Hard Money Lending: Guide on how hard money lending works with real life examples.
After doing various research into hard money lending, initially the thought of a high simple interest loan quite frankly scared me. However, after additional thought and consideration, I found that there were several pros in using a Hard Money Lender.
What is a hard money lender (HML) and what types of properties do they lend on?
Since hard money lenders typically don’t follow the same guidelines as a traditional lender will need to, the loans offered usually will have less strings attached. They will loan on distressed properties while traditional banks generally do not.
For example, they can typically lend on properties that have roof damage, drywall damage, foundation issues, are in need of a complete rehab, have water or mold issues, etc. These are things that traditional commercial banks would run away from, but hard money lenders would not rule out.
As an investor, we tend to look for distressed properties that we can rehab and make whole again, while in return for the trouble either flipping for a profit or keeping long term with equity already created.
Why use a hard money lender anyways?
Suppose that you purchase a distressed property for $50,000 and put $25,000 into the property through rehab. It is possible that said property is now worth $100,000. While there are certainly more things to consider numbers wise in a real example, such as holding or closing costs, you theoretically could sell the property and make $25,000. Or, you could hold on to the property, refinance it and get all of your initial money back, and still have $25,000 equity in the property. Again, I am oversimplifying the process and how the numbers work just to show the overall concept.
Benefits of using a hard money lender
To show a simplified example, suppose that you purchase a distressed property for $50,000 and decide to spend an additional $25,000 on the property for rehab (you would be into the property for $75,000). However, with the additional work through the rehab process, your property is now worth $100,000. If you decided to sell the property, theoretically you would end up making $25,000. Or, you could refinance and get your additional money ($75,000) and have $25,000 equity in the property.
This is extremely simplified, just to show the numbers. In a real example you would need to factor in holding and closing costs. The example above is to show a generalized concept of how hard money lending could work for real estate investing.
Another benefit of using a hard money lender is the ability to close on properties quickly. Generally they can close on properties within 7-14 days.As an example, the hard money lender I use can close as quickly as 4-5 days on properties where I may need quick closing. If you decide to use a traditional bank to finance your investment properties, your closing date is usually 30-45 days after an offer was accepted. This can be a hassle if you are purchasing distressed properties, as the seller is generally wanting out of the property as quickly as possible. As an example, if someone selling their property needs cash quick and gets 2 offers for the exact same amount, but one of them is a 7 day close versus a 45 day close, which one do you think a seller chooses?
This has proven to be especially true when you add in the fact that hard money lenders will not care about all the work that needs to be complete whereas a traditional bank may have a list of things that the seller needs to correct before the final closing day. If the seller does not agree to fix said items, the deal could fall through. It is not uncommon for traditional financing on real estate properties to fall through well past the initial sale agreement. In other words, a seller and buyer could have a sales agreement and the deal could fall through at day 30 or even a few days before hitting the 45 day mark.
This means that the seller will have essentially waited for 30-45 days only for the deal to fall through. In this case, the seller would have to continue listing the property waiting for another buyer. Once they find another buyer, the same process could happen again.
Hard money lenders generally will not fuss about things that need fixed and have less strict lending guidelines than traditional banks do, so when you say to a seller you will close in 7 days, there is a much higher probability that the sale actually closes in 7 days. The things that traditional banks will have issues with are generally not issues to an investor using hard money lending. This is a huge benefit to using a hard money lender and should not be overlooked.
Typically, I try not to close this fast, so I save those situations for properties that are great deals that would only close if it were done that quickly. The reason it is not ideal to close that quickly is because there are a lot of items that you need to get done in such a short window, such as: getting insurance lined up, getting back end refinancing approvals, switching over utilities, getting a home inspection done (if applicable), getting the appraiser to go out and actually verify the ARV, and in general every party involved will need to be working at a fast pace. While it still is possible to obtain a 4-5 day closing, it is just less ideal.
What do hard money lenders use to determine if they will loan on your particular investment property?
While hard money lenders tend to loan on most types of properties, they do still have criteria. Based on my experience, I have found that hard money lenders will look for the following:
- The ability to pay back the loan and holding costs associated; even in the event that you are unable to rehab the property, sell the property, or refinance the property.
- Most hard money lenders will want to make sure that you have some experience with real estate investing in the past and are not brand new to investing in real estate.
- The hard money lender I use allows first time real estate investors, but they do charge higher fees to reduce their risk (though I would argue this at times can actually increase their risk). The hard money lender will also only allow you to have a lower amount of money loaned out at any given time.
