A common question about hard money is, does hard money work the same way as cash when buying a property? The short answer is no, but there is a more complete explanation.
Hard money loans are often used in situations where the purchase of a property has to close quickly. Sometimes, this is because the quick close was necessary to get the offer accepted over competing buyers. Other times, it is because the original loan fell through and the buyer had to scramble for a fast solution.
Regardless of the reason, many buyers and real estate agents think of hard money loans as the same as cash. After all, when was the last time a bank closed a loan in just a few days? (In case you were wondering, the answer is never.)
Hard money, also known as private money, is typically handled by a broker with individual investors providing the money for the loan. Because one investor can review an entire loan file in a short period of time, sometimes in as little as a few minutes, it is impossible for a bank to compete on speed.
Their processes are split between different people. They have one person to collect data and set up the file, another one to underwrite the file, another to review the appraisal and another to close the file. This is a simplified version and it usually has more people to handle other steps. The fact is that they aren’t set up to move quickly.
Speed alone can cause hard money to be considered the same as cash but it is still a loan and it requires someone other than the buyer to approve it and produce the money needed for the loan.
You have probably seen listings that said they would only accept cash offers. This is almost always because the seller thinks that the property won’t qualify for any kind of mortgage. In most cases, they are wrong because hard money is used for exactly that type of property.
When making an all cash offer, it is almost always required that you provide proof of funds. The seller and their real estate agent want to see that you have the cash to close. And if you are getting a hard money loan, the lender isn’t going to give you a copy of their bank statement to prove they have the cash you need.
The proper way to handle it would be to make the offer showing that you are using a hard money loan to buy the property. Hard money is still a loan and a pre-approval letter is needed to go along with your offer. It may need to say something about the condition of the property not being a problem. A properly worded pre-approval letter can make all the difference in the world in getting your offer accepted.
Another important key is that the loan officer who wrote the pre-approval letter has to be available to talk to the listing agent before the offer is accepted. This can be the final requirement before an offer will be accepted.
So even though hard money is similar to cash and can be almost as fast, it is not the same.
ITIN is the abbreviation for Individual Tax Identification Number. It is the number issued to individuals who do not have or are not eligible to have a Social Security Number. They are used by individuals without Social Security Numbers for federal tax filing purposes with the IRS.
Banks don’t typically lend to those who have an ITIN. This isn’t because they aren’t eligible to buy property or get a mortgage. There is no restriction on buying a home just because one has an ITIN. Banks just don’t lend to them.
The most common solution for someone with an ITIN to own real estate is through private money loans (aka hard money). This is because private lenders aren’t so worried about the little details the banks focus on. Instead, they look more at the property value and the down payment than anything else.
Another big problem for many of these buyers is that they don’t have sufficient credit. Often, they think they can’t get any kind of credit unless they have a social security number. This is completely untrue. I have worked with many clients who have well established credit that they used their ITIN to get.
(For more information on credit and how to establish it, go to CrackMyCredit.com.)
Fortunately, private lenders aren’t as worried about credit as the banks so even if you have no credit at all, that shouldn’t stop you from getting a mortgage to buy a property.
The only real requirement for buying a property (other than having the money or getting a loan to buy it) is that you have to be able to prove your identity and you have to be able to prove where the money came from. In other words, just because someone has an ITIN is no reason they can’t own real estate.
There are certain attributes I have found in successful hard money investors. Following are some of the key characteristics that are common to many of them.
The very first thing that is noticeable about successful investors is that they are decisive.
They make decisions fairly quickly and commit to doing the loan or not doing the loan. At the same time, they are often willing to change their mind when new data is provided or when the terms of the loan change.
To be decisive, an investor needs to be trained in how to analyze deals. Often, this is done with a mentor because there aren’t a bunch of seminars on how to become a hard money investor. The mentor could be an experienced investor or it could be a broker who arranges hard money loans.
