10 Important Terms To Know When Applying For A Hard Money Loan

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Applying for an investment property loan requires understanding the terms used in the lending industry. This is especially important if you are considering taking out a hard money loan. Hard money loans are typically used for short-term financing and are secured by real estate. 

Let’s take a look at 10 hard money terms to look out for when applying for a loan.

1. Loan-to-Value Ratio

The loan-to-value (LTV) ratio is a common term used in hard money lending. It describes the ratio between the loan amount and the appraised value of the property being financed. Hard money lenders use this ratio to decide how much financing they will give for a property.

For example, suppose your property is appraised at $200,000. The lender has an LTV ratio of 70%. This means they would lend up to 70% of the appraised value, which is $140,000.

The loan-to-value (LTV) ratio is essential for hard money lending. It establishes the amount of equity you will need in the property. In general, hard money lenders will require a minimum equity position of 20-30% in the property.

You must have a down payment or equity of 20-30% of the appraised value of the property. This is necessary for a successful purchase.

Did you know? 

It is essential to understand that the loan-to-value (LTV) ratio differs from the loan-to-cost (LTC) ratio. The LTC ratio is calculated on the total cost of the property, accounting for any renovation or construction expenses. The LTV ratio is based solely on the appraised value of the property.

2. Loan-to-Cost Ratio

The loan-to-cost (LTC) ratio is a term used in hard money lending. It is the ratio of the loan amount to the total cost of the property being financed. This includes the purchase price of the property and any rehab costs that will be incurred.

Hard money lenders use the loan-to-cost ratio to determine the amount of financing they are willing to provide for a particular property, usually a fix-and-flip. Generally, hard money lenders will provide financing up to a certain percentage of the total cost of the property.

For example, suppose your lender has an LTC ratio of 70%. This means they are willing to lend up to 70% of the total cost of the property. In this case, if the cost is $100,000, then the maximum loan amount would be $70,000.

Here’s a takeaway

Again, the loan-to-cost ratio is distinct from the loan-to-value (LTV) ratio. LTV is based on the property’s appraised value, not the total cost.

The LTV ratio is usually lower than the LTC ratio. This is because it only considers the appraised value of the property. It does not consider the cost of renovations or construction.

3. After-Repair Value

ARV stands for “after-repair value“. This refers to the estimated value of a property after it has been repaired or renovated.

In hard money lending, the ARV is an important factor in determining the loan amount for which a borrower may be eligible. Lenders will typically consider both the current value of the property and the estimated ARV when making lending decisions.

For example, suppose your property is currently worth $150,000, and the estimated ARV after renovation is $200,000. In that case, the loan amount may be based on the value of the property after the rehab is complete instead of the current value. 

The amount may be up to a certain percentage of the ARV. This is because the lender is considering the increased value of the property after the repairs or renovations have been completed.

Some hard money lenders may also assess the ARV to decide how much to lend for renovation or construction costs. For example, let’s say the estimated ARV of your property is $200,000. The lender has an LTV ratio of 70%. This means they may be willing to lend up to $140,000, including the purchase price and renovation costs.

Take note

Understand the estimated ARV of a property. Work with your lender to make sure the loan amount and terms fit the project.

4. Debt Service Coverage Ratio

You may have heard of DSCR loans—also referred to as investment property loans, non-QM loans, and rental loans. DSCR rental loans are popular amongst real estate investors looking to grow their rental portfolios. 

DSCR is a financial ratio that lenders use to assess your ability to make your loan payments. Depending on the lender, the ratio is calculated by either dividing the property’s net operating income (NOI) by the annual debt payments or the property’s PITIA—principal, interest, taxes, insurance, and homeowners’ association fees—by its monthly costs.

The higher the DSCR, the more cash flow the property generates relative to its debt obligations. Hard money lenders typically require a minimum DSCR of 1.0 to 1.2. This depends on the type of property and the lender’s individual criteria.

For example, if your property generates $100,000 in annual income and has $50,000 in operating expenses, the NOI would be $50,000. If the annual debt service payments on the loan are $25,000, the DSCR would be calculated as follows:

DSCR = NOI / Total Debt Service

DSCR = $50,000 / $25,000

DSCR = 2.0

A DSCR of 1.0 indicates that your property is generating enough income to cover the debt service payments on the loan. A DSCR of less than 1.0 indicates that you may have difficulty repaying the loan.

Lenders may require a minimum DSCR as part of their underwriting criteria in hard money lending. This helps them ensure that the borrower is capable of making the required payments. The required DSCR can vary depending on the lender and the type of property being financed – typically a rental property – but is typically in the range of 1.2 to 1.5.

What to expect

Be prepared to provide detailed financial information about the property. This includes operating income, expenses, and debt obligations. This is in order to calculate the DSCR. Work with your lender to ensure their loan amount and terms suit your project while meeting the lender’s requirements.

5. Points 

Points represent fees charged by the lender at closing, typically expressed as a percentage of the loan amount. For hard money loans, the points can range anywhere from 2% to 10% of the loan amount and are used to cover the lender’s origination and administrative costs.

Each point typically represents 1% of the loan amount. For example, if you take out a $100,000 loan with a lender that charges 2 points, you would be required to pay $2,000 in points (2% of $100,000) in addition to the interest and other fees associated with the loan.

The number of points charged by lenders can differ. This is due to various factors like credit history, property type, and the risk of the loan. Hard money lenders usually charge more points than traditional lenders. This is because hard money loans are seen as riskier investments.