- Once you gain more experience, they are willing to increase how much money they have loaned out to you.
- As an example, when I was just starting out the hard money lender only allowed me to have $200,000 loaned out. This has now increased substantially as I have a more proven track record.
- Most hard money lenders initially will want to see previous years tax returns, proof of income, checking account balances, balance sheets you may have including any assets and liabilities you may have, etc
- If you plan on keeping the property as a buy and hold versus a flip, then the hard money lender will generally want confirmation that you have back-end refinancing in place.
- This means that you would need to have a bank that has already reviewed your entire financial status and is willing to refinance you out of hard money, once you get to that point. You will likely need to do this before you even start looking at any properties for a broad overview of your financial status with the bank, but you also likely will need to do this on a per property deal as well.
One of the biggest pieces of criteria that a hard money lender will look at will be the Loan to Value (LTV). Essentially, they will analyze the purchase price and the budget for the rehab. In addition, the hard money lender will review bids from general contractors to confirm and demonstrate what the actual costs and the actual work that will be completed.
Once the above information has been collected, it will be compared to the assumed worth of the property after the repairs have been complete. All of the information collected will be sent to the hard money lender prior to an offer being sent to the seller.
For this reason, all of the data up to this point needs to be as solid as possible as the property will be under contract during the inspection period. During this period, the hard money lender will send an appraiser to the property. When the appraiser looks at the property, they will look through the bid from your general contractor, work to be done, and will determine the value of the property once the work has been complete.
Should the information that was provided prove to be wrong, it could hurt your relationship with the hard money lender. They will generally talk to the appraiser based off your initial data to see if your thinking is at least close to avoid wasting anyone’s time, if you continuously send over deals that prove to be completely wrong in terms of After Repair Value (ARV), then they may start really questioning you as an investor.
My hard money lender only allows the LTV to be no higher than 75%. This means that the total hard money loan ((Purchase price – down payment) + rehab cost) cannot exceed 75% of the ARV (After Repair Value). If it does, then I will either need to put a larger down payment down to reduce the total hard money loan or they simply will not fund the investment.
While this can sometimes be annoying, it is actually a rather helpful guideline as it helps the investor not get too far in over their head. It protects both the hard money lender and the investor. If things get bad and you need to sell the property versus keeping it as a buy and hold, if your LTV was 100% and they still pushed that loan through to you, then you would be upside down right out of the gate. That is if you could sell right at the ARV number. If you couldn’t even sell at the ARV, you will surely be at an even larger loss. The hard money lender would also be less likely to get their money back from you, which would be a lose-lose situation.
What are all of the costs associated with using a hard money lender?
Hard money lending is all about properties needing rehab that traditional banks won’t likely lend on. They make their money, though, off of various fees and interest rates. These will range across various hard money lenders so be sure to check the market for the best company suitable to your needs; however, they all typically charge loan origination fees, monthly simple interest fees, and back end loan fees.
The hard money lender I use charges a $500 loan origination fee, 10.25% simple interest for months 1-6, 12.50% simple interest for months 7-12, and the loan is due in full as a balloon payment at the beginning of month 13. The simple interest is the above percentages during those months, but it is actually calculated daily. At loan closing, they also charge 2% of the total hard money loan.
Lastly, the other fee they tend to charge are draw fees. These are fees that they charge when they pay a contractor a sum of money out of your rehab budget that is available to you. They usually pay the contractor with a check, but some even do ACH payments. The process works like this.
Draw Schedule: How rehab costs are paid from the hard money lender to the general contractor
Let’s assume you have $25,000 for your rehab budget. You may decide to pay the contractor according to a certain draw schedule. Typical draw schedules might look like 30/30/30/10. This means that you pay 30% of the rehab budget when the project is 30% complete, another 30% when the project is 60% complete, another 30% when the project is 90% complete, and the last 10% when the project is 100% complete. The last 10% is more of a saving grace to ensure that all finishing touches are buttoned up.
It is not uncommon for there to be a lot of “little” things left undone at the end. Saving the last 10% for ensuring these get done increase your chances of the contractor doing them to your satisfaction.
The hard money lender I use charges $150 per draw. So, using the 30/30/30/10 example above, this would equate to 4 draws. Each time the draw is issued, I get charged $150. For 4 draws, this would mean $600 gets rolled into the total amount owed to the hard money lender.
