small, local lender can.
Consideration 4: Loan Repayment Requirements
Another huge item to consider with any potential hard money lender is the loan repayment requirements. That is, how will you need to pay off your hard money loan balance? This structure will have a major impact on your cash flow, so you should carefully review a lender’s terms before making a decision.
Broadly speaking, three hard money loan repayment options exist:
- Accrued interest with a balloon payment: With this model, the interest on your loan regularly accrues and rolls into the loan balance. As such, you don’t make regular payments while the loan is outstanding. Instead, you make a final balloon payment – typically with proceeds from a flip sale – that pays off the loan principal and all accrued interest.
- Interest only for the life of the loan: In this scenario, you make an interest-only payment every month. That is, your payments do not pay down the loan principal at all – just the interest on the outstanding balance. Then, at the conclusion of the loan term, you pay off the entire principal balance.
- Hybrid: As the name suggests, the hybrid model includes elements of both of the above repayment structures. Normally, a lender will provide an accrual period – often six months – where the interest rolls into the loan principal. Then, beginning after the accrual period, you make interest-only payments. At the conclusion of the loan, you use the flip proceeds to pay off the principal and any accrued interest.
Investors should note that any repayment structure including regular debt service will affect the cash-flow planning considerations of a deal.
Consideration 5: Interest Rates
As with any loan, real estate investors should closely consider the interest rates a hard money lender will offer. Seemingly small rate differences can lead to thousands of dollars (or more) in total debt costs. Accordingly, finding the best rates will help you maximize the profit you can realize on a particular deal. Rates are largely market driven, meaning you likely won’t see huge variances between hard money lenders. But, you should absolutely still shop around to find the best deal.
And, related to rates, many new investors often get “sticker shock” when they see hard money loan interest rates compared to conventional mortgages. Accordingly, I want to include the following section:
Why are Hard Money Loan Rates So High?
- No Government Backing: The majority of conventional mortgages are backed by the federal government. This government backing means that there’s far less risk associated with originating these loans. Consequently, lenders can afford to offer extremely low interest rates, because they know there’s government protection in the case of a borrower default.
- Asset-based Risk: When banks provide conventional 15- or 30-year mortgages, their loans are secured by a finished property. This is why an appraisal is critical to closing a conventional loan – the bank wants to ensure it’s not lending you more than the home is actually worth. In case of foreclosure, banks have recourse by selling a completed property at least worth the loan amount. Conversely, hard money loans are backed by what a property will become in the future, not what it is now. In essence, hard money lenders make their loans based on a vision of what a property will become. However, if the borrower defaults on the loan, you can’t foreclose on and sell a vision.
- No Income Requirements: With a conventional mortgage, borrowers qualify for a loan with their soft financial status, that is, their income and cash on-hand, in addition to the hard asset (the completed property). Lenders calculate borrowers’ debt-to-income ratios to ensure that they will have a certain amount of income every month to more than cover the mortgage payments (and any other debt payments). Hard money loans, on the other hand, only have a hard asset qualification – the target property and its projected post-rehab value. If the borrower defaults and fails to completely rehab the property, there’s no verified income available to pay off the loan. The only recourse the lender has is a partially completed property.
Consideration 6: Support the Hard Money Lender Provides
Lastly, real estate investors should ask what sort of support a hard money lender is willing to provide beyond issuing the loan. In other words, will a given lender help guide you through the house flip process, or simply issue the loan and wait for you to repay that loan?
At Do Hard Money, we do more than simply issue loans. And, because I believe so strongly in our model, I will shamelessly plug this support now.
We understand that most new investors need some help and guidance during their first deal. We provide this support. Our team will link you up with project managers and advisors to assist you through the entire fix & flip process. For us, we see this as a win-win:
- Win 1: We help new investors by giving them access to hard money loans for which they likely wouldn’t otherwise qualify.
- Win 2: By helping new investors, we help ourselves. We want you to succeed, as this lowers our risk as lenders. And, helping you along the way sets you up for success in that first deal.
With this philosophy in mind, we’ll guide and mentor new investors through the major steps of the fix & flip process:
Finding a Deal
As a house flipper – new and experienced – you’ll spend the bulk of your time trying to find quality deals with numbers that work for your investment goals. We understand this, and we help investors search and vet deals that’ll work for their situations. Of note, we offer an incredible resource for finding deals: Investor’s Edge. This software allows investors to search through over 160 million properties. Using your desired filters, you can narrow these properties down to the potential deals.
