There are many misconceptions in the marketplace about hard money loans, as well as some confusion about the differences between hard money lending and private lending. Although the precise definition is debatable and varies by source, a hard money loan is based primarily on the value of the subject property while borrower credit-worthiness is secondary.
This means that while a hard money lender may fund a loan largely based on the value of an asset, it is still necessary to pull the borrower’s credit, review their financial history and ask for bank statements to establish cash reserves. Private lenders may offer hard money programs, but they also might specialize in nonprime mortgages or even conventional loans.
The private lender label is typically applied to smaller-sized companies that don’t offer agency-backed loans through Fannie Mae or Freddie Mac but work with multiple asset classes in both residential and commercial real estate. Additionally, private lenders may have several types of loan programs, ranging from those with lower interest rates that compete with conventional loans to hard money products with high interest rates that are often used for bridge lending scenarios.
Mortgage brokers and their clients should understand the loan parameters for hard money products. Along with deal structure and pricing, originators also should be aware of the funding process and the importance of the appraisal in closing on time.
In a hard money lending scenario, the decision to lend is based on the subject property, and this usually results in the lender being conservative with its loan-to-value (LTV) ratio. The lender will offer less leverage on the purchase price, or the “as is” LTV. With a fix-and-flip loan — which is designed to finance property improvements so that the investor can quickly resell for a profit — a hard money lender also will have a conservative ceiling for the loan amount based on the after-repair value (ARV).
In terms of setting expectations for a borrower when applying for a hard money loan, there is a presumption that more cash will be brought to closing than is required for a conventional loan. For example, let’s say that a lender caps the as-is LTV at 80%. After all repairs are done, the lender will likely want to have an LTV of 65% to 70%. Hard money loans are usually underwritten with these coinciding LTV guidelines. These are basics when preparing a client to qualify for a hard money loan, whether it’s for a fix-and-flip project or a long-term purchase of a rental property.
Once the broker and their borrower have started the funding process, there are items that can still affect the closing timeline, and it is vital to understand them. Many times, borrowers assume that a hard money loan can close quickly simply because of its name. But what they don’t realize is that because hard money lenders base their decisions primarily on property values, the first step in the funding process is to obtain an appraisal or another type of evaluation through a third-party professional.
Although a hard money lender may be able to close much more quickly than a conventional lender, an appraisal may slow down this process in markets where evaluations are taking longer to be completed than their historical norms. If an appraisal takes three to four weeks to get done because the appraisers in a particular market are exceptionally busy, then a borrower cannot expect to close a hard money loan in 10 days. In this case, the borrower and the broker must make sure to submit everything required by the lender to get an appraisal ordered within the first few days of the process. Completing this initial step in timely fashion is crucial for speeding up the closing process.
If the borrower and broker do not make the appraiser aware of the features that are being added to the home, then this will naturally result in a lower after-repair value.
Having discussed borrower expectations and closing timelines, as well as touching a bit on the importance of appraisals, let’s expand upon the appraiser and hard money lender approaches to the after-repair value. For a fix-and-flip borrower to get the best loan terms possible, they and their mortgage broker need to make sure the appraiser is thoroughly aware of the remodeling plan since it will clearly affect the ARV.
For example, if a home flipper is planning to enclose a car port to create a garage, add a master suite, and improve the landscaping and outdoor living space, each of these items would need to be provided to the appraiser in advance of the inspection. If the borrower and broker do not make the appraiser aware of the features that are being added to the home, then this will naturally result in a lower after-repair value.
The borrower’s loan expectations may not be met if an accurate scope of work is not provided, due to the restricted leverage of the ARV. In this case, before an appraisal is ordered, the borrower should meet with their contractor to establish a full budget and detailed project plan. This way, the appraiser has a line-by-line illustration of the plans to remodel and improve the property.
Additionally, the appraiser can pull nearby sales of comparable properties with similar features. The scope of work can be attached to the appraisal report for lender and borrower reference during the rehabilitation process. If the scope of work is not included with the appraisal order, the appraiser may establish an as-is value of, say, $200,000 and an ARV of $210,000, which is clearly not a good profit margin for a home flip. But if the appraiser has these details prior to visiting the property and is able to see all of the planned improvements, then the ARV may come in at $300,000 — resulting in a much higher and more acceptable yield for the fix-and-flip investor.
The most important difference between hard money lenders and private lenders is that hard money lenders are always nonconventional, and they focus on unique deals that require flexible underwriting while balanced against higher interest rates. The hard money lender typically establishes value and a loan amount by working with a third-party appraisal management company.
When applying for a hard money loan, a mortgage broker should be prepared for the appraisal order by having their client fill out the necessary documents — including the scope of work being done — to obtain the most accurate after-repair value. The ARV is extremely important for establishing a loan amount and helping a client generate profits from their investment property.