An Introduction to Hard Money Loans

Understanding how to finance real estate deals is an essential part of any real estate investor’s education. There are many financing options available to investors who want to buy rental properties; however, savvy investors know that utilizing leverage via the correct financing vehicle is key to increasing return on investment.

What is Leverage?

Leverage is the money borrowed to finance the purchase of an investment property. In other words, someone else’s money is being used to maximize (or leverage) your ability to buy investment properties while using less of your own money.

Conforming Mortgages – Leverage to Purchase a Primary Residence Versus Rental Properties

If you have a mortgage on your home, then you used leverage to purchase it. Typically, conforming mortgage lenders will lend up to 80% of a property’s purchase price thus requiring a 20% down payment from the buyer. A conforming mortgage is the best way to purchase a primary residence when the buyer has good credit, income history, and has time to go through the lengthy approval process required by a bank.

A conforming mortgage is not the best financing vehicle to use when purchasing a rental property for a variety of reasons. Conforming mortgages will have higher interest rates (5-7%) on loans for rental properties, may require larger down payments, and have different approval requirements than owner-occupied properties. Furthermore, you cannot use a conventional mortgage to purchase a property with deferred maintenance because the underwriter will not approve the loan. Even then, the approval process will be onerous. Conforming mortgage lenders will require proof that you can repay them and will evaluate your credit score, your income, and your debt to income (DTI) ratio before approving the loan.

Hard Money Loans Maximize Leverage When Purchasing Rental Properties

A hard money loan is a way to secure financing for a rental property without using conventional mortgage lenders such as banks or credit unions. Hard money loans are funded by private investors (or a fund of investors). They are short-term, asset-based loans for non-owner occupied (rental) properties. This means that the rental property is used to secure the loan.

Real estate investors typically buy properties with deferred maintenance. Therefore, the purchase price is lower than the after repair value (ARV) of the property. The ARV is the estimated value of a property after all necessary repairs or major renovations have been finished and is based on sales of comparable nearby properties.

In contrast to conforming mortgage lenders, hard money lenders will lend up to 65 – 75% of the property’s ARV rather than 80% of the purchase price. This ability to maximize leverage is the reason savvy real estate investors prefer to obtain hard money loans when purchasing investment properties. Table 1 provides a very basic illustration of the difference in leverage between conforming mortgages and hard money loans.

Table 1: Comparison of Conforming and Hard Money Loans

Table 1 shows that a conforming mortgage lender will only lend $60,000, which is 80% of the $75,000 purchase price. The borrower (real estate investor) will need to put down $15,000 to purchase the property. Then, he or she will need to address the deferred maintenance (make repairs).  If $15,000 is needed for repairs to the property, then the investor will be out of pocket an additional $15,000. All in, the real estate investor will have $30,000 of his or her money in the deal when financing the property with a conforming loan.

In contrast, a hard money lender will lend $82,500, which is 75% of the $110,000 ARV. This loan covers the $75,000 purchase price and provides $7,500 to be kept in an escrow account for necessary repairs to the property. The assumption with hard money loans is that the borrower will improve the property to the standards of the after repair valuation. If the repairs cost $15,000, then the real estate investor only needs to use $7,500 of his or her own money with the other $7,500 coming from the escrow funded by the hard money lender. The hard money loan keeps more cash in the investor’s pocket than a conforming loan.

Hard Money Loan Terms

There are additional loan terms to consider when evaluating hard money loans. There is greater risk on the part of the hard money lender because the amount of the lender’s capital increases while the amount of the borrower’s capital decreases. This increased risk causes the hard money lender to charge a higher interest rate (7-14%) than that associated with a conforming mortgage. But, hard money loans have interest only payments and are meant to be short-term loans (6-12 months). An investor should refinance into a conforming mortgage as soon as the property repairs are complete and a tenant is in place.

It’s All About Leverage

The example from Table 1 above should clearly illustrate why it makes sense to use hard money loans when purchasing long-term, buy-and-hold investment properties that have deferred maintenance. Using the example above, someone with $30,000 in savings could purchase four rental houses using hard money loans. It’s that simple. A hard money loan offers greater leverage to the buyer.

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