Real Life Planning Podcast Ep 42: Questions to Ask Yourself Before Borrowing a Hard Money Loan

In Episode 42 of the Real Life Planning Podcast, Cynthia Meyer, CFA®, CFP®, ChFC®, breaks down the key considerations for real estate investors exploring hard money loans, including when to use them, typical terms, and risks. She also shares essential tips for asking the lender questions and understanding the pros and cons of private loans.

" …if you've got a private money lender that works in your market, they may be able to give you very helpful feedback about whether or not your spending plan for the project is on track and realistic.” - Cynthia Meyer

This week on Real Life Planning Podcast:

Takeaway Quotes:

" I would say that the costs of having… a real estate attorney review this document with you are going to be well worth it because you'll fully understand what is really there and what the potential downsides are for you and what you're really on the hook for if things don't work out with your real estate project.” - Cynthia Meyer

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About the Real Life Planning Podcast

Hosts Cynthia Meyer and Vekevia Tillman-Jones explore practical steps for real estate investors to build financial freedom and make working for someone else optional.

Episode 42 Transcript

[00:00:11]Welcome to the Real Life Planning Podcast. I'm Cynthia Meyer, real estate investor and financial planner. And today we're talking about questions to ask yourself before you take a hard money loan. So hard money is a synonym in the real estate world for private lending. So lending that comes not from a bank or a savings and loan, but from a private individual or a group of individuals who are lending in private transactions.

[00:00:47] And this is really common in real estate investing, in particular for properties that might not otherwise qualify for traditional bank lending or for borrowers who might not qualify for traditional bank lending.

[00:01:02] Typically, private lending happens in these circumstances.

[00:01:07] One is a renovate and sell transaction. That's also commonly known as a flip or a fix and flip. A renovate and rent transaction. Again, a renovate and rent transaction when either the property or the borrower would not qualify for a traditional loan. Private lending often happens in new construction projects. Sometimes there can be a cash out refinance a private loan, or owner financing, or private mortgages are another type of private lending or hard money.

[00:01:41] So typically the loan terms in a private transaction are both similar and different from a regular bank loan. Now, the first thing to know is that interest costs are considerably higher than a traditional lender. Private loans are not sold or securitized after the loan closing process, unlike a conforming loan or a conventional loan.

[00:02:10] So interest rates are much higher. And so a gold star borrower, the experienced flipper with many projects in their history might have a good record of delivery, might pay in this environment, maybe a minimum of 10 percent or 11%;. Rates to inexperienced borrowers might be as much as 16 to 18%, not too dissimilar from some credit card rates of interest.

[00:02:41] Private lending or hard money often has an origination fee. Typically, that's going to be 3 to 5% of the loan balance plus regular closing costs for the loan, like getting an appraisal, for example, if that's necessary.

[00:02:56] Typically, hard money or private lending is a short term loan. Could be as short as three or six . Could be as long maybe as 18 months, possibly two years, but generally, we're looking at a 16 to 18 month loan period.

[00:03:10] Often the loan is interest only during the initial period and then might be refinanced later with hopefully with a conventional loan. A private loan often has a prepayment penalty; so that helps the lender who is, again, usually a private individual or a fund of private individuals, investors lock in that rate of return for the loan period.

[00:03:35] It doesn't take very long to close a hard money loan. That can be really helpful as a real estate investor. You can often close in one to three weeks. The loan amount is typically going to be 80 to 90 percent of the project cost or 60 to 70 percent of what's called the after repair value; a conservative estimate of what the property will be worth after the repairs and renovations are made. So those are typical loan terms andif you've noticed they're slightly different from going to get a typical 30 year or 15 year loan mortgage at the bank. The underwriting process is a little bit faster. The interest costs are higher and it's more flexible to meet different kinds of flexible situations.

[00:04:21] Now, hard money or private money is often used, as I mentioned earlier,when the property or the borrower wouldn't meet the conventional underwriting standards. So, in the case of a flipper, for example, they might buy a property that needs a lot of renovations or structural work and consequently a bank isn't going to appraise that property very much or might not lend on it at all. Then they can also borrow for the construction work in the project to fund their construction project and that is not something that a regular bank would typically lend on, as well. Just something to think about when would you use a hard money or a private loan? Again, it's when you couldn't normally finance that project through a bank when your timeline is really fast and you want to go and make an offer on a property and you can't get financing approved in a short period of time, or if you as the borrower don't have enough capacity to borrow from a traditional lender in terms of your debt to income ratio, for example. There are underwriting standards in hard money loan, but the lender, because it's a private transaction, can be a little bit more flexible. Some cases they'll charge more, of course. When we think about risk management in a hard money borrowing situation, there's some things to keep in mind, right?

[00:05:47] One of which is if your holding period is longer than expected, then the interest costs of a private loan, a hard money loan can really add up. So as I mentioned, interest is typically interest only during the initial period with a balloon payment at the end. We've all seen shows, renovation shows, for example, where it's taken longer to sell the renovated property than originally anticipated and those interest costs can really add up over time. If you're paying sometimes as much as twice or two and a half times as much as the market rate of interest for a traditional mortgage. Renovation and rehab costs could go over budget. I think all of us who have worked with contractors know that while you can have a contingency in your construction budget, sometimes you discover things during the construction process that cost a lot more money and that is certainly is something that you have to plan for in a private money situation.

