Fix and Flip Financing: What is Gap Funding?

If you’re a house flipper already approved for a hard money first mortgage and need a second mortgage to cover down payment and closing costs, chances are you’re talking about something called gap funding. This blog post will discuss what you need to know about gap funding, including:

• What is gap funding?
• How much does gap funding cost?
• Why gap funding is rare?
• Where FCTD still sees gap funding.

Let’s get started.

What is Gap Funding?

As I mentioned above, gap funding is a hard money second mortgage to cover down payment and closing costs. In addition to the down payment and closing costs, some gap funding loans include the rehab costs on a fix and flip project.

The most common request FCTD sees for gap funding is a borrower will already be approved for a first mortgage at 80-85% Loan-To-Value (LTV) and needs gap funding for down payment and closing costs.

How Much Does Gap Funding Cost?

If you can get a gap funding standalone hard money second mortgage to go behind your high-leverage first mortgage, it’s going to be expensive. Like, very expensive.

Be prepared for 20% per annum between upfront points and the interest rate:
5 points at 15.00% interest rate = 20.00%

It’s not cheap nor should it be cheap. The gap funding lender can lose a lot of time and money if your project falls goes south.

Why is Gap Funding So Rare?

There are two reasons.

Risky for the Lender if You Default

Gap funding can be very risky and become very expensive for a lender if you default, as I explained in this blog post about second mortgages for down payment and closing costs.

Securitization of the Hard Money Lending Industry

Gap funding became rare because securitization came to the hard money lending industry.

Let me explain.

In 2013 and 2014, there were a few bond funds and pension funds buying hard money loans from lenders whose business model was originate and sell to secondary market buyers. We call them “conduit lenders” – a finance company that originates a loan with the intent to sell. Then, in 2015, Wall Street investors came into the market, providing those same conduit lenders with a warehouse line of credit (industry lingo is “a credit facility”) to fund loans that they’d then sell to the Wall Street investor or into a $500 million or $1 billion securitization that would hold those loans until they were paid off. This is known as securitization.  

Wall Street securitization changed the game, bringing more capital into hard money lending at higher leverage (think 80-90% LTV on a fix and flip loan) because it spread out the risk across more investors backing these loans. Kind of like conventional lending where interest rates are very low for a 30-year mortgage because hundreds of thousands of investors own a share of the mortgage bonds and the full faith and credit of the United States government guarantees the mortgage bondholders. Essentially, risk is spread out.

Junior Liens Prohibited on the Promissory Note

With securitization, it brought standardized loan documents acceptable to the Wall Street investors, including the Promissory Note, which almost always had a Due-on-Sale clause noting that junior liens are prohibited. Below is an example of the Due-on-Sale clause:

High-Leverage Fix and Flip Plus Rehab Made It Less Attractive

Most hard money fix and flip loans over the past eight years have been made by the conduit lenders, offering high-leverage 80-90% LTV on the purchase money loan and 100% of rehab funds through rehab reimbursement, which significantly reduced the demand for gap funding. The borrower would only need to come in with 10-20% down payment, closing costs, and have part of the rehab funds available to flip a house.

House flippers, if they had $75,000 to $100,000 of liquidity, could obtain a high-leverage loan at an interest rate of 9.00% without turning to a gap funding second mortgage at 15.00% to 20.00%. They could go it alone at a lower cost rather than paying a lot more in interest and fees having two mortgages.

Where FCTD Still Sees Gap Funding

Gap funding in some form or another still exists in the hard money second mortgage market. It just doesn’t exist as a standalone second mortgage behind a high-leverage 80-85% LTV first mortgage from a conduit lender.

Local Lenders for Both Hard Money Loans

I have seen a few situations in 2022 where an experienced house flipper came to us seeking lower cost debt for their next acquisition. For the past few years, they had been borrowing from a local individual with simple loan docs (and a Promissory Note that didn’t have any language prohibiting junior liens). The terms were typical of an individual investor making hard money loans:

First Mortgage: 

• 65% LTV
• 10.00% interest rate
• 6 Month Term
• 3 Points

They’d also borrower from a gap funder, or what they’d call an equity investor, in the project for the down payment and closing costs. 

Second Mortgage / Gap Funding: 

• 100% Combined Loan To Value (CLTV)
• 12.00% to 15.00%
• 6 Month Term
• 2-3 Points

The gap funding second lienholder was someone who had invested with the borrower in the past and was confident that they’d get paid back despite the risks associated with being in second position.

Seller Financing in Second Position

Seller financing in second position shows up every so often. However, it’s rare to see a hard money first mortgage at 80% LTV and seller financing up to 100% CLTV. The reason is that the first lienholder usually wants a borrower to have “skin in the game” with down payment funds, usually 10-20% of their own money going toward the purchase. It’s rare to find a hard money lender that will allow a borrower to come with no down payment or have seller financing.

It's also rare to find a seller willing to carry a second mortgage at 100% CLTV. I see this in situations where the seller is trying to spread out long-term capital gains on the sale of the property. In 2021-2022, when real estate values increased by 25-40% in some markets, I saw a seller carry in second position (and a hard money first lienholder actually allowed it) because the buyer was overpaying for the property by $300,000 to $400,000. For the seller, it was free money over the next five years. 

Blanket or Cross-Collateral Loan – This Works Best

FCTD does several blanket or cross-collateral loans each month for our real estate investor clients where we use the significant equity position of an existing property as additional collateral for the loan, allowing borrowers to come in with very little down payment and closing costs on a new purchase.

These are almost always a first mortgage on the purchase and in second position on the additional collateral, which usually has a low-leverage first mortgage on title.

Below is an example of the financing structure: 

If you want to acquire a property with zero down payment, a blanket or cross-collateralized loan structured like above is the best way to go about it. FCTD has several lenders that will structure a purchase like this, allowing you to keep more capital on hand for you project.

Conclusion

As you can see, gap funding as a standalone hard money second mortgage on a fix and flip project is hard to obtain. It’s very expensive for the borrower, very risky for the lender, and usually prohibited by the first mortgage lienholder under the Due-on-Sale clause in the Promissory Note. Wall Street’s entrance into hard money fix and flip financing with high-leverage purchase and rehab loans made lower cost capital around 9.00% available to more house flippers, reducing the need for house flippers to seek a gap funding second mortgage.  

If obtaining 100% financing on a new fix and flip purchase is essential to your project, it’s best to have another investment property with significant equity that can be used for a cross-collateral loan. This is how FCTD gets it done for our investor clients time and again.