We didn’t randomly pick the company name The Investor's Edge. We chose this title because we actually are hard money lenders. This brings up a question that a lot of new real estate investors ask: what do hard money lenders do?
Most banks provide mortgages based on the home’s value and the borrower’s ability to repay—the borrower’s “soft assets.” Hard money lenders provide loans based solely on the property—the “hard asset.” They provide investment loans based on what a distressed property will become after a repair.
I’ll discuss more of what hard money lenders do in the following article to help you understand hard money lenders and the hard money loan industry.
What is Conventional Mortgages and How Does It Works
To understand what hard money lenders do, it helps to understand conventional mortgages 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 conventional lenders will not provide mortgages for homes in need of major repairs.
What Are Hard Money Loans and How Hard Money Loans Work
Hard money exists as an alternative to the above conventional financing. Popular to the beliefs of some, hard doesn’t mean challenging. Rather, it means that these lenders solely concern themselves with the “hard” asset, meaning the property itself.
As stated, conventional 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 investors.
Conventional 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. 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 conventional 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. Conventional mortgages typically require 30 to 45 days to close. You can close a hard money loan in less than a week.
What Are ARV Appraisals in Hard Money Loan
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.
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 $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 the 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.
Final Thoughts on Hard Money
Conceptually, hard money lenders look at a deal’s potential—not a property as it currently stands. As a result, they assume more risk and charge a premium for this risk. But, hard money lenders also offer real estate investors three tremendous advantages over conventional financing: 1) they don’t require good credit scores; 2) they let you finance distressed properties; and 3) they let you close loans quickly.
These characteristics make hard money lenders indispensable to fix & flip investors. And, as with everything in real estate, it helps to have relationships with hard money lenders. Once you get used to working as a team, applying for loans becomes a rapid and effective process, letting you focus on what matters most—doing deals!
Learn how to make money flipping real estate with us by attending our next webinar.