What is a Hard Money Loan

Okay.  You have heard (or maybe not) of the terms “Hard Money Lender” or “Hard Money Loan”.  What is a Hard Money Lender?  What is a Hard Money Loan?  Why is it “hard”?  What does all of this mean?  Is there easy money out there?  Ironically, “hard money” is the easiest money to find and borrow.  This book will walk the reader through a step-by-step analysis that a Hard Money Lender should utilized in deciding to issue a Hard Money Loan.

First, a Hard Money Loan (“HML”) has been defined as “a specific type of asset-based loan financing through which a borrower receives funds secured by the value of a parcel of real estate.” (Wikipedia).  How is that any different from the financing provided to you on the house you live in (i.e., your homestead)?  Presumably, your home is not in distressed condition and therefore not as much of a risk (if you ignore the last three years) to the banks.  HMLs are typically issued at much higher interest rates than conventional loans and are primarily based on the future  value of the asset (asset-based lending) rather than the current value of the distressed asset.  Because the asset is distressed, the value (in the conventional lender’s mind) is more difficult to calculate and the loan is perceived to be more speculative and higher risk.  A HML is generally based on the after-repair value (“ARV”) of the asset in contrast to the actual value (“AV”) of the asset.  A conventional loan is typically based on the AV which is quite simply defined as the value of the asset “as is” at the time the loan is made either using the contract price or an appraisal of comparable assets.  The ARV, on the other hand, is calculated based on the value of the real estate asset after the estimated repairs are made on the property.  This ARV is usually determined by an appraiser who searches for comparables of similarly distressed properties that have been rehabbed and sold in the same neighborhood within the last 6 to 12 months.  We will discuss the calculation of ARV later in this book.  As set forth below in Exhibit 1, there is a huge difference in the amount a conventional lender will loan on an asset versus that of a Hard Money Lender assuming that the conventional lender wouldf entertain a loan on the distressed asset.

In Exhibit 1, we use the typical example of a buyer finding a distressed home that is listing for $50,000 and in need of approximately $20,000 of repair work.  After the anticipated repairs are made the asset should be worth $100,000 (ARV).  Assuming that a conventional lender would loan on this distressed investment property, it would most likely lend based on the actual purchase price.  At a 70% loan-to-value formula, the investor would only receive financing from the conventional lender of $35,000 (70% of contract price) vs. $70,000 (70% of ARV) from the typical Hard Money Lender.  Remember, to complete the house and have the house sell at comparable market value, the investor needs approximately $70,000 (acquisition cost and rehab cost).  Yes, you are correct in your analysis, the investor will come out-of-pocket  of approximately $35,000 in order to avoid incurring higher interest and higher fees.

Why do we have Hard Money Lenders?  Why not use a Conventional Lender?

Now that we know the basic difference between a HML and a convention loan, we need to know who the hard money lenders are.  Yes, you probably already figured out that a convention loan is issued by a conventional lender and a HML is issued by a ….. Hard Money Lender.   What is a Hard Money Lender?  A Hard Money Lender can be an individual, a self-directed IRA, a group of individuals, a corporation a limited liability company, a business….. (the list goes on and on).  None of these are regulated depository institutions, except for the self-direct IRA which is subject to its own set of rules and regulations.  In reality, a Hard Money Lender is anyone or any entity that is willing to loan money based on a distressed real estate asset having a higher ARV in 3 to 6 months.  To simplify, a Hard Money Lender is lending on the future value of the asset.   Higher risk yields higher returns, in the Hard Money Lender’s mind.  The novice investor may think there are higher risks on a Hard Money Loan; however, we will attempt to dispel the notion of lending on ARV is a higher risk than lending AV on the same distressed asset.

Wow!!  You should be nervous now.  We are telling you that a federally insured bank will lend money to a startup company with no real property as collateral (knowing approximately 2 in 10 startup companies fail in their first year); however, it will not lend on a distressed real estate asset that has a value (or future value) of at least 30-40% more than the loan amount.  Additionally, the HML will be personal guaranteed by the borrow (i.e., a “recourse” loan[1]).  That’s right, generally, conventional lenders will not lend on distressed assets.[2] That is one of the most important reasons why we have Hard Money Lenders.

