A saying exists in real estate that “financing is king.” In other words, a deal is only as good as its financing. If you can’t pay for a property and its rehab, it doesn’t matter what the numbers look like. This reality leads to people asking about the best strategies for financing deals. In particular, new real estate investors often ask me: Ryan, what does 100% financing mean when buying a home?
Simply put, 100% financing means that you pay for an entire home with other people’s money (e.g. banks, private lenders, business partners/investors, etc.). That is, you don’t use any of your own cash to make a deal happen. This financing – or leverage – can dramatically increase a deal’s returns.
In the following article, I’ll dive into the details of 100% financing in real estate. Specifically, I’ll cover these topics:
- An Overview of 100% Financing in Real Estate
- Traditional Financing Challenges for Real Estate Investors
- How Hard Money Loans Can Finance an Entire Home Purchase
- Using Gap Financing to Cover the Difference
- Risks of 100% Financing a Home Purchase
- Final Thoughts
What Does 100% Financing Mean When Buying a Home?
What is 100% Financing?
Financing refers to the way you use other people’s money to pay for a home. For instance, debt financing means you use loans (debt) to pay for a home. Most homeowners, whether they are investors or not, understand this reality, as traditional mortgages represent a form of debt financing. With debt financing, the borrower gradually pays off the loan balance. And, as the loan balance lowers, the borrower’s ownership – or equity – in the property increases.
On the other end of the spectrum, equity financing involves using other people’s money by selling an ownership interest in the property. For example, you could bring a business partner in to provide you a portion of a home’s purchase price, providing an ownership interest in exchange.
In simple terms, 100% financing means that you only use other people’s money to buy a home. With house flips, investors can achieve this by financing a property’s purchase, rehab, and sale with a hard money loan. However, it takes a really good deal to 100% finance with a hard money loan. As a result, most investors who 100% finance a flip use a combination of financing techniques. For instance, a hard money loan may cover $150,000 of a $175,000 deal budget. To finance the remaining $25,000, investors can bring in business partners (equity financing), use credit card loans (debt financing), or a variety of other techniques to achieve 100% financing.
How Leverage Increases ROI
The concept of leverage (i.e. using debt to purchase a home) also significantly increases your return on investment. As the chart above illustrates, as the loan-to-value (LTV) increases on a property, the cash-on-cash return increases, as well. In other words, with a properly analyzed real estate deal, the greater your leverage, the greater your returns. I’ll demonstrate with a basic example.
Assume you can buy a rental property for $250,000, and it generates $15,000 in net operating income every year. If you paid all-cash for this property, that would translate to a 6% return on investment, or ROI ($15,000 / $250,000). But, what if you instead used a mortgage with a 20% down payment to purchase the property? That would mean you invested $50,000 in cash and a $200,000 loan to buy this property.
Now, your loan payments would cut into your cash flow. But, you’d also increase your ROI. Assuming a 3.5% interest rate and 30-year term on that $200,000 mortgage, you’d have annual debt payments of ~$10,900. As such, your annual cash flow would now be $4,100 ($15,000 NOI – $10,900 in debt service). This translates into an 8.2% ROI, 2.2% higher than an all-cash deal! ($4,100 / $50,000 down payment).
And, in addition to the higher ROI with a leveraged deal, you also gain two other great benefits. First, you gradually build wealth through that loan’s amortization, as outlined in the above profit paths. But, more importantly, you can now use the remaining $200,000 for other deals. Instead of buying one property for $250,000, you can buy five $250,000 properties, each with a $50,000 down payment. With this approach, you’d then own $1.25 million in real estate!
Yes, these are simplified numbers, but the important takeaway is the concept: using debt to buy real estate increases your ROI. And, by extension, this leverage speeds up the process of building long-term wealth. Furthermore, the above example included a down payment. If you can reduce that down payment to zero, you potentially have unlimited returns, as you have no cash into the deal – incredible!
