Private loans, sometimes referred to as “hard money” loans, are a critical part of the real estate industry. Without private lenders, many profitable opportunities would fall by the wayside as conventional lenders determine a particular project falls out of their lending guidelines. Private lenders however can review an application that otherwise might be turned down by a traditional bank. If you’re exploring a potential project and you’ve never worked together with a private lender, here is what you can expect.
Private loans are very short term from as little as 90 days up to three years. A private lender will fund the project both to acquire the property as well as provide needed funds to rehabilitate the project. An important part of your loan application is not just the sales price of the property but also an itemized list of what needs to be done along with rehabilitation costs, soft costs and labor required. Depending upon the type of property, a private loan can be made up to 70% of the “as repaired” value. The private lender will order an independent appraisal to make the determination of what the final value will be.
You can expect to provide evidence that you have not only enough cash in the bank for the down payment and closing costs but also have funds left over in your bank account. Lenders refer to this amount as “cash reserves.” Liquidity is key here.
Rates and terms will be higher than conventional loans, hence the term “hard money.” Most private loans however allow you to make interest only payments during the rehabilitation period, keeping your monthly payments to a minimum. A private lender wants to make sure the property being financed is marketable and there are similar types of properties in the general area. The property appraisal will confirm marketability.
When presenting your proposal perhaps the most important of all is to have a clear exit strategy. For example, if you’re going to fix-and-flip, provide a signed sales contract from a ready and willing buyer. Go ahead and provide a copy of the buyer’s preapproval letter from their lender. If you’re going to hold onto the property for the long term both for appreciation and monthly cash flow, show that you’ve already applied for a conventional loan and have a preapproval letter in hand.
Conventional lenders use a term called “compensating factors” which means there are other things in a borrower’s financial profile that improves the quality of the loan file. For example, let’s say that a borrower’s debt to income ratio is a bit high and the lender is contemplating whether or not to approve the application. The borrower provides evidence of not just the minimum amount needed for the down payment and closing costs but a significant amount of cash in the bank. That’s a compensating factor. Or, the borrower has been self-employed for 20 years and business bank statements show a solid cash flow. Private lenders can also employ compensating factors.
If a private lender is reviewing an application and sees the borrower may be stretching some of the lending guidelines, showing the lender how the private loan will be paid off and when can push the application over the goal line. Have your exit strategy well planned. Don’t apply until you have one.
And where do you apply for a private loan? It can be a bit confusing because many of the online ads you see are not direct lenders but brokers. No harm there are at all but many times the companies that advertise private money don’t review the application upfront to see if hard money is a possibility. Instead, they send the application to as many private lenders as they know to see if they get a nibble.
Ideally, you want a lender or broker that knows private lenders and the reputations they’ve established. Let the mortgage company help find the ideal private lender for your situation. The mortgage company gets a fee from the private lender for originating the loan so there is no additional charge.