New real estate investors often assume that successful investing requires hundreds of thousands of dollars in capital. In reality, experienced investors take advantage of leverage, typically using hard money loans, to make deals happen. But, before blindly applying for a hard money loan, you need to conduct your due diligence. In particular, there are certain questions I highly recommend asking. As such, I’ll use this article to outline the questions to ask hard money lenders.
You should ask hard money lenders questions about the property types they’ll finance, as some only focus on specific types. Next, you should ask about the loan terms offered (e.g. LTV, max loan amount, ARV or purchase price, repayment etc.). Lastly, a good lender should provide support to investors.
In the rest of the article, I’ll dive into the details of different questions to ask hard money lenders. More precisely, I’ll cover the below topics:
- Hard Money Lender Overview
- A Hard Money Lending Example
- Questions to Ask Hard Money Lenders
- Final Thoughts
Hard Money Lender Overview
An Overview of Hard Money Loans
Before discussing questions to ask hard money lenders, I need to provide a general overview of how hard money lending works.
Hard money exists as an alternative to traditional financing (i.e. your standard, 30-year home mortgage). And, hard doesn’t mean challenging. Rather, it means that these lenders solely concern themselves with the “hard” asset, that is, the property itself.
As stated, traditional lenders require minimum standards with the borrower’s “soft” assets. Hard money lenders don’t concern themselves with this. These lenders look at a property and ask, what will this property become? They base their decision to lend on the projected after-repair value (ARV) of a property.
This system provides real estate investors two key advantages. First, you can secure a hard money loan even if you don’t have a great credit score (but, lenders likely won’t work with you if you have bankruptcies or judgements in your credit history). Second, you can use hard money loans for distressed properties, making them ideal for fix & flip and BRRR investors.
Traditional lenders want to confirm that, if foreclosed upon, a property will cover the loan balance now. Hard money lenders assume more risk. They lend based on what they believe the property will be worth in the future. While each hard money lender offers different terms, at The Investor's Edge we’ll lend up to 70% of a property’s ARV. As such, if a borrower fails to successfully rehab a property, hard money lenders need to recoup their outstanding loan balance with a distressed property sale. And, selling a property in the middle of a repair likely won’t pay off the outstanding loan balance, as the loan was based on what the property would become.
Due to this increased risk and the shorter term nature of hard money loans, they have higher rates than traditional mortgages. Depending on your investing history and the quality of the deal, you can expect an interest rate from 7.99% to over 15%. However, investors can also close these loans extremely quickly. Most traditional mortgages typically require 30 to 45 days to close. You can close a hard money loan in less than a week.
Lender Criteria
I touched on it above, but hard money lenders only have a few criteria regarding personal background when reviewing an investor’s loan application:
- 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.
- 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.
- 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.
Assuming you clear the above hurdles, hard money loan approval really just comes down to two items. First, what loan-to-value (LTV) terms will a lender offer. That is, how large of a loan will they provide, based on a property’s ARV. This leads directly into the second item hard money lenders closely scrutinize: a property’s ARV.
ARV Appraisals
Once again, hard money lenders base their loans on what a property will be worth. But, how do you value something that doesn’t exist yet? To do this, hard money lenders require an ARV appraisal prior to issuing a loan.
With a standard appraisal, appraisers look for recent sales comps for the property in its current state. ARV appraisals also include “as-is” comps and determine an “as-is” value. But, they also account for the planned renovation and what the house will look like after they’re complete. More precisely, an appraiser will analyze your submitted contractor bids for work, find properties that have had similar levels of work, and determine an ARV based on those comps.
While more expensive than standard appraisals, these ARV appraisals provide hard money lenders the information they need to determine how much they’ll lend.
A Hard Money Lending Example
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 $120k, and you think that with a $100k renovation and sale budget, you’ll be able to sell it for $310k. With a little back-of-napkin math, that’s a nice $90k profit.
But, as you don’t have $220k cash for the purchase and repairs, you apply for a hard money loan to cover these costs. While you think you can get $310k 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 $300k – $10k less than your initial estimate.
With a $300k ARV, the hard money lender (assuming 70% ARV loan), will lend you $210k ($300k ARV times 70%). However, your deal budget totals $220k. This means that, to move forward with the deal, you’ll need to put in $10k cash to cover the difference between the $210k 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.
Questions to Ask Hard Money Lenders
But, before choosing a hard money lender, I recommend doing some initial screening. At a minimum, you should ask the following questions:
Question 1: What is the maximum LTV you will offer?
Depending on the amount of cash you’re willing to contribute, this will make or break a deal. And, from a return on investment perspective, the more leverage you can use in a deal, the larger your return on contributed capital. (NOTE: Increased leverage also increases risk, which is why we harp on the importance of properly analyzing deals before committing).