Traditional Financing Challenges for Real Estate Investors
To understand the best ways to 100% finance your first investment property, it helps to understand traditional financing first. More precisely, investors need to understand why this financing doesn’t work for investment properties. First of all, these mortgages generally require at least a 20% down payment on investment properties, with many lenders not allowing that money to be financed. This reality inherently eliminates the ability to 100% finance a home purchase.
Additionally, 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.
This soft asset verification automatically disqualifies many first-time investors. Simply put, people often decide to buy investment properties because they don’t want to pursue a traditional career. Accordingly, these same people often haven’t spent years A) building their credit scores, B) raising cash reserves, and C) establishing long track records of W-2 income. Lacking these elements, investors will find it extremely difficult to meet a traditional lender’s strict underwriting standards.
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.
And, most residential investing strategies inherently depend on a property’s distressed nature. In particular, both of the following commonly embraced strategies rely on purchasing a distressed property, one that likely wouldn’t qualify for traditional financing:
- Fix & flip: With this strategy, investors find a distressed property – typically at a deep discount. They purchase this home and renovate it to a standard that will meet traditional financing standards. Once renovated, these investors then sell the property to someone using a traditional mortgage, normally a primary homebuyer. Investors pocket the difference between this sale price and their acquisition/rehab/holding/transaction costs as profit.
- BRRR: This stands for buy, rehab, rent, refinance. And, these investors look for a similar property to the above, that is, a distressed home at a deep discount. Next, they complete the rehab process, but they have an aim to rehabbing a home for tenants – not owners. Once renovated, investors then lease the home to quality, long-term tenants. Once leased, investors can refinance their short-term, high-interest hard money loans into long-term, traditional mortgages. As such, they profit three ways: 1) cash flow from tenants, 2) property appreciation, and 3) loan amortization.
In addition to being common investing strategies, both of the above clearly hinge upon finding distressed properties in need of major repairs. And, if investors can’t use traditional mortgages to finance these properties, what can they do?
How Hard Money Loans Can Finance an Entire Home Purchase
Enter hard money loans! Regardless of whether you opt for a fix & flip or BRRR strategy, hard money loans provide a means of 100% financing a deal.
An Overview of Hard Money Loans
More precisely, hard money exists as an alternative to the above traditional financing. 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 Do Hard Money 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.
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.
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 conventional 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.
Financing Your First Real Estate Investment with Hard Money
Above, I provided the background information on using hard money loans to finance an investment property. Now, I want to outline a hypothetical example of how an investor could use one of these loans to finance a real estate investment. Ideally, this example – combined with the above information – will provide you a framework for hard money financing for real estate investments.
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, which Do Hard Money offers), 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.
If you have the cash on hand to cover this $10,000 extra, you can contribute that to the deal. But, returning to the focus of this article, we want to 100% finance home purchases. Fortunately, options exist to finance this remaining requirement (as opposed to putting your own cash into the deal).
Using Gap Financing to Cover the Difference
This above example covers 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 cover the gap between a hard money loan and deal budget:
Credit Card Financing
Credit card companies want your money. As such, if you’re a responsible borrower, they’ll provide you pretty good personal loan options. Say you have a $25,000 limit on your credit card, but you only use $2,000 of it every month, always paying it off on time. There’s a good chance the card company will offer you a relatively low interest personal loan for the difference between the credit you regularly tap and your limit. This can be an outstanding gap financing strategy.
Alternatively, you can seek a business partner. Plenty of people A) want to invest in real estate, but B) don’t have the time or experience to do so. If someone has money to invest, you can potentially bring them on as a limited – or “money” – partner. These individuals provide funds, have no role in the day-to-day operations, and receive a return on their investment. Yes, you’ll need to sacrifice a portion of your returns. But, if it makes the difference between funding a deal or not, bringing on a partner can be a great option.
