Hard money can provide real estate investors with fast capital when they spot a great deal. However, the specifics of the process need to be well-understood by investors to protect themselves from risk. We discuss how to use a hard money loan to buy an investment property in this post.
What Type of Investment Property?
There are multiple property types you can use a hard money loan for:
- Fix & Flip
- Single Family Rentals
- Multi-Unit Rentals
In this article we focus on using hard money to finance rental property investments.
TIP: To learn how to use a hard money loan to fix & flip properties check out our house flipping with hard money article here.
Buying Rentals With a Hard Money Loan (Buy and Hold)
At a high level, here’s the process of investing in rental properties using hard money loans:
1. Find 2-3 hard money lenders to work with. You want to build relationships with multiple lenders to increase the chances of getting financing when a good deal comes along.
2. Find a good property investment deal. This should be the worst property in a good neighborhood. Make sure you can inspect the property and identify all major renovation areas.
3. Build your pro forma financial plan covering the purchase, financing, rehab and rental (or sale). Plug your estimated costs into your model along with a 10-20% contingency. Make sure your cash flow estimates on the deal are as correct as possible.
4. Negotiate and close the property purchase deal with a hard money loan.
5. Rehab the property.
6. Rent the property out.
7. Refinance the hard money loan.
8. Repeat (BRRR method).
Hard Money Loan Fundamentals for Property Investors
Hard money loans are high-interest loans with short maturities designed to facilitate rapid real estate investment. They typically have a repayment period ranging from 1-5 years (but usually just 1 year). Interest rates can range from 8-20%.
A 20-30% down payment (cash or other collateral) is usually required to get a hard money loan. The buyer is responsible for putting up the necessary capital. This amount can be in cash or liquid securities. The buyer can put it up or obtain it from another cash investor in the deal.
Additional points and fees are included in the cost of the hard money loan. All of this also depends on the lender and negotiation skills of the borrower. Experienced borrowers that have a prior trusted relationship with the lender will likely get better terms.
The hard money lender will place a lien on the property when the loan is approved. If the borrower cannot pay back the hard money loan, the lender will foreclose on the property, repossess it, then hold it as an investment or sell it to recover the loan amount.
Primary documents needed to close on hard money loan:
- Purchase Agreement
- Scope of Work (work to be done on the property)
These are the primary documents needed, and any more depend on the hard money lender’s requirements.
Get Your Deal Math Correct
You must get all your investment calculations right on the deal to get approved for a hard money loan. More importantly, they need to be correct to ensure you will turn a profit on the deal.
Rental Property Hard Money Loan Example
Here is an example assuming the hard money lender provides a 65% ARV loan.
NOTE: In this example the contingency cost is low because the property was bought at a foreclosure auction free and clear of title issues. The house was a complete tear-down replaced with a small prefabricated cabin.
Purchase + rehab + closing costs = ~65% ARV
Here is the loan breakdown assuming $131,000 ARV:
Purchase price = $27,500 (20% is a downpayment)
Contingency = $7,500 (8.8% of total cost)
Rehab Costs = $45,000
Closing Costs = $5,000
All in costs = $85,000 (64.8% ARV)
ARV = $131,000
The ARV is the expected future sale price by comparing to other properties in the area sold within the last 6 months. Per our example, the local market will support a $131,000 sale price.
Profits look like this:
$131,000 – $85,000 = $46,000 profit
Return on Investment (ROI) = $46,000 / $85,000 = 54%
The goal here is to buy, renovate (or in this case rebuild) and fix up the property for a total cost of $85K. High interest rates and points matter less if you can do this kind of deal because the profit margins can be high. But it requires doing your research and planning very well, and closing on the right deal.
Getting Renters to Pay the Costs
In the above example it is assumed the investor sells the property immediately after it is repaired and rented. The investor uses the first month’s rent to cover the hard money loan fees, interest and points.
If renters are not available to help pay these costs, the borrower will have to add this to the cost of the deal. The overall profit will be slightly less.
Refinancing Hard Money Loans on Rental Investment Properties
Rental property investments last far beyond the ordinary time frame of a hard money loan. Even if an investor plans to sell a rental property after renovating it, they will most likely want to refinance it first with a traditional mortgage or bridge loan.
How Much Equity Is Needed to Refinance?
Refinancing with a traditional mortgage usually requires 20-30% equity. If you’ve done the rehab project right, and the market has not taken a dive, then your equity value should have gone up already. This can be supplemented with the down payment and collateral used to secure the original hard money loan.
When To Refinance?
You should have a plan on day one to refinance your hard money loan with another lender and exit the hard money loan. Otherwise you could be trapped in a high interest loan with onerous repayment terms.
Investors should seek to refinance an investment property bought with a hard money loan as soon as a traditional lender is willing to. This will likely happen after rehab is complete and a renter has moved in so there is cash flow on the property.
Refinancing will generally require tenants in the property paying rent and generating cash flow for the property.