[00:06:49] Could have depreciating property prices if your exit on the project is to sell or if you plan to refinance to a conventional loan and pay off that hard money loan with a balloon payment at the end of the renovation.

[00:07:03] What if prices go down and you can't refinance the property for as much as you have borrowed? Or you sell the property and you don't have as much profit baked in? You might have to bring some cash to to the end of the transaction to pay off that hard money loan.

[00:07:18] If you're renovating and renting, could have decreased expected rents. There are certain assumptions of how to service the loan and the eventual refinance mortgage are baked into your project plan, but something goes awry, the market moves against you, and the rent turns out to be lower or the vacancy rate is higher.

[00:07:36] You could have inexperienced or unreliable contractors. So, as opposed to a traditional construction loan, say, for example, building a home where the bank is your partner in keeping the contractors on track, in a private money situation, the good thing is that the private lender, the hard money lender will help you budget and evaluate for your project so they can be a good partner in figuring out whether the post renovation value of the project might be profitable. It's still up to you to pick and manage your contractors and they may not be able to deliver in the time allowed for the project budget allowed that you've borrowed for.

[00:08:22] What are some common questions that you should ask if you are considering a hard money loan? So the most important question is what are your goals for the real estate purchase and renovation? Again, we talked about beginning with the end in mind. Are you planning to renovate and rent? Renovate, refinance, and rent, or renovate, rent, and refinance?

[00:08:48] Are you planning to sell the property? Is this a traditional fix and flip where you're planning to get in, make renovations, get out as soon as possible, and you're never going to refinance that hard money loan, you're just going to sell it and pay it off?

[00:09:00] You want to ask your hard money lender if they will review the property budget together with you. These experienced hard money lenders have seen gazillions of renovation projects, fix and flips, BRRRR projects; Buy, Rehab, Rent, Refinance, Repeat. They've seen them all and they particularly, if you've got a private money lender that works in your market, they may be able to give you very helpful feedback about whether or not your budget or spending plan for the project is on track and realistic.

[00:09:38] Ask your lender if they have modeled a range of situations. In your risk management, you want to create a kind of worst case, best case, and a median expected case scenario for your spending and exit plan for the project. So make sure that you've modeled a range of scenarios and if possible you've discussed this with the hard money lender so that everybody is on the same page about what the project is typically expected to deliver on.

[00:10:09] Ask yourself if you have other sources of liquidity if something goes awry. For example, you have an unexpected construction or project cost. It takes longer to sell the property. It takes longer to refinance the loan if that's what you're trying to do at the end of the hard money period.

[00:10:29] What other sources of liquidity do you have? Do you have cash reserves in your rental property business or in your personal emergency fund? Do you have access to a HELOC on your home that you could tap into? Could you borrow against a taxable brokerage account or liquidate some securities to pay for an unexpected expense? Do you have access to a 401k loan in extreme circumstances that might be an option or a cash value life insurance loan, right? Do you have other sources of liquidity that you could use to pay extra interest costs if the loan period is longer or extra project costs if the project goes over budget?

[00:11:07] Next, what due diligence have you done on the lender? You'll see if you just do an online search of real estate loans, you're going to see so many people, so many lenders pop up, but you really do want to get references from other real estate investors about their work with a lender. You want to interview the lender. You want to take them for a test drive. You certainly want to read all of your documentation and the loan agreement really carefully. So this is definitely a situation where you want to check somebody's references. You want to look at their track record and then also make sure that you feel like they are a good personality fit or a partner for your situation.

[00:11:55] Under all circumstances, you want to ask yourself, have you had a legal or attorney review of the loan documents? A loan document is a long and complicated legal agreement. You want to make sure that you understand it completely. I would say that the costs of having an attorney, a real estate attorney, review this document with you are going to be well worth it because you'll fully understand what is really there and what the potential downsides are for you and what you're really on the hook for if things don't work out with your real estate project.

[00:12:30] Then finally, do you understand the tax implications of the holding period that you plan for the project? If you're planning to renovate and sell, for example, is this project going to cross multiple tax years? Perhaps you're starting in November and you're not going to finish until February of the next year. Soyou have some tax planning to do there.

[00:12:54] To sum up today, we've talked about what private lending or hard money is, what the typical loan terms are, what many of the benefits, but also the risks of taking a private or hard money loan are. And then we talked about seven questions to ask yourself if you're thinking about taking a hard money loan, things to ask yourself and to discuss with your lenders.

[00:13:20] What your goals are for the renovation and purchase of a property asking them if you can review the property budget together and talk about the deal and get their opinion about it. Modeling a range of scenarios if things go wrong. What other sources of liquidity do you have to help if something goes wrong with the project or it takes longer than expected?

[00:13:42] What due diligence have you done on the lender? Do you have an attorney to review the loan documents? And do you understand the tax implications of a short term holding period and of taking the hard money loan? So that's it for our quick conversation about hard money or private lending. If And the next time we talk about this topic, we'll talk about it from the point of view of whether or not you should become a hard money lender and lend out private money.

[00:14:09] Thanks, and we'll see you next time

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