Home equity lines of credit, or HELOCs, are another great gap financing strategy. Typically, investors tap the equity in their primary residences. So, assume you have $50,000 in equity in your property. A lender may not extend a HELOC for that entire amount, but even if you secure a $25,000 HELOC, this gives you a tremendous amount of gap financing flexibility. And, with HELOCs, you only pay interest on the money you draw. Once you repay the outstanding balance, you don’t need to pay interest.
Home Equity Loans
Home equity loans (a.k.a. second mortgages) provide investors another gap financing option. Whereas a HELOC provides homeowners a revolving line of credit based on the equity in their homes, home equity loans function as one-time loans. That is, once you qualify for one of these loans, you’ll receive a lump sum payment, gradually paying it off over time. In this fashion, a home equity loan is an amortizing loan just like your primary mortgage (i.e. a portion of each loan payment goes to principal to reduce the loan balance, while another portion goes to interest).
Most investors get home equity loans on their primary residences, as lenders are more willing to issue these than ones on investment properties. Generally, lenders will issue these loans on an 80% LTV basis. For example, assume your home appraises at $300,000. 80% LTV of that equals $240,000. But, if you also have $100,000 outstanding on your primary mortgage, you must deduct that, meaning you can potentially qualify for a $140,000 home equity loan ($240,000 max LTV – $100,000 outstanding primary mortgage). And, once you receive that cash, you can use it to help finance home purchases as an investor.
Functionally, a business line of credit (LOC) acts the same as a HELOC. However, rather than secure the credit against your primary residence, banks use your business’s operations to secure a business LOC. Obviously, this option only exists for investors with a business. But, if you have a successful business, a LOC secured by its operations can be an outstanding gap financing option.
Risks of 100% Financing a Home Purchase
While 100% financing a home purchase can dramatically increase your return on investment, it also poses some risks. As with all investments, the greater the reward in real estate, the greater the potential risk. And, while using other people’s money to buy a home increases your potential returns, it exposes you to market risk.
For people who remember the Great Recession, you likely have heard the phrase “underwater mortgage” before. Simply put, a borrower is underwater on a mortgage when he or she owes more than the home is worth. And, when this happens, you lose the ability to A) refinance the property, and B) recoup all of your outstanding loan balance when you sell.
In “normal” times, home values won’t completely collapse in the six months or so that it takes you to buy, rehab, and sell a flip. But, it’s worth understanding the potential risk if something like this does happen (as it did in 2008-09).
As discussed, hard money lenders issue loans based on a property’s ARV. So, assume that you secure one of these loans in January, when the ARV is $300,000. Due to some economic factors outside of your control, say that in July, when you’re ready to sell the property, it is now only worth $200,000 – unlikely, but possible.
At an exit price of $300,000 – the ARV – you could sell your property, pay off the hard money loan ($210,000 plus accrued interest) interest, and still net a nice little profit. But, at $200,000, you cannot A) sell the property and pay off the hard money loan, or B) refinance it into a permanent mortgage to convert the property into a rental. As a result, you’d now be stuck with a high-interest hard money loan without the ability to completely pay it off, either via other financing or a sale.
In this situation, you have two options, both of which are bad. Option 1: you default on the loan and enter the foreclosure process, crushing your credit score in the process and losing any cash you have in the deal. Option 2: you sell the property at a loss and pay off the remaining hard money loan balance with cash.
While this level of market volatility generally doesn’t exist in real estate (as it does in stocks), it’s still worth understanding the potential risks of 100% financing a deal.
In basic terms, 100% financing a home means that you pay for the home entirely with other people’s money. While this can include either debt or equity financing, most real estate investors use hard money loans (debt financing) to 100% finance a property. By doing so, these investors can significantly increase their return on investment. But, 100% financing also comes with the potential for market risk, with drops in real estate value crushing a deal. With thorough due diligence and quick deals, house flippers can mitigate these risks, though. In other words, the advantages of 100% financing a home purchase generally more than outweigh the potential risks for investors.