Real estate investors cannot use traditional financing to purchase distressed properties to flip. As a result, you can either use cash or a hard money loan to finance these deals. Most new investors don’t have enough cash to self-finance, so people often ask me how to qualify for a hard money loan.
The most important factor in hard money loan qualification is the deal itself. Hard money lenders want to ensure they have enough equity secured to protect themselves in case of default. And, they typically guarantee this by not lending more than 70% of a property’s after-rehab value, or ARV.
In the rest of the article, I’ll dive into a detailed review of how to qualify for a hard money loan. Specifically, I’ll cover the following topics:
- Qualifying for Hard Money Loans
- How Hard Money Loans Work
- The Importance of Off-Market Deals
- Other Hard Money Qualification Considerations
- Final Thoughts
How to Qualify for a Hard Money Loan
As stated above, the most important aspect of hard money loan qualification is the deal itself. This confuses a lot of first-time investors. Many of these people have purchased primary residences before, and they assume that the hard money process is the same.
But, this just isn’t the case. Traditional lenders deep dive into your financial health, confirming that you’ll be able to continue repaying a loan. Rather than focus solely on the property, they concern themselves more with your income, credit score, debt-to-income ratio, and other “soft” assets. And, after confirming these details, many traditional lenders will lend significantly high loan-to-value (LTV) mortgages, especially for owner-occupied properties.
Hard money lenders, on the other hand, focus solely on the “hard” asset, that is, the property. If they can secure enough equity in the home, they’ll issue the loan. And, most of these lenders base this equity on the after-rehab value, or ARV. That is, they look at market comps to appraise the value following the rehab, and they typically will lend up to 70% LTV on that number. Accordingly, hard money lenders protect themselves with a far higher secured stake in the underlying property.
For example, if a property appraises with an ARV of $300,000, the hard money lender will qualify you for a $210,000 loan ($300,000 ARV x 70% LTV). If you can buy, rehab, and sell this property for $210,000 or less, you both A) qualify for the loan, and B) can entirely finance the deal with hard money.
Traditional Financing
Now that I’ve provided a brief overview of the hard money process, I want to dive more into the details. And, to understand what hard money lenders do and how they approve loans, it helps to understand traditional financing first. With these mortgages, lenders like banks and credit unions issue loans based on two broad criteria:
- The borrower’s “soft” assets: These include the borrower’s general financial picture. Lenders will want to ensure that credit scores, income, debt-to-income ratios, and cash reserves all meet certain minimum standards. Basically, lenders want as much assurance as possible that the borrower has the ability to continue making payments.
- The property itself: If a borrower defaults on a loan, that is, stops paying, the bank still wants its money bank. For this reason, lenders require formal home appraisals during the mortgage loan closing process. They want to make sure that they’re not lending you more than the house is actually worth. That way, if you stop paying, they know that they can foreclose on and sell the property, with the proceeds paying off the loan balance. In this vein, most traditional lenders will not provide mortgages for homes in need of major repairs.
Due to this rigorous qualification process, traditional lenders will issue loans up to 100% LTV (VA loans) or 96.5% LTV (FHA loans). Simply put, these lenders do not need to secure huge equity stakes in a property, as they’ve conducted thorough enough due diligence to confirm that a borrower has the financial capacity to make loan payments.
Qualifying for Hard Money Loans
Now that I’ve provided a brief overview of hard money loans and, for comparison’s sake, traditional financing, I’ll discuss the best ways to qualify for a hard money loan. As stated, hard money lenders don’t care about your financial health (as long as you don’t have judgments or bankruptcies on your credit history). Rather, they want to make sure you have a quality deal. That is, a property’s ARV justifies your requested loan amount. In other words, a hard money loan application shouldn’t exceed 70% of a property’s ARV if you hope to qualify.
Having said that, here are a few techniques I recommend to help you qualify for a hard money loan:
- Confirm lender requirements – early!: 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 slightly different 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.
