The short answer to the question whether you can use a hard money loan for foreclosures is “yes”. In this article we discuss how hard money loans work for financing purchases of foreclosed real estate, and some tips to consider.
Hard Money Loans for Foreclosures
With pre-foreclosure short sales and foreclosure property auctions, it’s essential to have enough cash in hand to get the deal done quickly.
If you can’t fund a foreclosure property purchase with your own cash, and don’t have investors to provide the cash, then a hard money loan is your next best option.
However, even with quick access to capital provided by a hard money lender, there are some complexities to take into account.
The primary interest of the hard money lender in a foreclosure situation is this:
Will there be enough value left over after the expected costs of evicting residents, fixing up the property, resolving any mechanics or other liens, and marketing the property?
In a nutshell, hard money lenders reduce their risk of a borrower defaulting by securing the loan with marketable real estate and other “hard” collateral. The lender is focused on valuing the foreclosed property after all expenses conservatively to ensure they can get paid back.
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Key Considerations with Hard Money Loans for Foreclosures
Let’s break this down by the two stages of a typical foreclosure:
Pre-Foreclosure (aka Short Sale)
When a bank isn’t getting paid by the property owner / borrower, there are a number of options. For individual homeowners, banks tend to go through a long drawn-out process of modifying the loan, agreeing to lower payments, calling in loan guarantees, etc. For commercial borrowers, the bank may also agree to loan modifications and payment delays, with penalties and fees tacked on.
The Bank’s Goal
The goal of the bank is to avoid having to foreclose and auction off the property. This typically results in a significant loss (20% or more of the loan value). The less the bank loses on the loan while the borrower continues to make payments, the better.
However, at some point the situation is eventually deemed hopeless by the bank. The borrower may have passed away, or declared bankruptcy, or has become non-responsive for too long. The bank no longer expects to get paid enough and is facing a major loss.
Bank Initiating Foreclosure
The bank will then initiate formal foreclosure procedures. This starts with a written foreclosure notice mailed, delivered and/or tacked to the door of the property. In a judicial foreclosure state, the bank will petition the court to allow it to repossess and foreclose on the property. In a non-judicial foreclosure state, the bank may initiate the foreclosure without a court’s consent.
An astute investor can often step in this pre-foreclosure period and offer the property owner and bank a reasonable amount of money to buy the property.
Offering to Buy the Property in Pre-Foreclosure (Short Sale)
The investor offers less than the value of the property on the open market, but more than it’s worth to the bank after foreclosure. This is called a “short sale” and it can be a great way for you to buy property at a discount while helping the bank and property owner.
Investors can use hard money loans to purchase these pre-foreclosure short sale properties.
The benefits of buying pre-foreclosure short sale properties with hard money loans are:
- The ability to inspect the property, which helps accurately value any repairs needed.
- Avoiding the risks and costs of foreclosure auctions.
- Helping homeowners in financial distress get out of properties they can’t afford.
- Helping banks avoid significant losses and time needed to foreclose and auction the property.
Post-Foreclosure / Foreclosure Auction
If the borrower continues to default and the bank isn’t able to sell the property in a short sale, then the bank will eventually foreclose and sell the property at a foreclosure auction.
Foreclosure auctions can be wild and wooly events. There may be well-funded buyers in the crowd purchasing multiple properties for real estate investors. There may be individuals looking for a fixer-upper to rent. Even the current property owner (borrower) might be there trying to buy their own property back.
Hard Money Funding
For an investor looking to buy a property at a foreclosure auction, you must come well-funded with cash to pay a “good money” deposit. You need to provide proof of cash availability to close the deal within 1 day.
(NOTE: there are some exceptions to this timing for online auctions, but most physical auctions require full payment within 1 day).
But what if you don’t have 100% of the cash necessary to buy a foreclosed property?
Use of Hard Money Lenders
Hard money lenders can quickly provide the cash to purchase properties at foreclosure auctions. Once you (the investor) win the property auction, the hard money loan can be quickly finalized, and the proceeds released to you.
The investor then writes a cashiers check or sends a wire to the auction company to complete the deal. Once all payments have been made and the property deed is given to you, the deal is done.
The key to securing a hard money loan for foreclosure auctions is preparation. The investor must have everything lined up before the auction.
Info to Provide the Lender Before a Foreclosure Auction
You must provide the following info to your hard money lender for each property purchased at a foreclosure auction:
- The property or properties he or she will bid on at the auction. In some cases this is not necessary, but most lenders want to know what property they’re lending against so they can do their own due diligence.
- The expected after-repair value (ARV) of each property, if that can be estimated reasonably accurately
- A title research report showing all the known liens and liabilities attached to the property that must be cured for it to be marketable
- The maximum acceptable bid the investor expects to pay for each property
- All necessary loan documentation
- A cash deposit and/or other collateral to secure the loan
Once this information is provided, your hard money lender will decide the maximum amount it is willing to finance for each property. This is basically the LTV with the value determined by the maximum auction bid for the property.
Typical Hard Money Loan Terms for Buying a Foreclosure Property
An example of hard money borrowing terms for a foreclosed property might be:
- Amount borrowed – $100,000 (maximum estimated bid minus cash and collateral put up by the investor)
- Term of Contract – 1 year (depends on the property’s condition and whether it’s a pure flip, fix & flip or complete renovation needed)
- Interest Rate – 18% (compounded monthly on unpaid balance)
- Total Interest Paid at Term – $8,877
- Closing Fees – 3 points = $3,000
- Other Costs – Real Estate Appraisal – $600, Credit Report – $50, Documentation Fee – $250
- Total Costs Excluding Principal – $12,777
- Late Fees – 50% of monthly interest charge or 15% of payment
- Collateral required – $20,000 in cash, appraised equity in real estate, securities, gold, jewelry or other liquid assets
Collateral Makes the Loan Possible
Your hard money lender will secure the loan with a piece of real estate, plus the liquid cash and other collateral you put up.
The lender is gambling that if the borrower defaults, they can get their money back plus more. That’s why these lenders take the risk on foreclosure deals.
The Reality of Hard Money Loans Used for Foreclosures
Hard Money Lenders expect one of two things to happen with the loan:
One, they expect the borrower to repay everything on time and in full. This happens when the investor wins the foreclosure auction, is able to successfully take possession of the property, fix it up, cure any liens, and sell it or rent it profitably (and refinance with a regular bank).
Two, they expect the borrower to default. When hard money borrowers default, things happen fast. Your collateral will be quickly taken away by the lender. In many cases, the remaining debt continues until it is repaid by the sale of the property. If the sale doesn’t generate sufficient funds to repay the loan, and the borrower personally guaranteed the loan, the borrower stays on the hook until the debt is repaid in full.
In either case, it doesn’t matter if your bought the property on the open market, by short sale, or in a foreclosure auction. Hard money lenders will structure the financing and loan security so the have the highest chance of getting paid back.
Hard Money Loans Work for Buying Foreclosed Real Estate
If you’re buying foreclosed real estate and don’t have enough cash, then using hard money financing is convenient and fast. There are risks to hard money loans. But if the economics of a foreclosure deal are favorable, this is a great way to obtain short term financing. You will close quickly and have the potential to get into more profitable foreclosure deals.