Should You Use a Hard Money Loan for Rentals?

In This Article

Part of the growth of real estate investors comes with understanding the various ways to use OPM (other people’s money) to grow MOP (my own portfolio). There are a million paths (well, close to that, anyway) to fund real estate investments. Hard money loans are an option for borrowers who need to get money quickly to purchase a rental property.

Let’s explore how a hard money loan for rentals is a great alternative to traditional bank loans, especially for real estate investors who need a short-term loan.

What is a hard money loan, and how does it relate to rental properties?

Hard money loans are funded by private investors and are typically short-term loans.

Traditional long-term financing from banks has a whole process that requires a lot of paperwork, underwriting, and background checks. Banks do this to make sure that buyers will pay the loan back, and the process can take a couple of months, depending on the type of loan.

Hard money loans are the opposite—they can be approved in a couple of hours, and little paperwork is required. Hard money lenders are not as concerned with the borrower’s credit history, and some have minimal approval qualifications.

These loans are specifically suited for investments that will turn a quick profit, and interest rates can go as high as 18%. While this may seem like an exceptionally high rate, the trade-off is being able to finance large expenses quickly to secure an investment. In contrast, traditional mortgage loan interest rates usually hover around 4% to 5%.

Prospective borrowers looking to flip a foreclosure, those who have a lackluster credit score, or those who simply do not want to jump through conventional lenders’ hoops for long-term financing can all reap the advantages of taking out hard money loans for rentals.

Is it difficult to get a hard money loan for a rental property?

The short answer is no. These lenders look at the rental property’s potential to gauge if the buyer can pay the loan back in time. The hard or private money lender will generally lend on the property’s value, its ARV (after repair value), or what it will rent for.

They also base the loan on the value of the collateral or the loan-to-value ratio (LTV). The LTV is the loan amount divided by the value of the property. It is generally around 60% to 70%.

Mortgage Amount / Appraised Property Value = LTV Ratio

For a $100,000 loan, the property needs to be valued somewhere between $140,000 and $160,000. The formula would look like this:

100,000 / 160,000 = 62% LTV

That way, if the loan is not paid back, the lender remains secure since the property is valued higher than the amount loaned. The potential to gain or lose an asset with substantial equity motivates the lender to supply the money and encourages borrowers to pay it back quickly.

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Using private money lenders and hard money loans for rentals

In this scenario, I use the hard money upfront, funding all or nearly all of the upfront costs of the rehab. This way, I control the house and get the rehab done with little or no money out of my pocket. Once the rehab is done and the house is ready to rent or already rented (private money lenders love to see the house rehab finished and the house rented), I let the back-end lender know I am ready.

One of the private money lenders I use looks at a comparative market analysis (CMA) and wants the basic rent of the area, a workup of the property, and its projected cash flow after all expenses. Another one knows the area pretty well and wants to know what we are all in for and what the after-repair value (ARV) is, and that’s pretty much it.

Some private money lenders want to see a full or drive-by appraisal of the property. Each lender is a bit different; just know what they are looking for and prepare your property, wallet, and efforts for whatever they are asking for.

Let’s say the back-end lender funds up to 65% LTV, and our ARV is $70,000. That means the lender will loan up to $45,500. Let’s say we are all in our property for $48,000, including our hard money costs, so we would need to bring the closing costs of the second transaction (if it’s a full closing with title insurance, etc.), plus the difference of the hard money loan.

(For the example, I am not adding anything with our closing costs for the second transaction for simplicity.)

$48,000 – $45,500 = $2,500

In this scenario, for an asset worth $70,000, with $45,500 financed, I would be out of pocket $2,500, and the investment would rent for $800–$900 monthly.

#BOOM

Can you say hello #CashOnCashReturn?

The wonderful thing about private financing is how easy it is to work with a private money lender. The downside is that you may pay points and have a higher interest rate than you would at a bank.

Using mortgages and hard money loans for rentals

We have done everything we talked about above in this scenario, except now we go and get a mortgage loan with a traditional bank instead of a private lender loan. I have a wonderful community bank that I work with, and they will loan up to 65% to 70% LTV, but they require a certain percentage of the deal to come from our own funds. The costs upfront regarding points are usually lower, and the interest rates are significantly lower.

However, remember that in this scenario, if they require we have 20% of our own funds in the deal, we would need to have 20% of the $48,000—so we would need to be able to come up with:

$48,000 x 20% = $9,600 cash, out of pocket, plus any other bank closing fees

Now, that comes off the loan balance, leaving us with a $48,000 – $9,600 = $38,400 loan balance (which is close to a 50% LTV), but it also means we have to be able to come up with nearly $10,000 at close.