- Establish a relationship with a general contractor: Hard money lenders assume increased risk due to the fact that their loans are secured by distressed properties. As such, they’ll want to confirm that you have a detailed, feasible plan to rehab the property from its “as-is” state to finished product. And, they’ll confirm this by reviewing bids from a general contractor (GC) outlining exactly A) what work you’ll do, and B) how much it’ll cost. If you have an established relationship with a GC, it’s far easier to get this information to the hard money lender for review.
- Understand the numbers: While hard money lenders may not worry about your financial health, they do want to confirm your competence. That is, can you accurately and realistically run the budget numbers on a house flip? If you show up with shoddy or overly optimistic numbers, most lenders won’t have much faith and confidence in your abilities to execute a successful rehab. At The Investor's Edge, we understand how challenging this can be for new investors, so we’ve created a house flip calculator to help!
How Hard Money Loans Work
While the above provides an overview of what hard money lenders do, it helps to see a concrete example. Assume you find a great deal on a distressed property. It’s selling for $120,000, and you think that with a $100,000 renovation and sale budget, you’ll be able to sell it for $310,000. With a little back-of-napkin math, that’s a nice $90,000 profit.
But, as you don’t have $220,000 cash for the purchase and repairs, you apply for a hard money loan to cover these costs. While you think you can get $310,000 for the property after the rehab period, the hard money lender will need assurances from an ARV appraisal. You submit all of your contractor bids, and the professional appraiser determines ARV to be $300,000 – $10,000 less than your initial estimate.
With a $300,000 ARV, the hard money lender (assuming 70% ARV loan), will lend you $210,000 ($300,000 ARV times 70%). However, your deal budget totals $220,000. This means that, to move forward with the deal, you’ll need to put in $10,000 cash to cover the difference between the $210,000 hard money loan and your total budget.
This is a common situation with hard money loans. That is, you’ll typically need to find funds in excess of your hard money loan. Frankly, it’s extremely difficult to find the sort of awesome deal that a hard money loan will 100% cover. This reality means that most investors have other financing techniques to meet their budget needs above a hard money loan. While not a comprehensive list, investors can do the following to bridge the gap between a hard money loan and deal budget:
- Put their own cash into the deal.
- Use a business line of credit.
- Use a home equity line of credit.
- Use a home equity loan.
- Bring on limited partners.
The Importance of Off-Market Deals
When it comes to the deals the hard money lenders want to support, experienced real estate investors understand that seeking properties on the Multiple Listing Service, or MLS, just doesn’t work.
Most new real estate investors understand the MLS. That is, if you’re looking to buy an investment property, you’ve probably already purchased a primary home. And, when you bought your home, there’s a good chance you worked with a real estate agent. This agent probably took your general search parameters (e.g. price, area, size, etc.) and gave you tailored access to the MLS where you could scroll through every listed property meeting your search criteria.
While this system works great for finding a primary home, finding investment properties on the MLS rarely works. More precisely, due to the following three reasons, investors will struggle to find good deals on the MLS:
- Competition: In theory, if you work with a real estate agent (or are a real estate agent), you can access MLS data from anywhere in the world. Accordingly, when investors try to find potential deals on the MLS, they’re really competing against three different parties: 1) primary home buyers, 2) other local investors, and 3) out-of-market investors. This situation significantly drives up the competition for MLS properties.
- Property Condition: While you can buy investment properties on the MLS, you’re unlikely to find a distressed property that will qualify for a fix & fix deal. People primarily list properties on the MLS for primary home buyers, meaning that these homes need to qualify for traditional financing. In other words, they are not distressed properties in need of repair. Instead, most MLS properties are in good enough condition to meet standards required by traditional lenders.
- Price: Related directly to property condition, MLS properties generally have prices that don’t support a fix & flip budget. Rather, these homes list at retail price. This means that, even if an investor does find a property to rehab, there’s a good chance that its price will not support a deal budget.