Something to ponder

As a borrower, you should evaluate the cost of points when looking into different loan options. Additionally, work closely with your trusted lending partner to understand the fees and charges associated with the loan.

6. Interest Rate

Interest rates refer to the cost of borrowing money from a lender, expressed as a percentage of the loan amount. Hard money interest rates are usually higher than traditional loans. This is because hard money loans involve increased risk and shorter loan terms.

Hard money lenders charge interest rates of 8-15% annually. This varies by lender and the risk of the loan. Interest rates charged by non-QM lenders can be higher than those charged by traditional lenders such as banks and credit unions.

Important to note

Work with your lender to understand the loan’s interest rate and fees. Also, take time to understand the repayment terms and requirements. Evaluate whether financing a project is right for you. Consider the potential return on investment and your ability to repay the loan.

7. Prepayment Penalty

A prepayment penalty is a fee charged by a hard money lender. This fee is charged if you pay off the loan before the end of its term. Prepayment penalties are designed to compensate the lender for the loss of interest and fees that would have been earned if the loan had been paid off according to its original schedule.

Hard money lending often includes prepayment penalties. These loans are usually short-term and intended to be repaid quickly. The penalty amount for a loan varies by lender and terms. It is usually a percentage of the loan amount and can be between 1% and 5%.

For example, if you take out a $100,000 hard money loan with a prepayment penalty of 3%, you’d be required to pay a fee of $3,000 if you pay off the loan before the end of its term.

Here’s a takeaway

Not all loan products offered by hard money lenders come with prepayment penalties—depending on the lender. It is important to evaluate the terms of a potential hard money loan carefully. Consider any prepayment penalties before signing the loan agreement. This will help ensure that the loan is beneficial for all parties involved. 

8. Loan Term

A loan term represents the length of time that you have to repay a loan. In hard money lending, the loan term is typically much shorter than traditional bank loans. These terms often range from a few months to a few years.

The length of the loan term can vary. It depends on several factors, such as the lender’s underwriting criteria, the type of property being financed, and your financial situation.

Hard money loans are typically short-term loans, with terms ranging from six months to 2 years. You must have a plan to repay the loan. This can be done by selling the property (fix-and-flip) or refinancing into a long-term loan, such as a DSCR rental loan (buy-and-hold). 

The shorter loan term is one of the key characteristics of a hard money loan. These loans are designed to provide you with quick access to capital to finance real estate investments, expecting the loan to be paid back quickly, often with the sale or refinance of the property being financed.

What to consider

It’s important to consider the loan term carefully when evaluating a hard money loan. Shorter loan terms can result in higher monthly payments, which can be challenging for some borrowers to manage. However, the shorter loan term can also give you greater flexibility and the ability to capitalize on investment opportunities quickly.

9. Appraisal

Hard money lenders may require an appraisal of the property used as collateral. This appraisal helps determine the property’s value and the loan amount. It is used to calculate the loan-to-value (LTV) ratio. This helps to identify the best interest rate and points charged.

An appraisal is an evaluation of the value of a property being financed. The appraisal aims to determine the property’s current market value. This ensures that the loan amount requested is appropriate and the lender is not taking on undue risk.

The appraisal process usually requires a licensed appraiser. They will visit the property and inspect it. They will also collect data about its location, size, condition, and any updates or renovations. The appraiser will also research comparable properties in the area to determine the property’s current market value.

Appraisal is an important part of the underwriting process for some hard money loans. Lenders use the appraisal to calculate the LTV ratio.

Hard money lenders often have a maximum LTV ratio that they will offer. This can vary depending on the lender, the property type, and your situation.

You should be prepared to pay for the cost of the appraisal as part of the loan application process. Be aware that appraisal is one factor the lender will consider when evaluating the loan application. It is not the only factor they will consider.

The lender may consider other factors when making a lending decision. These factors could include your credit history and real estate investing experience.

Did you know?

While many hard money lenders ask for an appraisal on all of their loan products, not all do. For example, Kiavi doesn’t require an appraisal for a fix-and-flip / bridge loan, but one is required for a long-term DSCR loan.

That’s why you should always ask a potential lending partner upfront about the appraisal requirements for your real estate investment property. This will help ensure that you are prepared.

10. Underwriting

Underwriting evaluates and assesses a loan application. It determines if you qualify for the loan and the terms and conditions. Underwriting evaluates the potential risk of a loan. This protects both the borrower and lender from default or other losses.

The underwriting process can vary depending on the lender and loan type. It may involve a detailed review of the project, the scope of work, and the property’s condition. Also, an appraisal of the property being financed may be necessary.

Lenders may consider various factors when evaluating an investment. These include your experience in real estate investing, the area’s market conditions, and the investment’s potential profitability.

The underwriting process is usually more streamlined and faster than with traditional bank lending, as hard money lenders are primarily interested in the value of the property being financed rather than your creditworthiness. However, lenders still need to ensure that you have the ability to repay the loan, even if the property doesn’t perform as expected.

Be prepared

Be ready to give comprehensive information about the financed property during the underwriting process. This includes itemized rehab details. You should know that underwriting criteria may vary depending on the lender and the financed property type, so ask questions.

Final Thoughts

Understanding these hard money terms can help you make informed decisions when applying for a loan. It’s important to work with a reputable and trustworthy lender who will explain these terms and answer any questions you may have. With the right information and a clear plan for repayment, a hard money loan can be a valuable tool for financing your real estate investments.

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.