The other reason that this niche for Hard Money Lenders exists, and in our opinion, the most important reason is the investor/borrower.  The investor/borrower wants to pick up that distressed property, rehab it and either flip it or rent it.  The investor/borrower has contracted to acquire the asset at a discounted price; thereby, creating a large equity spread between cost and ARV.  This equity spread encourages investors to seek out Hard Money Lenders for funding vs. tying up significant amounts of their own money in one property via cash or using their own self-directed 401k as funding.  This is called “OPM”.  OPM simply means “other people’s money.”  Many real estate investors have significant amounts of cash and other resources, yet they still choose to use OPM.  By using OPM, you keep your cash for other investments, emergencies, college education for your children, etc., in exchange for paying a higher interest rate and additional fees.

Let’s recap.  We have told you that it is extremely difficult to find a conventional lender that will loan on distressed properties.  We have told you that if you actually find a conventional lender willing to loan, the loan will most likely be based on the actual value.  We also mentioned that there are higher fees and interest rates associated with Hard Money Lenders vs. a conventional lender; however, we haven’t discussed what they are and how they effect your return on investment (“ROI”).  Are the interest rates really that high and fees really excessive?  Yes, this is written by brutally honest Hard Money Lenders; however, facts are facts and we will layout what we believe to be the average fees and expenses[3] associated with a HML versus a conventional loan and why investors still choose hard money.  Exhibit 2 – Conventional Loan versus a Hard Money Loan for a Buy/Rehab/Flip

Exhibit 2 above is a typical example of analyzing the difference between a conventional loan and a HML on a buy, rehab and flip investment.  In this example, the investor is buying that same home for $50,000 and needs to put $20,000[4] into the house to be able to sell it for $100,000.  We have laid out the basic fees and expenses associated with each type of loan based on averages.  For clarification purposes, closing costs are points, fees and other expenses[5].  A “point” is simply a percentage of the loan amount (i.e., 1 point on $70,000 is equal to $700).  In the example above, the investor could qualify[6] for $70,000 of financing by using a Hard Money Lender (70% of ARV) vs. $35,000 (70% of the acquisition price) with a conventional lender (if one is willing to lend on this asset).  One lender will lend $70,000 and the other will lend $35,000.  Without taking into consideration points, fees and interest, the investor using the conventional lender will be out-of-pocket $35,000 in order to rehab the asset.

Now, let’s review the difference in interest rates of a conventional lender and a Hard Money Lender (6.5% vs. 14%[7]).  We are presuming that the subject house will be rehabbed and sold within six (6) months in this example.  Remember, the interest rates are annual interest rates.  If the investor is holding the property for six (6) months, the interest paid on the loan amount is cut in half (3.25% vs. 7%).  In our example above, the interest rate is a little more than double the conventional rate, but the amount of the loan is twice as high.  The points and fees typically charged by Hard Money Lenders are 4 points and $1,000 in administration fees.  There may also be an appraisal fee, inspection fee and survey fee as well.  We have rounded the points and fees to 8% of the loan amount.  If you add the interest payments, closing costs and out-of-pocket for rehab you are left with the “Total Out-of-Pocket” costs.  The Hard Money Loan is less than one-third of the conventional loan when looking at total cash out-of-pocket to the investor.   The closing costs on the sale side are pretty self-explanatory.  10% for closing costs typically represents the 6% commission to the agent plus seller’s concessions and title fees and costs[8].  Bottom line is the return to the investor cash on cash and the amount of cash used for the property.  In this example, the investor’s return on cash is almost 2 times greater using a hard money loan and that is using 1/3 of the amount of cash that would be needed for a conventional loan.

Let’s recap.  The investor/borrower can make twice as much profit on every dollar she puts into the subject property while useing about 1/3 of her cash to buy and flip a house by utilizing a Hard Money Lender.  In other words, in the example above, the investor could have purchased three homes (assuming same costs and expenses) and would have still used less cash than the one purchase with convention funds, yet have a return of $28,500 (3 times $9,500) on approximately $31,500 in total out-of-pocket.[9] That’s right, the investor can use $6,000 less to make $10,500 more in profit on essentially the same cash[10].

In the example above, we have presumed that the borrower/investor is buying, rehabbing and flipping the property.  Below is an example of the conventional loan versus a Hard Money Loan in the buy, rehab and rent scenario.