As stated above, The Investor's Edge offers terms of 70% LTV. Alternatively, say a lender offers you 65% LTV terms instead. On a property with a $300k ARV, that 5% difference translates to a $15k smaller loan – potentially the difference between the hard money loan completely covering your costs or needing to secure additional gap financing.
Question 2: Do you base LTV on purchase price or ARV?
In addition to the actual LTV, you need to ask potential lenders whether they base these calculations on ARV or purchase price. While most hard money lenders base their LTV calculations on ARV, not all do. And, this difference can lead to tens of thousands of dollars in reductions in hard money loans.
For example, say you purchase a distressed property for $100k, think you can put $50k into it, and then sell it for $200k. If the appraiser confirms this $200k ARV, The Investor's Edge would offer a $140k loan. Conversely, say a lender offers 80% LTV – seemingly high – but bases it on purchase price. This lender would approve a hard money loan of $80k, meaning you’d have to either A) put a significant amount of your own cash into the deal, or B) secure gap financing to cover the difference.
Question 3: What is the maximum loan amount you will offer?
This relates directly to the above questions. For instance, a hard money lender may offer 75% LTV loans – a fairly high standard. At first glance, this seems like a great opportunity, as you can finance a larger portion of a deal than a 60% or 70% lender will allow. But, if that same lender caps maximum loan amounts at $150k, you’ve significantly limited your pool of available deals.
Question 4: Do you finance a particular type of property?
Many hard money lenders focus their lending on a particular property type, normally something with which they have a lot of experience. I made this mistake as a new investor. I found what I thought were great deals, but I couldn’t find a lender interested in those properties. As such, I learned the hard way – it’s better to find out what sort of properties a lender will finance before you go out looking for deals.
Question 5: Do you only lend for properties in certain geographic areas?
As with traditional lenders, many hard money lenders focus their lending activities in certain markets. Smaller lenders may only lend for properties in and around certain cities, significantly limiting the pool of available properties. But, these smaller lenders may also have an advantage in market familiarity and ability to provide local support.
Next, some lenders offer loans for larger regions or nationwide. These expanded lending markets open up the pool for potential properties. But, it may also mean that a particular hard money lender has less understanding of a particular market. Fortunately, though, most hard money lenders that operate nationally are large enough to provide significant administrative support for their borrowers, even if they don’t have a “boots on the ground” presence in a given market.
Question 6: How do you handle loan repayments?
This is massively important. Some lenders require monthly interest (or principal and interest payments) after a certain amount of time. This can seriously challenge your cash flow and disrupt your deal’s budget. Alternatively, at The Investor's Edge, we accrue all interest up front, meaning that investors pay everything off at once at the end of a deal, which simplifies the budgeting and cash-flow process.
Question 7: How do you handle loan draws?
With a traditional mortgage, you receive a single lump sum to purchase a home. Lenders can accept this risk due to the quality of the property serving as collateral. In other words, they’re providing you loans on a completed, ready-to-occupy home in need of no or few repairs. That way, if you stop paying your mortgage, they can foreclose on the property, sell it, and recoup the entire loan balance.
Hard money lenders, on the other hand, use distressed properties as collateral. And, these lenders base their loans on what a property will become. Say for instance, you qualify for a $210k hard money loan based on a $300k ARV. That property isn’t currently worth $300k – or, likely, even $210k. Therefore, if a hard money lender needed to foreclose on the property, they wouldn’t recoup their entire $210k balance.
To account for this reality, hard money lenders issue loans in increments – known as draws. For example, you may receive your first draw to purchase the home. Then, after completing a certain percentage of the repairs, you may receive a second draw. When the work is finished, you’ll receive your final draw.
Every hard money lender structures these draw requests and the associated milestones differently. These procedures will significantly affect your cash flow during the renovation period. As a result, it’s critical that you understand a lender’s draw procedures and requirements.
Question 8: What support, if any, do you provide to your borrowers?
Next, 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 The Investor's Edge, 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.
Question 9: Do you have any net worth or liquidity requirements?
One of the primary advantages to using hard money lenders is that you generally don’t need a ton of cash to complete a deal. Rather than reviewing your personal financial health, hard money lenders approve or deny loans based on the quality of the deal itself.
Unfortunately, though, some lenders do have net worth or liquidity requirements. For example, a lender may not approve hard money loans unless the borrower is worth $500k. Or, another may say that you need to have at least $100k in cash or cash equivalents on hand. While these are just example figures, the important takeaway is that you need to ask if a hard money lender imposes these sort of requirements.
Question 10: What are your origination fees and interest rates?
Hard money lenders make money through the origination fees and loan interest. Before signing a loan application, you’ll want to confirm exactly how a given lender structures them both:
- Origination fees: These are the fees a hard money lender charges to actually originate, or put together, a loan. Loan originations take time and administrative effort, and lenders require compensation for this work. Depending on the lender, these fees can be charged as 1) a flat fee, 2) a percentage of the loan amount, or 3) a combination of these options.
