New real estate investors typically do not have boatloads of cash to purchase properties. Instead, they look to commit their available capital as efficiently as possible. As such, investors frequently ask me: Ryan, do I need cash reserves to apply for a loan?
It depends. If using a traditional lender to purchase an investment property, you’ll likely need cash reserves. This protects the lender if you have property problems or an extended vacancy period. On the other hand, hard money lenders generally do not require cash reserves for fix & flip loans.
I’ll talk more about cash reserves requirements for different loans in this article. Specifically, I’ll cover each of the below topics:
- Cash Reserves, Defined
- Cash Reserve Requirements for Traditional Mortgages
- Cash Reserve Requirements for Hard Money Loans
- Requirements for Cash Reserves after a Hard Money Loan
- Final Thoughts on Cash Reserves
Cash Reserves, Defined
Simply put, cash reserves include any money you have set aside that you can use to make debt payments. Lenders typically measure this in terms of months of payments. In other words, if an amortizing loan calls for $1,000 monthly payments, $6,000 would equal six months of reserves ($6,000 / $1,000 = 6 months).
And, most lenders who require cash reserves do not mandate that borrowers keep them in cash. That is, you don’t need to keep your reserves in a savings or checking account. Rather, these reserves need to be highly liquid assets, which means they can be quickly converted to cash. As a result, stocks, bonds, and mutual funds held in a brokerage account would also generally qualify as cash reserves, as you can sell those quickly to convert them to cash.
But, investors should also recognize the inherent volatility of these assets. Bottom line, you don’t want to be forced to sell stocks when they’re down, as you’d potentially realize a significant loss. For this reason, I highly recommend that investors keep the bulk of their required reserves in high-yield savings accounts. These may not provide the same upside as stocks, but you’re protected from losses if you need to tap the funds quickly.
Conversely, assets like real estate, restricted (not-for-sale) securities, and precious metals generally will not qualify as cash reserves. These assets lack the necessary liquidity to meet lender requirements. They just can’t be converted to cash quickly enough. However, some lenders may accept gold or silver as cash reserves. If you can document value via a formal appraisal, lenders may accept a portion of your precious metal value towards a reserve requirement. More likely, though, the lender will require you to convert these metals to cash before closing the loan.
Cash Reserve Requirements Requirements for Traditional Mortgages
Now that I’ve defined cash reserves, the question remains: do lenders require them? Well, it depends on the type of loan. For a traditional mortgage loan on an investment property, the lender will absolutely require cash reserves. However, the specific requirements for those reserves will vary based on several factors.
Depending on the unique situation, lenders will require anywhere from two months to a year of reserves for a traditional mortgage on an investment property. The size of the home, the borrower’s credit score, the loan-to-value, and the number of other outstanding mortgages in the borrower’s name will all factor into the required reserve. In simple terms, the more risk the lender assigns to you as a borrower, the larger the required reserve.
Cash Reserve Requirements for Hard Money Loans
If you want to purchase a distressed property to rehab, a traditional lender won’t work with you. These lenders only issue loans for ready-to-occupy homes. Instead, you’ll need to work with a hard money lender to finance the purchase and rehab of a fix & flip property. And for the most part, hard money lenders do not require any cash reserves.
These lenders don’t mandate cash reserves as a result of the way they structure their loans. With a traditional mortgage, you receive a single lump sum to purchase a property. For the lender, this makes these loans riskier, because if a borrower defaults, the lender is “all in” on the deal. Hard money lenders, on the other hand, don’t provide their loans in a single sum. They structure them based on draws.
For example, assume a hard money lender agrees to provide you a loan based on a $300,000 after-repair value, or ARV. Of note, the property isn’t currently worth $300,000—it will be following the rehab period. And most hard money lenders issue loans of 70% LTV based on this ARV. In this case, the hard money loan would total $210,000 ($300,000 ARV x 70% LTV).
But, the investor won’t receive this $210,000 loan up front. Instead, the hard money lender will place the funds in a separate escrow account. Then, as the investor hits certain milestones in the rehab process, he or she will submit draw requests. These requests will include detailed accounting of all contractor work to that point in time, and the lender will authorize the release of a tranche of funds based on that work done to date. As such, hard money lenders don’t provide more than they can recoup via foreclosure, which makes cash reserves largely irrelevant.
Furthermore, many hard money lenders will even delay a borrower’s repayment schedule. For example, at Do Hard Money, we build five months of payments into all of our hard money loans. This means that investors have a five month buffer to get their deals going before needing to start paying interest.
Requirements for Cash Reserves after a Hard Money Loan
Investors using hard money loans do need to understand cash reserve requirements after their hard money loan period. With fix & flip investors, this isn’t an issue. Once they sell a rehabbed property, they use a portion of the proceeds to pay off the hard money loan.
BRRR investors will, in fact, need cash reserves to pay off their hard money loans. Like fix & flip investors, these investors buy a distressed property to rehab. But, rather than sell it, they rent it out then refinance into a traditional mortgage. They use these refinance proceeds to pay off their hard money loan and, potentially, put some cash into their pockets. Due to the fact that they refinance into traditional mortgages, they’ll need to meet the cash reserve requirements of these lenders. As a result, BRRR investors need to anticipate cash reserve requirements above and beyond any cash they need for the deal itself. Refinancing depends on these reserves.
Final Thoughts on Cash Reserves
While investors absolutely need to understand their cash reserve requirements, they also need to be aware of other cash requirements. For one, investors need cash to cover their loan closing costs. Additionally, diligent investors should keep cash reserves on hand—aside from lender requirements—to cover property contingencies.
What happens if your property sits vacant for longer than anticipated? Do you have the cash to cover debt service and other expenses? Or what if the air conditioner breaks? Do you have several thousand dollars (or more) available for the repairs? While cash reserves are often a lender requirement, savvy investors understand that having cash on hand also provides peace of mind. Requirement or not, you should absolutely keep a reserve as a real estate investor.