The process generally looks like this:
- The general contractor lets you know that 30% of the work has been complete, along with which line items on the original scope of work have been so far completed
- I request pictures and videos to prove the work was actually done as I am a long distance real estate investor and cannot physically go out to the property to verify the work.
- Once I verify through photos and pictures, I let my hard money lender know that the general contractor is ready for the first 30% draw, along with which items were said to have been completed.
- The hard money lender then schedules a time to go out to the property to verify themselves that the work was completed. Once they verify, they hand the check over to the general contractor.
Example of how hard money costs are incurred
Figuring out all of the costs associated with a hard money loan can get somewhat tricky, so I will use numbers from an actual property I purchased awhile ago.
First let me explain the quick breakdown. The hard money lender I use will loan up to 90% of the purchase price and 100% of the rehab. They do, however, have a minimum down payment requirement of $5,000. So, in essence, you put $5,000 down on any purchase price that is under $50,000, otherwise it is simply 10%. During months 1-6 of the loan, you do not need to actually make any monthly payments. These payments, instead, get wrapped into the total amount borrowed. Only starting on the first day of the 7th month will I begin to pay the higher interest rate, and have to actually pay it directly, instead of it being wrapped into the loan.
- The property I purchased cost $32,000 (Property H).
- I put down $5,000 and closing costs were $2,500.
- Total money out of pocket was $7,500.
- The rehab budget was $22,000.
- So, in this case, my purchase price was $32,000, but I had to put $5,000 down. This makes the loan amount for the purchase price $27,000.
- They fund 100% of the rehab cost, so the rehab loan amount available to me is $22,000.
- This puts my total hard money loan amount to $49,000 ($27,00+$22,000) if I used the full rehab budget.
Suppose you do a 30/30/30/10 draw schedule and each draw was 31 days apart. This rehab project would thus take 124 days (31 days for each draw x 4 total draws) or roughly 4 months to complete. The draws would be paid out like this. The first draw of 30% at 30% completion is $6,600 ($22,000 x .30). The second draw of 30% at 60% completion is another $6,600. The third draw of 30% at 90% completion is another $6,600. The last draw of 10% at 100% completion is $2,200 ($22,000 x .10).
The first 30 days you would only be charged simple interest from the hard money lender on the $27,000 purchase amount loaned. This means your simple interest expense would be $7.58 per day (($27,000 x .1025)/365). The total hard money loan at this point stayed at $27,000 for the entire 30 days so you would have accrued $227.40 in interest ($7.58 x 30). At day 31 you had the hard money lender submit your first 30% draw in the amount of $6,600. This brings your total hard money loan now to $33,600 ($27,000 + $6,600). You then went another 30 days before submitting any further draws. After this next 30 days, your simple interest expense would be $9.44 per day (($33,600 x .1025)/365). You thus would have accrued an additional $283.20 in interest ($9.44 x 30). This would repeat for the rest of the hard money loan until you refinanced. All of the various 30 day interest amounts would get added together and rolled into your total hard money loan. The point is that you only pay simple interest on money that the hard money actually loaned to you. Until you submit a draw, they technically only have it available for you, but not actually paid out on your behalf.
How I keep track of hard money lending costs
The above is how you calculate simple interest fees on hard money loans. Whenever I keep track of hard money loans, I always just assume I am paying 10.25% simple interest on the entire available loan amount. So, in the case above, this would be the $49,000 number. I also don’t break this amount down to days, but just break it down into months. This is because its easier math but also easier to get a rough gauge for how many months you plan on holding a property before getting out of hard money lending than it is to figure out exactly how many days. You could do either, though.
While I don’t recommend everyone do this, it helps ensure I am seeing more worse case scenarios since I am assuming I am paying higher interest each month even though I have not actually borrowed all available funds from the hard money lender. This also creates an even higher sense of urgency for me to quickly exit the hard money loan.
So what I do is simply figure out what the interest equates to monthly on the entire amount loaned and available to be loaned from the hard money lender. I then just multiply the yearly 10.25% interest on the total amount loaned and available of $49,000 to get $5,022.50. I then divide by 12 months in a year to get the monthly simple interest fees of $418.54. This means that each month that passes by during months 1-6, my total hard money loan amount increases by $418.54. If I held the entire loan for just 1 month, I would owe $49,418.54 ($49,000 + $418.54). If I held the entire loan for 2 months, I would owe $49,837.08 ($49,000+ ($418.54 *2)). This is just the simple interest fees and a quick way to gauge roughly what the costs will be and will be higher than by doing it by only the amount actually loaned and by days.