And, with a refined list of potential deals, you can market directly. The software lets investors print and mail postcards with pre-filled addresses. Or, if you prefer, you can send voicemail messages directly to property owners. This gives you the tools to bridge the gap between a great deal in theory and one in reality.
Finding Contractors and Confirming a Fix & Flip Budget
While we can certainly help you narrow down potential deals, investors eventually need to run accurate numbers. They need to A) find contractors, and B) confirm a fix & flip budget for a potential deal. Without contractor bids, everything is just back-of-the-napkin math. And, while that’s good for narrowing down lists, successful investors need to build and stick to accurate fix & flip budgets. Following an accurate and realistic budget is the key to executing profitable deals.
For new investors, vetting contractors and building a budget can be extremely overwhelming. We understand this (remember, we were new investors once, too!). Our advisors can help you find and vet reliable contractors in your area. And, we can guide you through the process of working with a contractor to confirm a rehab budget. This doesn’t need to be an overwhelming task. With the right amount of support and guidance, new investors work with contractors to solidify an accurate budget for the deal.
Closing on the Property
Once we help you confirm your fix & flip budget, we’ll move onto actually closing on the property. As stated above, hard money lenders don’t release loan funds in a single lump sum. Instead, they issue fund draws based on key milestones. Purchasing the home will be the first such milestone, and we’ll work with you to release these funds and close on the property.
Related to this, new investors may not be familiar with the legal aspects of a home closing. We can help. We’ve been doing this for years, and we intimately understand the legal and regulatory requirements of closing on a home purchase. We will use this experience to support you during the process – and make sure you’ve covered all your bases.
Conducting the Rehab
After closing on the property, our project managers will help you through the entire rehab process. Broadly speaking, this involves two tasks. First, investors need to supervise the contractor team, making sure key deadlines are met. And, second, related to this supervision, fix & flip investors need to monitor – and enforce – the rehab budget. For example, if your budget calls for $10,000 in all new appliances, buying a single refrigerator for $10,000 would blow your entire budget.
This may seem like an extreme example, but a small miscommunication with a contractor could lead to this sort of situation. By closely monitoring and enforcing your budget, you can avoid these inevitable communication SNAFUs. This requires attention to detail and organization, and we can set you up for success. We’ll help you implement the processes that we’ve used flipping houses for years, ensuring that you have an effective and efficient rehab period.
Marketing and Selling the Rehabbed Property
Lastly, investors need to sell their rehabbed properties. This is how you profit on a deal. In basic terms, the excess of the sales price over the purchase, rehab, and holding costs equals your profit. During the rehab process, you try to keep costs down. During the sale, you try to maximize the selling price. By doing these two things, you get the most profit possible from a deal.
However, pricing a property for sale has its own dangers. Price too high, and it sits on the market forever, increasing your holding costs. Price too low, and you may drastically cut into your profit. Unless you’re personally a real estate agent, we recommend working with an agent for the sale. Yes, the agent commission will cut into your profit, but we would’ve already helped you factor this into your budget. And, real estate agents can bring tremendous experience in understanding the local market – and pricing your rehabbed property accordingly.
Our team will help you connect with reliable real estate agents in your area. And, we’ll explain to you all the steps of this process, making you feel comfortable with the entire process – and maximizing your profit, to boot!
Clearly, there’s a lot to look out for when selecting a hard money lender. But, I can’t emphasize enough: this up-front due diligence on your part will pay huge dividends in the future. As I learned the hard way, it’s a fool’s errand trying to find deals before you’ve secured hard money financing. However, once you A) establish a relationship with a hard money lender, and B) confirm the approval requirements of that lender, you set yourself up for success. Simply put, it’s far easier to find a property in accordance with a lender’s criteria than find a lender in accordance with a random property.
As I like to say, no matter what path you take as a real estate investor, financing is king. Without access to reliable financing, the best deals remain nothing more than wishful thinking. As such, one of the most important relationships you can build as an investor is with a reliable, trustworthy lender.
The Do Hard Money team would love to build that relationship with you to help with your financing needs. Regardless of your situation and experience as a real estate investor, we can help you meet your goals. Drop us a note, and we’ll figure out the best way to support you on your real estate investing journey.