In Exhibit 3, we demonstrate the costs and expenses associated with a conventional loan on AV and a HML on ARV.  The examples assumes that the conventional loan on AV will be able to be refinanced out in 6 months on ARV and (a big “and”) the borrower receives a “cash out” of up to 70% of the ARV less the original loan amount (i.e., $35,000).  Assuming the assumptions above, at the end of the 6 month period, the investor would be out-of-pocket about $8,500 less than if she went to the Hard Money Lender.  Remember, that is at the end of the 6 months.  If the investor/borrower did not have $35,000+ in cash to pay for her rehab and remaining acquisition costs, she would only be able to do the HML.  Another way, from the investor/borrower’s standpoint is that the investor/borrower had $37,000 tied up in the property for 6 months with a conventional loan, while the investor borrower that chose to go with the Hard Money Lender only tied up $10,500 for the same time frame.  If other great opportunities on distressed properties occurred during that time frame, the investor/borrower that went with the conventional lender, would have missed such opportunities unless she had another $35,000+ to put down on each deal.

We cannot stress enough that the likelihood of finding a conventional lender that will lend on distressed assets is practically nil.  Further, the likelihood of the conventional lender allowing for a refinance on the investment property in 6 months without a pre-payment penalty may be slim as well as finding another conventional lender that will allow you a “cash-out” on the refinance of up to 70% of the value.  If the investor/borrower is able to find conventional lenders that can facilitate these transactions, then they should utilize them to their fullest extent and send us their contact information so that we can use them as well.

Finally, while we have provided financial and leverage scenarios as to why investor/borrowers choose Hard Money Lenders over conventional lenders; another reason it time.  The time it takes to get lender approval and actually loan money to the investor/borrower to acquire the subject asset will make or break a deal.  Many times, the only leverage that an investor/borrower has when making an offer to a seller is the promise that she can close the transaction within 3-5 days after the option period (if one even exists).  To our knowledge, there are not many conventional lenders that can do that nor can they normally get the loan to committee in 3 to 5 days.  We do want to be clear that we are not stating that every Hard Money Lender has the ability to close a transaction in 3 – 5 days; however, our company can as well as a few of our competitors.  This ability gives the investor/borrower leverage with the seller.  If the seller is aware that the investor/borrower is pre-approved with a reputable Hard Money Lender and can close in 3 – 5 days, the likelihood of that investor/borrower obtaining a lower acquisition price on the subject asset is much greater.  The lower the price, the greater the potential equity for the investor/borrower and for the Hard Money Lender looking at the asset as collateral.

[1] A non-recourse loan means that the loan is not backed by a personal guaranty.  It should be noted that there are some Hard Money Lenders that issue loans without requiring the personal guaranty of the borrower.  These Hard Money Lenders are strictly asset-based lending.  We, on the other hand, lend on the asset as well as the strength of the borrower financial wherewithal.

[2] If you are an investor reading this book, you already know that conventional lenders will not lend on distressed assets; otherwise, you would not have any interest in learing about hard money lending.

[3] Many Hard Money Lenders do not disclose all of the fees and expenses up front.

[4] This does not include maintenance, ultilities and/or unanticipated overages on rehabs that may occur.  We know it may sound ludicrous that the actual rehab amount may be more than the estimated rehab amount, but its true.

[5]Expenses may include, administrative expenses, loan document preparation fees, survey fee, appraisal fee, any applicable title fees and/or expenses.

[6] Qualify shall mean that the investor/borrower has satisfied all of the Hard Money Lender’s prerequisites to issuing a loan.

[7] These are average interest rates based on numerous transactions that the authors have reviewed.  Interest rates may vary state to state and by lender.

[8] It is very important to note that closing costs, when the investor is selling the rehabbed property can vary greatly depending on the commission charged by the listing agent to the percentage give, if any, to the buyer as seller’s concessions.  We have seen closing costs range from 5% to 13%.  It is critical to the investor/borrower (as well as the Hard Money Lender if you have to take the property back) to have your listing agent lined up prior to acquiring your asset so that you will know what the commissions will or should be when making your analysis to go forward with a deal.

[9] Keep in mind that we are not factoring in any carrying costs (excluding interest payments) associated with the home or overages on rehab.  These numbers would be the same whether an investor used conventional financing or a HML.  The Closing Costs are a little greater than actual closing costs to cover carrying costs during the 6 month period.

[10] We are telling you from the borrower/investor’s perspective, she has the ability to spread her risk on her $35,000 in the example above over three properties versus one by using a Hard Money Lender.  From the Hard Money Lender’s perspective, the borrower has put 8% plus of her own money down, has rehabbed the property such that the property has an ARV that give the Hard Money Lender a 30% cushion if it has to foreclose and take the property back.  If the proper due diligence is followed, this becomes a win-win for both the borrower and the Hard Money Lender.