Some private lenders use a method of interest accrual known as “Dutch interest” for a hard money construction...
Know Your Exit Strategy Before Taking Out a Hard Money Loan
Having a definitive exit strategy is one of the most important things to determine for a borrower who utilizes private money or hard money financing to acquire real estate. Hard money loans are usually short-term in duration and more expensive in comparison to traditional bank financing, with terms ranging anywhere from nine months to three years and interest rates starting around 7.99% to 12.00%. Therefore, it’s best that potential hard money borrowers know what they are getting into and how they will get out of the loan before starting the process.
We work with several hard money borrowers with the following common “borrower profiles” where the exit strategy is very clear going into the loan:
- Experienced house flippers who need the money for 2-12 months.
- Owner Occupied buyers using hard money until the three year anniversary of their short sale arrives.
- Self-Employed borrowers who don’t declare enough income on their taxes to qualify for conventional financing.
- Down payment funds coming from a friend and not a relative, which wouldn’t qualify as “Gift Funds” under conventional lending guidelines.
Experienced House Flippers
Experienced real estate investors who’ve flipped several homes for a profit can predict within a week or two how long they’ll be “in the property”. That means how long it will take them upon acquiring the home to handle evictions (if necessary), renovate the home accounting for hidden surprises (often times water related), time on the market, and the eventual sale of the property.
It’s safe to say that the experienced house flipper will carry the hard money loan anywhere from 2-12 months before paying it off at the close of escrow. They usually know their numbers on their pro forma pretty well and often pay off the loans well before the note comes due in 12 months.
Owner Occupied Borrower With A Prior Short Sale
Another common private money exit strategy scenario we see is the home buyer who had a short sale or foreclosure sometime within the past three years who knows that as soon as the three-year anniversary date of the short sale arrives, they’ll refinance out of the private money loan and into a conventional loan.
Usually, the three-year anniversary date to their prior short sale is embedded in their mind and they know that in the month before it arrives, they’ll start the refinance process with their A-Paper mortgage broker.
For self-employed borrowers who don’t declare enough income on their personal income taxes to qualify for conventional financing, the hard money loan is a stopgap solution until they do one or many of the following:
- File the next two years of tax returns with much higher income.
- Find a portfolio lender who will take into account the business revenue, net income, liquid and real estate assets, and will back out many of the deductions taken against their personal Adjusted Gross Income (AGI).
Hmm? Sounds like we just might know of one such portfolio lender that has a program for people who fancy themselves as “Job Creators.” Or, they’re just better at working for themselves. For info on the program, see our Self-Employed Jumbo Loan page.
Hard To Source Down Payment Funds
The fourth common hard money borrower scenario we see is where the down payment funds are coming from a friend and not a family member, therefore the funds cannot be considered gift funds. Conventional lenders allow gift funds from a family member but consider gift funds from a friend a personal loan and would disqualify the borrower for financing.
We recently had a scenario like this in Northern California where a husband and wife bought an REO in need of repairs about $40,000 under market value, financing the purchase with a private money loan. The down payment gift funds came from a close personal friend who had lived with them for many years and would continue living with them for many years to come.
The husband and wife took out the private money loan knowing they would need to make some renovations to the house and also knowing that they would need to wait six months until they could do a cash-out refinance up to 80% LTV with Fannie Mae using the new appraised value, and not the purchase price. This way, the hope is, they’ll be able to repay the friend his down payment gift funds and then reduce their monthly payment by dropping their interest rate from 8.00% to 4.00%.
It’s important that home buyers and real estate investors know with a high degree of certainty what their exit strategy from the hard money or private money loan will be. They need to map out going into the loan how they’re going to pay the balance off prior to the balloon payment due date. For house flippers, they know the loan will be paid off with the sale of the house in 2-6 months. For owner-occupied borrowers with a prior short sale, they know that they will refinance out of the loan on the three year anniversary of their short sale. Or home buyers with gift fund obstacles who bought homes well under market price, they know they’ll have to keep the private money loan for six months until they can pull cash-out using new appraised value.