Hard money lenders actually play a vital role in financing all kinds of real estate investments across the country, particularly when it comes to flipping houses. Hard money loans afford real estate investors the opportunity to expand their projects and increase the amount of deals they can afford.
What exactly is Hard Money anyways? Broadly speaking, a hard money loan is a loan secured by real estate from a non-traditional lender (i.e. not a bank, credit union, etc.) the amount of which is based primarily on the value of the asset and less so on the borrower’s credit. However, compared to traditional bank loans hard money loans typically have higher interest rates, higher fees, and shorter terms.
Considering the higher rates and fees, why would anyone not hard up for funds want to borrow one, especially when traditional bank loans seem to cost so much less? Here are seven reasons why:
- A private lender can give you a quicker loan proposal.
- They can fund a loan much faster.
- They don’t always require third party appraisals.
- Hard Money Lenders will make loans on distressed homes that need rehab, where many traditional banks won’t even touch that type of property.
- They rely heavily on the value of the property versus banks typically rely heavily on the borrower’s credit.
- They have much shorter approval process, less red tape, and less paperwork.
- Private lenders don’t have maximum exposure limits to one borrower.
There are also two major important reasons and benefits to using hard money:
Leveraged returns and the ability to grow and do more deals than with a fixed amount of capital. The concept of leveraged returns can get complex, so let’s just look at a simple example to help illustrate.
Assume you have a flip deal that has $250k in total costs. Further assume you have $250k in cash, don’t need a loan, and therefore are going to fund it all yourself. If you can sell the house for $300k, your projections show that you will make $50k in profit ($300k – $250k in total costs) on your $250k cash investment. That’s a 20% profit margin, which is not bad, right?
Now let’s assume you do the same deal but borrow $200k from a hard money lender (so you now only need to put in $50k of your own cash, versus $250k above). Since there is a cost for using a hard money lender (interest, points, etc.), your project expenses are going to increase from $250k to say $270k for example. So now your net profit is only $30k ($300k sales price, less $250k in project costs, less the $20k in lender costs) instead of $50k in the all cash example. So if you had the cash, why would you use the hard money loan if you make less money by doing it?
Well, let’s look at what happens to your investment return when you use the hard money loan. You are making $30k on a $50k cash outlay (remember, the lender put in the other $200k). So, your investment return is $30k to $50k, or 60%! That is 3 times the return you were getting compared to doing the project in all cash. This is the power of leveraged returns.
The other significant benefit to using hard money is that it allows a flipper to diversify and do more deals. With that same $250k in cash, you could do one deal for $250k or 5 deals using hard money. If you make $30k net profit per deal, that’s $150k in total profit, 3 times what you would have made using all cash. The use of hard money in your business model can help you grow your business and diversify your risk across multiple projects.
So now that you have done some homework and you want to take the next steps in searching for a private lender, will any lender do? The answer to that is not all lenders are created equal, so make sure that you do your due diligence in finding the right hard money lender for your needs.
Unfortunately, anyone can call himself/herself a hard money lender. Hard money lenders can range from an individual with a few hundred thousand dollars, to a $5MM-$10MM mid-sized real estate fund, to a large institutionally-backed real estate finance company with significant capital resources.
You must protect yourself (and your business) and be sure you are doing a deal with a reputable lender with a good track record. There are a lot of good lenders out there; but there are a lot of shady ones too. Do your due diligence and ask questions. Remember, it is just as important that you are a good borrower for them, as it is that they are a good lender for you. It is a two way street.
Click here for more information on finding the right lender and 17 Questions to Ask Prospective Hard Money Lenders!
So now that you are thinking that hard money is even better than free house flipping advice or 75% off toilets at The Home Depot, you need to understand some of the risks. Rest assured, whenever you use someone else’s money in a deal, there are always additional risks. Understand that the lender’s security is almost always a secured lien against your property. It is that lien and its priority over your cash equity, which provides the lender collateral for making the loan. Putting it bluntly, if you mess things up with the project, do not make payments per the terms of the loan, or do not pay that loan back as agreed, the lender may call a default and ultimately get control of the property, thereby possibly leaving you with nothing. That is a big risk, but one that you somewhat control since you are driving the project. As long as you perform and do what you say you are going to do, this risk can be minimized.
Another important risk to consider when using hard money, or other people’s money for that matter, is your lender not performing. This is a real risk (sadly, one often overlooked by borrowers), and one in which you have very little control. Say everything is going well, you have your lender all lined up, the project is getting ready to close, and it’s time for everyone to fund. What happens if your lender doesn’t fund? Well, unless you have the cash to close yourself, you could lose the deal. What if just before funding, your lender tells you that won’t fund unless they charge you a higher interest rate and/or more loan fees? It happens, and while you most certainly wouldn’t’ do another deal with that lender; you are still stuck on the deal in question. Bottom line: it is your responsibility to do your due diligence on the lender and as best you can, make sure they will do what they say they will do. This is crucially important in the world of hard money lending.
One additional thing to consider is how much your lender will be involved once you close the loan. Are they going to be calling you every few days asking for progress reports, inspections, paperwork, and generally bugging you? Be aware that some lenders are people with money just looking for you to educate them on flipping homes. Be sure your lender will do what they say, fund when they need to, and stay out of your way, and let you run your business.
Where do you find hard money lenders? A simple Google search will get you all kinds of results. But as with most things, networking, word of mouth, and referrals are a much more effective means of finding a good lender. Ask other flippers who they use. Go to real estate investment club meetings and ask around. Be sure to look for lenders that focus on, and have direct experience in, making fix and flip loans. For additional advice, read our blog on How to Choose the Right Hard Money Lender for Your Project.