Refinance With a Low Doc Mortgage
Low documentation loans allow borrowers to get funding quickly without needing extensive financial documentation. The Consumer Financial Protection Bureau (CFPB) rules have made getting a low doc mortgage harder today than before the 2008 financial crisis. However, some lenders are still willing to grant a non-qualified loan.
A low doc mortgage can provide an efficient strategy to exit and pay off a hard money loan. The key is to be qualified and have the new loan approved and funded before the maturity date of your hard money loan.
Get a Cash Out Refinance Loan
The traditional bank lender may lend up to 90% (or even more) of the property’s value if it has solid cash flow. This allows you to get cash out of the property to invest elsewhere, pay off high-interest loans or hold for risk contingencies.
Cash out refinancing is best utilized if you plan on holding a cashflow-generating property for a long period of time. Assuming the property is rented out consistently and inflation rates are positive, this allows you to get cash out while growing your equity value over time.
Here’s an example of a cash out refinancing on the property above:
$131,000 ARV (current market value after renovations are completed).
Bank makes a cash out refinance loan at 90% of market value = $117,900
Pay off the hard money loan amount = $85,000
$117,900 refinance loan – $85,000 hard money loan = $32,900 cash out
Benefits of Cash Out Refinancing for Hard Money Loans
The bank will refinance the hard money deal with a lower interest rate and less points. On a rental property this might be 5% for a 30 year fixed rate mortgage. Compared to a typical 15% hard money interest rate, it’s a no brainer!
In our example, with a cash out refinance you could pull out $32,900 in cash and end up with a long term rental property generating positive cash flows.
A major bonus is you have no capital gains tax on this debt. You’ve generated cash without selling the property.
Traditional Banks vs. Hard Money Lenders for Investment Properties
Traditional banks will generally not approve a loan on a property that has significant damage, such as roofing issues, water damage, plumbing problems, etc.
However, a hard money lender will make loans on properties in poor condition. This allows you to buy the property and finance the repair costs, as long as you can put up enough cash collateral and prove the deal economics are good.
Hard money lenders are also less stringent with underwriting. They care less about your income, credit score, and other factors. As a result the amount of documentation is far less, and the approval and cash disbursal process is fast.
Tips for Maximizing Your Real Estate Profits Using Hard Money Loans
Discount Properties Only
Real estate investors need to make sure they only buy properties at a significant discount when using hard money. This generally means you’re looking for significant rehab projects, foreclosures and opportunities to add square footage. You’re looking for big discounts to ARV, not to current market value.
You Must Add Value
Adding value to the property during rehab is how a real estate investor makes profit using hard money loans. This means replacing the roof, adding a deck, more square footage, additional windows and lighting, or converting a garage into a bedroom. Plan a lot of landscaping work!
Try for 100% Financing
Although hard money lenders do not offer 100% financing, you can still get it. Using a business credit for your down payment, help from a private money lender, or leveraging other properties in your portfolio to provide the necessary cash.
The idea is to avoid using your own money for money down payments and collateral. This increases the number of properties you can own and boosts your cash flows and ROI.
Leverage Your Renters
If you combine 100% financing for a buy and rent property, you can also cover the interest on the loan(s) by using the rental income paid by your tenants.
One caveat: You should only do this with renters who pay a deposit and sign a long term rental agreement (6 months plus). The last thing you need is to leverage future rental income and have the renter bail out after a couple months with no cash penalty.
Build a Team of Deal Finders
A team of deal finders will allow you to cover more geographical area when searching for deals. The more people you have helping you, the more deals you will find.
Also, don’t be afraid to leverage realtors to find deals. Many of them will gladly help find distressed and pre-foreclosure properties.
Tip: You can also use your local real estate investment groups to connect with and team up with other investors.
Do 1031 Exchanges
Use 1031 exchanges to flip a property and invest in another one. You don’t pay capital gains taxes by using a 1031 exchange in an escrow account. You hold the property for 6 months you can use the proceeds for the next investment property.
Show Proof of Funds
Have your bank account statements and pre-approvals ready at all times. The ability to show cash on hand and proof of incoming cash flow is gold when doing a quick deal.
Pre-qualification letters from traditional mortgage lenders are highly useful. This proves a third party has already done their due diligence and is ready to finance you. You can use these pre-qualification letters as negotiating leverage with other lenders to get better terms.
Building a Real Estate Portfolio Using Hard Money Financing
Using hard money to buy more than one investment property works very well for portfolio growth strategy.
Using the BRRR (Buy, Rehab, Rent, Refinance) strategy, you can just repeat the process over again on more properties. Buying, fixing and renting using hard money to leg into new deals allows you to build a portfolio of properties that self-finances.
Owner Occupied Properties Cannot Get Hard Money Loans
Hard money loans are only for properties that are non-owner occupied. This rule is set by the Consumer Financial Protection Bureau (CFPB). So you should only use hard money loans if you’re living elsewhere.
Use Hard Money Loans at Foreclosure Auctions
Buying properties at foreclosure auctions using hard money loans is a great way to invest in distresed properties. Many hard money lenders are willing to loan up to the maximum bid amount on short notice. You will need to put up 20-30% cash collateral (or use a partner to fund that).