Summary example of all hard money lending costs incurred
Let’s wrap up and tie this all together. Let’s say I held property H above for 8 months and then refinanced out of hard money altogether. Generally speaking you want to get out of hard money as quickly as possible, but this is just an example. During this time I did 4 draws at 30/30/30/10.
If we use the example above, we would take the monthly simple interest for 6 months when the interest is the same 10.25%. I would multiply $418.54 by 6 to get $2511.24. My total hard money loan amount is now $51,511.24 ($49,000 + $2,511.24). Months 7 and 8 are at 12.50% interest, but it is at this point where I must begin making monthly payments to the hard money lender. This would equate to $510.42 (($49,000 x .1250)/12) per month for 2 months.
We now have to account for the initial loan origination, draw fees, and end loan fee. The initial loan origination is $500 but paid at initial closing. The draw fees would be $600 ($150 x 4 draws). The end loan fee which is 2% of the total amount loaned would be $980 ($49,000 x .02). My total hard money loan due at the refinance closing would be calculated by adding the total hard money loan, which is the purchase price plus the rehab cost, simple interest on the total hard money loan, draw fees, and ending loan fee. Mathematically for this example it would be $53,091.24 ($51,511.24 + $600+$980). The $53,091.24 is what is due at closing, though you need to consider your true total hard money lending costs, which would include the $500 initial loan origination and the 2 monthly payments you made in months 7 and 8 of $1,020.84 ($510.42 x 2). If you wrapped it in to know your true hard money lending costs you would get $54,612.08 ($53,091.24 + $1,020.84).
What happens to the money owed to the hard money lender when you go to refinance?
Property H has an ARV of $80,000, which was determined at the onset by the hard money lender appraiser who said that if the original scope of work was complete, the property would then be worth x amount. I refinanced with a commercial bank that loans up to 80% of the ARV. This means that at the refinance closing, the commercial bank essentially brings a check for $64,000 ($80,000 ARV x .80). The bank I use does cash out refinance mortgages for $1,500, and they allow that money to be wrapped into the loan. So, in essence, the new mortgage amount with the commercial bank is $65,500 ($64,000 + $1,500). The $64,000 pays back the total hard money loan due, which in this case was $53,091.24. This then put $10,908.76 into my business checking account. If I “pay myself back” the other hard money lending charges of the initial loan origination amount and the 2 monthly payments in months 7 and 8, I am left with $9,387.92. Given that I only put $7,500 into this property, I actually net profit close to $2,000, and have a cash flowing property.
In summary, this is how hard money lending works. It can be very advantageous to use; however, it can also get very dangerous without proper due diligence. This is because you are paying a lot of various fees and they are very high. The fees can really range, but mine are between 10.25% – 12.50% simple interest. Simple interest itself can be very dangerous since each simple interest charge is doing nothing to pay back the actual loan amount like a traditional amortized mortgage would. I hope this helps you in understanding what hard money lending is and how the fee structures work. If you have any questions, feel free to shoot me an email or post a comment. I would be more than happy to help in any way I can in navigating the sometimes treacherous shark filled waters of hard money lending.
Key Terms Used:
Hard Money Lender (HML): A lender that loans on specific pieces of asset-backed properties, often with a much higher interest rate than traditional bank lending.
As-Is-Value: This is the amount that the appraiser determines a property is currently worth in its current condition.
Scope of Work: This is the official document outlining the work that the general contactor will be completing, which outlines each line item and the corresponding cost associated.
ARV (After Repair Value): This is the amount that the appraiser determines a property will be worth after all repairs are completed.
LTV (Loan to Value): The total money being loaned on a property by a hard money lender divided by the ARV.
Total Hard Money Loan: The total amount that you owe the hard money lender back at loan payoff. This amount includes the purchase price of the property minus any down payment you made, plus all interests accrued, any draws made, and the ending loan fee.
Draws: Money that the hard money lender is holding for you in order to pay a general contractor directly for completed work, often submitted in the form of a check or ACH payment.
Draw Schedule: Term used to describe how and when the general contractor will be paid for work completed. Most common example I have seen is a 30/30/30/10 draw.
Simple Interest Loan: Loans where interest is calculated based off outstanding principal balance alone and not amortized out where the actual outstanding principal balance changes. On these loans, you are only paying the interest and not any principal whatsoever.
Cash-out-refinance: Occurs when you take out a new loan against an old loan where the new loan value is higher than the old loan value. The difference between the two amounts is paid back to you in the form of cash.
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