The Benefits of Off-Market Deals
Instead of dealing with the challenges associated with MLS properties, successful investors understand the value in finding off-market deals. In other words, they look for properties that A) fit their investment criteria, but B) haven’t been listed for sale.
Searching for deals in off-market properties presents two primary advantages. First, as these properties aren’t listed on the MLS, they inherently have less competition. In most situations, when you approach a potential seller, you’ll be the only investor making an offer. This lack of competition leads directly to the second major advantage: price. Off-market properties fitting an investor’s criteria will typically have major repair needs. Between these needed repairs and the lack of competition, sellers do not have the leverage to command retail prices.
Bottom line, successful investors understand the importance of crafting a strategy to find off-market homes. But, as I’ll explain in the next section, finding these homes is only one part of the problem.
Investor’s Edge
At The Investor's Edge, we absolutely recommend our software, Investor’s Edge, for finding off-market deals and connecting with motivated sellers. Yes, we’re biased, but we firmly believe that we’re justified in this bias. We poured our entire team’s collective real estate experience into creating the best software for investors. This program provides you access to over 90% of the MLS data in the US market, to include tax records, active properties, and sold property information. Simply put, Investor’s Edge provides you the MLS data you need to make informed real estate investment decisions.
Finding potential deals doesn’t equal actually closing those deals. Once again, we’ve poured our combined decades of real estate experience into our software to address this problem. With Investor’s Edge, you can market instantly to homeowners. As you narrow down your list of potential deals, our software lets you print postcards with pre-filled addresses or send a voicemail directly to these homeowners – for your entire property list! While not every homeowner will respond to you, the ones who do are likely truly motivated sellers.
Driving for Dollars
And, for another solid way to find off-market deals, I love a strategy I call “driving for dollars.” Simply put, you hop in your car, drive around some neighborhoods, and identify homes that look like potential deals. You may find a distressed property or one that looks abandoned. Regardless what type of property you’re seeking, driving around for a couple hours every week will help you find plenty of opportunities. And, we’re so confident in the potential of this technique that we’ve built a Driving for Dollars app to help!
This app helps achieve two major objectives: 1) find potential deals, and 2) connect with motivated sellers. With respect to the first, the app tracks your progress through a geographic area, helping make sure you don’t miss any streets – or potential deals! Second, the app seamlessly integrates with the above Investor’s Edge database of over 160 million potential deals, which gives you the ability to connect with the owners of homes you identify while driving for dollars.
More precisely, with Investor’s Edge and the Driving for Dollars app, you can market instantly to homeowners via printed postcards with pre-filled addresses or automated voicemails. This system lets you efficiently bridge the gap between a potential deal and putting a property under contract.
Other Hard Money Qualification Considerations
I touched on it briefly above, but I want to reiterate some additional hard money considerations here. While lenders don’t concern themselves with your general financial health, certain red flags do exist that will likely prevent you from qualifying for a hard money loan. In particular, these lenders will want to confirm that you:
- Are not in collections: If you have an outstanding judgement against you and are in the collections process, most hard money lenders will not provide you a loan. These individuals simply pose too much of a risk of repayment.
- Have no bankruptcies: If you have a bankruptcy on your record, you also likely won’t qualify for a hard money loan – for the above reasons. Of note, bankruptcies only stay on your credit report for seven years. So, while you certainly want to avoid them, having one doesn’t prevent you from qualifying for a hard money loan for life – just seven years.
- Have no major criminal background: Hard money lenders will absolutely run a criminal background check on investors. Minor misdemeanors can be waived on a case-by-case basis, depending on the nature of the crime. However, if you have a felony on your record, it’s highly unlikely that a lender will approve your hard money loan.
Final Thoughts
Hard money loans provide real estate investors an incredible way to quickly and efficiently finance a house flip. But, before applying for one of these loans, it’s important to understand how to qualify for them. For hard money lenders, loan approval depends on the deal itself. If you can find a good deal, one that can be completed for 70% of the ARV or less, you’ll likely qualify for the loan.
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