Not all banks require that, but just KNOW what you are getting into before you are a day or two from closing and have thousands of dollars to come up with that you aren’t prepared for!

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When is a hard money loan a good idea for rental properties?

A hard money loan for rentals is extremely useful when an investor does not have the cash upfront to get a traditional loan. For me, hard money was there when I had a deal I knew was great, but I didn’t have the cash to purchase it or fund the repairs.

I first tried hard money for flips, and the deal was structured as 15% of the purchase price and 100% of rehab, as long as the total loan was less than 75% of ARV. This means I needed a down payment of 15% (instead of the 20% to 25% of a bank loan), and the hard money lender was going to give me all the money for rehab (more on the rehab part below). But like I mentioned, my loan needed to come in below a certain ARV.

It looked like this:

• Purchase: $123,000
• Down payment: $18,450
• Rehab budget: $55,000
• Total loan amount: $159,550 ($123,000 – $18,450 + $55,000)
• After repair value: $255,000 (per appraisal)
• 75% of ARV: $191,250

Was my total loan amount less than 75% of the ARV amount? Yes.

Does this deal work for a hard money lender? Yes.

Since we are talking about having or not having enough money to take the plunge, was $18,450 just pocket change at the time? Heck no! It was a lot. However, if I had done a conventional loan at 25% down on the $123,000 purchase price, I would have written a check for $30,750. That’s a $12,300 difference.

Don’t forget, with this hard money loan, they were paying for 100% of the rehab too.

Let me be clear, though. They (at least for me) did not write me a check for the $55,000 that I indicated was the rehab budget to fix up for the property. Not even close to that.

Instead, everything was done on draws. Did I know that going into it? Not really. Do I really wish I understood that better? Yes.

Let me explain why.

The rehab aspect of the loan could potentially have a major impact on your wallet. Yes, they will pay for repairs, but there is a process.

My process went something like this:

1. The contractor and I agree on the budget.
2. The contractor and I agree on the timeline.
3. The contractor starts job No. 1 of the project.
4. I pay contractor funds to get rolling (cost of materials).
5. The contractor finishes job No. 1.
6. The third-party inspector comes out to sign off on completed work.
7. The third-party inspector submits his findings to the lender.
8. The lender issues you a payment (the “draw”) for whatever job(s) have been completed.
9. The lender may issue you partial payments if the inspector found the job(s) to be only partially completed.

For me, I needed to front the money (or at least part of it) for each job on the rehab outline. That means, aside from any down payments, lender fees, and points, I still needed to have some reserves to get the job done.

Please use caution. This particular fact has been discussed at length, but it is still worth mentioning: Do not give your contractor all of the money upfront.

Many argue that you should exchange no money before the job is completed and the draw is issued. This is for you to decide based on your relationship with the contractor, the level of trust you have, and, I suppose, how much cash you are willing to risk.

Speaking of draws, it is also possible to make money off of draws. My buddy Russ (of Homes R Russ) told me that the main reason he had done so many hard money deals was because of all the tax-free money he’d make on the draw. His strategy wowed me, as I never really thought about it like that.

At the beginning of his real estate career, he made a lot of hard money deals to purchase rentals. But the most important value was probably in the draw schedule. Once he closed on a property, after certain stages of work were completed, the hard money lender would release the next draw or batch of money.

So, if Russ was getting $10,000 from the draw schedule for all the work that was completed by paint and carpet, and if he was able to get his crew to do it for $6,000, he would make the remaining $4,000 off the draw tax-free, because it was a loan. He said he did this for several years starting, and it had become like a game to him to try to come in under budget.

How can an investor find the best hard money lenders?

As with anything involving real estate, investors need to research and shop around to find the best hard money lenders. A good starting point is BiggerPockets’ directory of hard money lenders, where the search can be refined by state. The things to watch out for are reviews and the reputation of the lenders; the speed and simplicity of acquiring the loans; if they cover renovation costs and what their requirements are to do so; and the interest rates that they typically charge.

Yes, there are ways to do no money down and even low money down (think seller financing) when funding investment property purchases. However, my experience with using a hard money loan for rentals was a great one.

This strategy checked all the boxes for this particular deal. I needed to get into the property with a lower down payment, and I needed someone to fund the rehab. Yes, there were points, and yes, the interest rate was comparatively high (9.9%). But at the end of the day, I got the property, rehabbed it, and rented it. Mission accomplished.

Sometimes you just have to take a calculated risk and not look back.

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.