Make hard money loans and you get a high rate of return on your cash. You have to do it properly to be safe, of course. You also need a lot of money to invest to do this.
What are “hard money” loans? They are short-term loans (usually 24 months or less) made to real estate investors, usually so they can purchase and rehab a property. There is often a loan fee of as much as five percent or more of the loan amount, and up to fifteen percent or more annual interest. Why do they want these loans?
Hard money means speed and simplicity. When using hard money lenders, an investor can tell a seller “I can close for cash in a week.” That gets the seller’s attention, especially if he has had offers that have fallen through due to financing contingencies.
Hard Money – How It Works
An investor can usually borrow 65% to 70% of the property value, but not just the current value. As a hard money lender, you’ll loan money based on the ARV, or “after repair value” (as determined by your appraiser). You’ll look at the property, more than credit scores, another reason investors will come to you. Let’s look at an example.
An investor finds a beat-up house that he can buy for $105,000. He has a plan that when complete will bring it up to a market value of $182,000. He figures it will take a month to complete, and two months more to sell it. He comes to you, and you agree that his projections seem reasonable. Your appraiser estimates a $186,000 market value when the project is done.
You agree to loan him 65% of the ARV, which amounts to $120,250. The excess beyond the $105,000 purchase price (about $15,000) goes into an escrow account, to be doled out as the repairs begin. Notice that if this investor keeps his costs down, he might do this whole project without any of his own cash invested.
The 4% loan fee you charge is $4,810, and is added to the loan balance, so the investor owes you a total of $125,060. You are charging him 15% interest, and he can pay just the interest due each month, but the whole balance is due within one year. If it takes longer than that and you have confidence in his plan, you might do another loan after that.
For the sake of our example, we’ll suppose that it takes Two months to finish the house, and two months to sell it. The investor gets $181,000 for it. He paid $105,000, and he made a profit of $31,000 after a total of $45,000 for all of his expenses. he is happy. Now let’s look at what part of those “expenses” went to you.
You had the buyer pay for the appraisal and any other costs of closing the loan, so your total investment was $120,250. This was repaid when the house sold, along with the loan fee of $4,810. You also collected four months of interest on the whole balance of $125,060 (the loan and the fee that was also financed), which totals $6253. Your total profit then was $11,063 on an four-month investment of $120,250. That’s an annual rate of return of 27.6%. How many banks make that on their loans?
Does that seem like a lot for the investor to pay? Well it is, but the interest rate and other fees are irrelevant if they allow you to make a good profit. Remember that he made $31,000 after paying those expenses. In any case it makes sense that hard money lenders get paid well to take risks that banks won’t take. If he screwed up the project, stopped paying, and you had to foreclose, you might be selling a half-finished house for just enough to get your money back.
Suppose you keep most of your money out there in these kinds of loans. Since it isn’t all invested all the time, and is making only 5% in the bank, you average just an 18% return. What does that do to a $200,000 investment portfolio in 12 years? It makes it into 1.6 million dollars. You can see why investors with cash make hard money loans.