For some, the thought of hard money conjures up notions of loan sharks threatening to break your legs if you don’t pay on time. While not all hard money lenders are ideal business resources, most are knowledgeable, professional and can be used to great advantage in your real estate investing.
With the lack of conventional lending products available to real estate investors, most investors turn to hard money financing as a bridge loan between the acquisition of a property and the permanent financing. Of course, hard money is not cheap, but typically is well worth the money for the purpose it serves. In most areas, the more prominent hard money lenders charge around 5 points and 15% interest. However, with local networking you may find private lenders willing to charge less.
One of the biggest advantages of hard money is the ability to borrow funds for renovation expenses. Most investment properties have some equity potential, but the average home buyer is often discouraged by the less-than-attractive condition of the property. As investors we create margin by having the ability to find, acquire and renovate these properties. The ability to finance the purchase and repairs is key to this equation, and hard money is one tool that allows us to do just that.
In today’s market, an investor obtaining a conventional loan would expect to pay 20-25% down just to acquire the property, and then come up with out of pocket cash to complete renovations. As an alternative, an investor may be able to use hard money financing for the purchase and repairs, while having to place only 10% down on the total cost.
As a quick example, a $50,000 purchase needing $20,000 in repairs could potentially cost an investor $30,000 out of pocket using a conventional loan ($50,000*20% plus $20,000). However, if that investor uses hard money financing instead, the out of pocket cost may be more like $7,000 ($70,000* 10%). Even if an additional $5,000 is added to the equation to cover loan fees and closing costs for the hard money loan, most investors are perfectly willing to factor in this cost in exchange for the leverage hard money provides.
Once the property is acquired and renovated using hard money, the investor can then employ a conventional lender for the permanent financing. Since the renovations presumably have increased the value of the property, the refinancing lender can use the new appraised value in determining the investor’s maximum allowable loan amount. Typically, a conventional lender will allow financing up to 75% of this appraised value. Best case, the appraisal will be high enough so that the investor can refinance the balance of the hard money loan as well as closing costs without any additional money out of pocket.
Another quick example – Using the scenario above with a purchase price of $50,000 and repairs of $20,000, a good appraisal would be in the neighborhood of $100,000 or higher. If the appraisal comes in at $100,000, the lender may allow the investor to finance up to $75,000, which should be enough to pay off the balance of the hard money loan and cover any closing costs.
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Be Prepared Because Guidelines are Changing
Up until now, Freddie Mac guidelines have allowed investors to refinance out of hard money without any seasoning (i.e. owning a property for a certain amount of time), while Fannie Mae has required investors to be on title for a minimum of 90 days. As of May 1st 2011, however, Freddie Mac is changing their guidelines to require that an investor own the property for a minimum of 120 days before they can refinance. This may not seem like a big deal, but, in today’s volatile economy, you might be amazed by what can happen in a short three to four month period.
For investors who plan to refinance out of hard money after May 1st, there are a few things to be cautious of:
1.) Just because you are approved for a refinance today does not mean you will be approved four months from now. If your eligibility is currently border line, talk to your lender about any upcoming guideline changes that may affect your approval status.
2.) Take care to not unknowingly do something to lose your approval status. A few tips: Don’t change job or work status. Don’t take out new credit or run up existing credit. Don’t deplete your checking or savings accounts. (I realize that these may seem obvious, but you would be shocked at how many times I’ve seen investors forfeit approval status because they made one of these missteps!)
3.) Stay alert to comparable sales near your property that may erode the value of your investment. Granted, there isn’t much you can do about this, but your due diligence should be as extensive as possible. Just because your property appraised for $100,000 today does not mean it will appraise for that a few months down the road. This is especially true in areas experiencing a high percentage of foreclosures.
4.) Be prepared to pay the hard money interest for this three to four month seasoning period. In the past, it was possible to refinance 30 days after acquiring a property and only pay one month of high interest. If you are locked into a hard money loan for multiple months, be sure to factor this payment into your holding costs.
No matter your investing goals, hard money financing can be a highly effective tool. Even with the upcoming guideline changes, using hard money to leverage your investment can be a great strategy to acquire, renovate and maintain investment property. However, keep in mind that going forward you will need to be a little more cautious in your approach; especially as it relates to refinancing out of hard money.