You can often refinance the property quickly after you win the foreclosure auction and fix any condition issues. It’s possible to refinance a property in under 30 days if it does not have significant physical defects.
Use After-Repair Appraisals to Establish Value
An appraisal after property renovations are complete can add significant value through accurate selection of comparables.
One problem that arises in property financings and sales is inaccurate selection of comparables. If the appraiser is very busy or simply makes a mistake and picks properties without doing a full analysis, it can cost you thousands of dollars.
When setting up the appraisal, provide comparisons of similar properties for the appraiser to consider. Appraisers are required to incorporate like properties in the area into their calculations. By doing some of the groundwork it eases their job, and makes the appraisal more accurate.
Don’t Get Stuck In a Hard Money Loan With No Exit
Remember, hard money loans are short term and charge high interest rates. You do not want to get stuck with one that can eat up all your cash flow. If you struggle to get tenants, or your renovation project goes way over time, then you can bump up against the loan maturity. When the balance is due, you have to pay, or you will lose the property.
Make Your Deal Lender-Proof
If you calculate the financials and cash flow properly, it makes your ability to refinance the property much stronger. This opens it up to multiple competing lenders and makes your property lender-proof.
National vs. Local Hard Money Lenders
TIP: To find a selection of good hard money lenders in your area, check out our hard money lenders directory by city or state.
Using out of state hard money lenders can affect the overall terms and rates you pay. Using in-state local lenders may be better in this regard.
National lenders tend to be more closely aligned with traditional banks in the strictness of their terms. Local lenders may be less strict in their underwriting than national lenders, because they undertand the local market better.
Have a Contingency
Always expect the unexpected with real estate rehabbing, flipping, and investing. To protect yourself from potential disasters, you must have a contingency amount to give yourself some financial margin.
We recommend you stick to the 70% ARV rule for calculating all-in costs. You should not pay more than this to purchase, finance and rehab a property. If you can do better than this, then great.
Total Borrowing Cost Must Also Include a Contingency
Make sure to include in your cost analysis a contingency amount of 10% to cover financing-related issues. This can occur if the lender pulls out and you have to find another one on short notice. Or your rehab is late and you get hit with fees. Or an unexpected lien appears that you have to cover.
Cash is King
You need liquidity to get a hard money or refinance loan, which includes access to funds as cash. Lenders will look for enough money in the bank, and if you don’t have enough then the deal may not go through
Loan Size Matters
Hard money lenders are sometimes more likely to grant a larger loan over a smaller one. For instance, a $75K loan is less likely to get approved over a $125K with a hard money lender. The reason is, a hard money lender will make less money on the smaller loan for the same amount of work.
A hard money lender must make a minimum of $2,500 profit on the loan which includes points, fees, and rates. This is the baseline level for most lenders. Also, points are usually driven by the loan size and every lender will want to make at least 2 points.
Ask the Hard Money Lender Lots of Questions
You should ask each hard money lender about what they need specifically. Do they want a deposit? A 2nd lien on the property?
Check out this article for a list of important questions to ask a hard money lender.
A Down Payment and Contingency May Not Be Enough
If the hard money lender will only give a 70% ARV loan on comparable properties, then your total budget for the purchase and rehab must match this. If you are short when adding up the purchase price, contingency, rehab and closing costs, then the lender will require you to put up more cash.
Here’s a good example:
Comparable properties = $375,000
$375,00 x .70 ARV = $262,500
Purchase price = $185,000
Rehab + contingency = $80,000
$265,000 – $262,500 = $2,500
In this case you will need to put up an additional $2,500 cash to get the hard money lender onboard.
So, should you put up the additional $2,500? Let’s do the math:
The sale and profit on this property is high. It is $375,000 – $262,500 – $2,500 = $110,000
Points = $7,875 (3 points)
Interest for 12 months = $31,500
Profit = $70,625
In this case, we still stand to make $70,625 if the financial calculations hold. So, yes, you should put up the additional $2,500 cash.
Hard Money Loan Tips for Real Estate Investors
TIP #1: Be fully prepared for the “deal process” when getting financing from any lender. Make sure you use a well-designed rehab cost estimator as discussed in this article >
TIP #2: Think like an entrepreneur when doing real estate deals. Learn all the creative angles you can use to get deals financed and have buyers and renters cover your cash costs.
TIP #3: You want to buy distressed and ugly houses in areas that are improving. Look for nice landscaping, good schools, high end stores, Starbucks, dog grooming, Target, Whole Foods, etc. in the area.
TIP #4: Partner with a private money lender or equity investment partner to pay for the downpayment needed for your hard money loans.
TIP #5: When using a BRR (Buy, Rehab, Rent) strategy be sure to maintain the property and keep it occupied so you can use it to draw out cash and fund further deals.
You Can Use Hard Money Loans for Long Term Property Investing
This article was designed to give you a good set of ideas on how to use hard money loans to buy long term investment properties. Hard money financing is a great way to move fast and build up a portfolio of properties without using much in the way of your own cash.