- Loan interest: This is what lenders charge for letting borrowers use their money. In conceptual terms, interest is how lenders are compensated for the risk they’re taking by lending money. And, hard money lenders assume greater risk than traditional mortgage lenders, because these loans are secured by properties that still need to be renovated. If a borrower defaults prior to completing the rehab, private and hard money lenders need to foreclose on a partially-rehabbed property. Due to this increased risk, these lenders charge higher interest rates than traditional lenders.
Question 11: Do you charge a loan application fee?
Related to the above fees, some lenders will charge you a hard money loan application fee. I highly recommend that you avoid a lender who charges such a fee. Confident and established lenders do not need to nickel and dime potential borrowers with loan application fees, understanding that they will instead make money through successful deals. Instead, lenders that charge these sorts of fees are typically unreliable at best and downright fraudulent at worst.
Question 12: Do you offer recourse or non-recourse loans?
Many house flippers organize each deal as a separate legal entity, typically an LLC. In theory, this limits the personal liability of an investor. That is, if someone sues your LLC, they can generally only go after the assets in that LLC – not your personal ones (e.g. primary residence, retirement accounts, etc.).
However, when it comes to loan repayment liability, most hard money lenders will require you to personally guarantee the loan, regardless of the fact that you’re borrowing as an LLC. In lending terms, this comes down to whether a loan qualifies as recourse or non-recourse. A recourse loan holds the individual personally liable for repayment, whereas a non-recourse loan only holds the LLC liable for repayment.
Most hard money lenders – especially for new investors – will only approve recourse loans. But, this is still a discussion worth having with a potential lender.
Question 13: How long does it generally take to close a loan after the appraisal?
Speed serves as a primary advantage of hard money loans. While a traditional mortgage averages 30 to 45 days to close, a solid hard money lender can close a deal in less than a couple weeks (or faster). But, not all lenders have such well-established and streamlined procedures, meaning they’ll take longer to close loans.
For investors, time is money. As a result, you’ll want the purchase draw of a hard money loan distributed as quickly as possible following the ARV appraisal. An experienced lender should be able to close a loan within a day or two of the final appraisal report. So, if a lender tells you that it will take a week or more after the appraisal to close the loan, it may indicate inexperience or inefficiency.
Question 14: What are the penalties on past due loans?
Even the most well-analyzed real estate deals don’t always go as planned. Realistically, unanticipated challenges often emerge, and these challenges can disrupt a repayment timeline. Accordingly, I recommend that investors take a conservative approach and ask about the worst case scenario. That is, if they have to extend a loan repayment period, can they do it? And, if so, what are the associated penalties?
While you never want to plan on blowing a loan repayment deadline, savvy investors understand the importance of contingency planning. For example, if you know in advance what a past-due penalty can be, you can build a model accounting for those penalties, arming yourself for a worst-case scenario.
Question 15: Do you offer a mini-perm option?
This question doesn’t apply so much to house flippers as it does to BRRR investors. These latter investors use hard money to finance a purchase and renovation but then rent out and refinance the property with a takeout, or permanent, mortgage.
Due to the fact that hard money loans have higher interest rates than permanent ones, BRRR investors have an incentive to refinance into a lower-interest, long-term loan as quickly as possible. But, closing on these loans can sometimes take an extended period of time. With many construction loans and some hard money loans, borrowers have the ability to refinance their short-term, interest-only loans into a lower-interest, amortizing loan for a short term (e.g. two years). These temporary loans are often referred to as mini-perms, or mini-permanent loans, and they can provide borrowers tremendous refinance-related flexibility and peace of mind.
Most hard money lenders won’t offer a mini-perm option, but it’s another conversation you should have.
Question 16: Can you provide contact information for three prior borrowers to serve as references?
It’s an unfortunate fact of life, but many businesses say they do one thing but actually do quite another. And, this certainly applies to hard money lenders, as well. A lender may market itself as well-established and proficient but in reality have poorly organized and inefficient processes.
When screening potential lenders, there’s a pretty straightforward way to confirm whether or not the marketing pitch aligns with reality: ask for references. Before working with a hard money lender, I recommend asking them to provide you contact information for at least three prior borrowers. That way, you can speak with these borrowers about their own experiences with a lender.
If a hard money lender refuses to provide you references, that should be a huge red flag. Conversely, confident, established lenders should have nothing to hide. Quite the opposite, a reliable lender will likely want to connect you with prior clients to vouch for their quality.
Final Thoughts
Not all lenders provide the same level of quality. And, some are just downright bad. As a result, real estate investors should screen potential hard money lenders before applying for loans. At a minimum, I recommend asking the above questions before working with any hard money lender. This up-front due diligence will help you avoid significant headaches in the long run.
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