The second thing is that they realize they are dealing with people who can’t get a loan from the banks so they don’t try to underwrite to bank guidelines. The banks offer lower interest rates because they have stricter underwriting guidelines. They also offer loans that require less protective equity than a private investor, sometimes doing loans as high as 100% of the property value.
Getting hard money rates requires a loan to have some problem that a bank can’t work with. It could be bad credit, a property in disrepair, inability to prove income or something else. Any private lender who wants a perfect file but wants higher rates is going to be disappointed. Files that are closer to bank guidelines will be taken by other investors who will do lower rates.
The third characteristic of successful investors is that they have developed somewhat of a system for choosing which loans they will do.
Each investor has their own preferences. Some will only do loans with certain rates offered. Others lend on properties they wouldn’t mind buying for the amount the are lending. This is actually a pretty good way of looking at it when you consider that if the borrower defaults, the investor could end up with the property.
Location can be a consideration too. Some successful investors like to be close enough to a property so they can drive to it. Others lend in areas they have some familiarity with. There are also some who will go further outside of their area when there is a full appraisal and the loan-to-value ratio is low enough for their comfort.
The fourth characteristic of successful investors is that they look at it as a business. Lending is not personal to them although they don’t want to foreclose on anybody. Their intent is to make a profit by helping someone who needs money from them.
Any successful business transaction is a win-win. Both the buyer and the seller, or in this case borrower and lender, benefit from the transaction. Keeping this in mind, they don’t assume the borrower is hiding something when an application is poorly done. Instead, they ask for the missing information that they want. Not jumping to conclusions but asking questions to get additional data allows them to do more loans and avoid the ones they shouldn’t be doing.
In summary, successful investors are professional at investing, having a system for analyzing and saving information as well as being knowledgeable enough to change their minds when additional information or changed circumstances are presented.
For anyone who does private notes, it is important to know how to analyze a credit report and be able to use that information in deciding whether to lend money to the borrower.
The biggest mistake made by investors is to rely too heavily on the credit score. This can be a mistake in either direction. You can miss out on a good opportunity just because of a low credit score or you could do a loan you shouldn’t when the credit score is high.
The very first rule in private lending should be that the most important part of any deal is the loan-to-value ratio. Everything else is secondary because if anything goes wrong for the borrower, the equity in the property is the only real protection you have. When things go wrong for a borrower, their credit score is not going to provide you with any protection.
Just because the banks rely on credit scores is not a reason for private investors to do the same. There are fundamental differences between what they do and what you do. Banks will lend up to 96.5% of the property value on FHA loans and up to 100% on VA loans. But those loans are insured against losses in case the borrower defaults. Private lenders cannot get that type of insurance.
On most loans, banks lend other people’s money, not their own. So if things go wrong and the loan ends up in foreclosure, they may have some hassles to deal with but the investors are the ones who lose the most money.
These are some of the ways a private investor is different from a bank and should look at loans differently. But credit does play a part in analyzing a loan application and whether to make it. Following are some tips on how to do it.
Everyone seems to look at the credit score first and place the most emphasis on it when deciding if a borrower is credit-worthy. It would be a mistake not to look any further. I have seen credit reports with low scores but no late payments and others with high scores but without many good accounts on it.
Tip #1 is to read the credit report. Don’t stop at the score because you are missing the story. It’s kind of like looking for the score of a baseball game instead of watching it. Toward the end of the game, it might have been very close and a fun game to watch but something happened and it ended up being a blowout.
The same can happen with credit. Everything can be fine then something happens and the scores crash. Maybe there was an illness or a divorce or something else. If you look at a report, you can see when the late payments started and ended, if they have ended. Maybe they haven’t ended but the loan they are asking for will help stop the bleeding and turn things around.
Tip #2 is that you should look at trends. What is happening now as compared to earlier. If there are late payments, when were they? Is it on one or two accounts or is it on all of them.
Did the borrower go through a rough patch and come out of it? Is he still in it? Will this loan handle the rough patch or have no effect on it at all? These are all questions that should be considered when reviewing a credit report. If there aren’t any answers to these questions, ask them. If you can’t get answers, maybe it isn’t a loan to do. Maybe the loan amount needs to be lower.
Tip #3 is don’t put too much weight on the credit. As mentioned above, if you put too much weight on the credit score or credit report, you can miss some good opportunities and you can make mistakes.
Part of this tip is to balance the credit with other factors like property value and the borrower’s ability to pay. When you have a borrower with horrible credit, do a lower loan-to-value ratio than you would with someone who has good credit. If you would lend 65% of the property value to someone with good credit, maybe you lend 60% to the borrower whose credit isn’t so good. Maybe you lend at a higher interest rate.
There is obviously much more to this than can be covered in a single blog post but this will at least give you more information to use when deciding whether to do a loan or not.
Before the housing crisis in 2008, there were many types of mortgages available to the consumer. There was “A” Paper for those with perfect credit, provable income and a property in good condition.
There was Alt-A (alternative to A paper) was for borrowers who almost qualified for an A paper loan but who had a minor flaw that prevented them from qualifying.
Then there was subprime, which was available for those who didn’t have good credit.
Finally, there was hard money. It was for those whose credit wasn’t good enough for a subprime loan or who needed a small loan, often a 2nd mortgage.
After the market crashed in 2008, the only things left were A paper and hard money. If someone couldn’t get an A paper loan, their only option was hard money.
The result was that many borrowers with reasonably strong profiles were getting hard money loans. In some cases, these people had credit scores well over 700 but either had trouble proving their income or had a property in poor condition.
Investors were funding these loans with rates in the 10-12% range and had little trouble finding opportunities. Then, more investors started lending. This increase in investors drove rates down on many loans, with some going as low as 7% for cleaner deals.
Then non-prime loans started to surface and took a big chunk of the hard money market. Their rates were lower and they could do more of the owner occupied properties. They could also work with lower down payments.
Over the last couple of years, I have had many investors ask me what happened to all the sweetheart deals they used to see. The answer has been that the non-prime loans have eaten lots of them up, leaving the more traditional hard money loans. These were the borrowers who had bad credit (bankruptcies, foreclosures, short sales, late payments, etc.), ugly properties and no provable income.
But with our current scene of having most businesses either closed or operating with reduced volume, non-prime loans have taken a break. Right now, they aren’t lending. You can go to the websites of these companies and see that they have “paused lending activities”.
This does add some uncertainty to the market but we don’t really know how much it will affect values or for how long. My opinion is that I think values will drop but not by a large percentage. Here’s why.
The vast majority of mortgages go through the banks. Since 2010, all mortgages going through banks have required proof of income. They have also required larger down payments on all rental properties along with proof of assets. Additionally, according to Zillow in July 2019, 37% of the homes in America are owned free and clear.
Combining these factors, you can see that this is a much stronger base than the house of cards we were dealing with in 2008. Plus, we don’t have the same problem of rampant mortgage fraud and predatory lending that we had in 2008.
Where do we go from here?
Right now is a good opportunity for private money/hard money investors to lend to borrowers who are stronger than the most common hard money borrowers. In the last couple of weeks, I have been approached by more people who had good credit and strong profiles than usual.
Some of them will wait to make a move because they don’t want to get a hard money loan but others will get the loan that will solve their immediate problem and plan to refinance when things settle down a little. And some will be interested if the rates are a little lower (7-9%).
In looking at these deals, you may need to do lower interest rates than you are used to. But if you can get stronger borrowers with more equity in the property, isn’t that better than having your money sitting in a bank earning effectively no interest? Of course it is. Just make sure you do your due diligence and make sure you have a solid loan.
If you have questions about how to analyze a deal, please call (707) 401-8080 or fill out the contact form on this website.