Conventional loans are often the most difficult for real estate investors to obtain. Some lenders do not allow income from investment properties to be counted toward total income, which can make balloon underwriting an issue for certain investors, especially those who already have several existing conventional real estate loans reporting on their credit. In these cases, the investor must look outside of conventional financing for his investments. Two of the most popular options for alternative financing are portfolio loans and hard money loans.
Loan Portfolio
These loans are loans made by banks that do not sell the mortgage to other investors or mortgage companies. Portfolio loans are intended to be kept on the books until the loan is paid off or comes to term. Banks that make these types of loans are called portfolio lenders and are typically smaller, more community-focused operations.
Advantages of Portfolio Loans
Because these banks do not deal in volume or respond to huge boards like commercial banks, portfolio lenders can make loans that commercial banks would not touch, such as the following:
- smaller multi-family properties
- dilapidated properties
- properties with an unrealized value after completion
- pre-stabilized commercial buildings
- single tenant operations
- special-use buildings such as churches, self-storage, or manufacturing spaces
- construction and rehabilitation projects
Another advantage of portfolio lenders is that they get involved with their community. Portfolio lenders like to lend on properties they can get out and visit. They rarely lend outside their region. This also gives the portfolio lender the ability to push guidelines when a deal’s numbers may not be stellar, but the lender can visit the property and clearly see the value of the transaction. Rarely, if ever, will a commercial banker visit his property, or see more than he can glean from the appraisal report.
Disadvantages of portfolio loans
There are only three downsides to portfolio loans and, in my opinion, it’s worth the trade-off to receive the services listed above:
- shorter loan terms
- higher interest rates
- conventional subscription
A portfolio loan generally has a shorter loan term than conventional conforming loans. The loan will have a standard 30-year amortization, but will have a balloon payment in 10 years or less, at which point you’ll need to pay the loan back in cash or refinance.
Portfolio loans also typically carry a slightly higher-than-market interest rate, typically about a half percentage point to a percentage point higher than what you’d see from your big-box mortgage banker or retail chain.
While portfolio lenders sometimes go outside the guidelines for a large property, you’ll likely have to qualify using conventional guidelines. That means decent income ratios, global underwriting, high debt service coverage ratios, better-than-average credit, and good personal financial health. If you don’t meet any of those criteria, your loan will be out of consideration with most conventional lenders. Two or more are likely to eliminate you from applying for a portfolio loan.
If you find yourself in a situation where your qualification criteria are affected and you cannot be approved for a conventional loan or portfolio loan, you may need to visit a local hard money lender.
Hard money loans and private money
Hard money loans are asset-based loans, meaning they are taken out primarily by considering the value of the asset that is pledged as collateral for the loan.
Advantages of hard money loans
Rarely do hard money lenders consider credit score as a factor in underwriting. If these lenders check your credit report, they will most likely make sure that the borrower is not currently bankrupt and has no open judgments or foreclosures. Most of the time, those things may not even get you out of a hard money loan, but they can force the lender to take a closer look at the documents.
If you are buying a property at a deep discount, you may be able to finance 100% of its cost with hard money. For example, if you’re buying a $100,000 bank-owned property for just $45,000, you could get that full amount from a hard-money lender who makes a loan at 50% loan-to-value (LTV). That’s something conventional and portfolio lenders can’t do.
While private lenders verify the income-earning capacity of the property, they are more concerned with the current value of the property, defined as the value of the subject property as it exists at the time the loan is originated. Vacant properties with no rental income are rarely approved by conventional lenders, but are favorite targets of private lenders.
The speed at which a hard money loan transaction can be completed is perhaps its most attractive quality. The speed of the loan is a great advantage for many real estate investors, especially those who buy properties at auction, or as short sales or bank foreclosures that have short contract fuses. Hard money loans can be closed in as little as 24 hours. Most take between two weeks and 30 days, and even the longest hard money timelines are still less than most conventional subscription periods.
Disadvantages of Hard Money and Private Money Loans
Typically, a private lender will make a loan for 50 to 70 percent of current value. Some private lenders use a more conservative as-is value called a “quick sale” value or a “30-day” value, which could be considerably less than a standard appraised value. Using a quick sale value is a way for the private lender to make a more conservative loan or to protect your investment with a lower effective LTV. For example, you might have a contract on a property comparable to other single-family homes that recently sold for $150,000 with an average time to market of three to four months. Some hard money lenders lend you 50% of that purchase price, quote it as value, and give you $75,000 toward the purchase. Other private lenders can do a BPO and ask for a quick sale value with a marketing exposure time of only 30 days. That value can be as low as $80,000 to facilitate a quick sale to an all-cash buyer. Those lenders would therefore make a loan of just $40,000 (50% of the $80,000 quick sale value) for an effective LTV of just 26%. This is most often a point of contention in deals that fall into underwriting with hard money lenders. Since a hard money loan is made at a much lower percentage of value, there is little room for error when estimating the true value of your property.
The other obvious drawback to a hard money loan is the cost. Hard money loans will almost always have a much higher than market rate of interest, origination fees, principal fees, exit fees, and sometimes even higher attorney, insurance, and title fees. While some hard money lenders allow you to finance these fees and include them in the total cost of the loan, it still means you get less when the loan closes.
Weighing the good and the bad
As with any loan, you need to weigh the good and the bad, including loan terms, interest rate, points, fees, and access to customer support. There is always a tradeoff present in alternative loans. If you have bad credit and no money for a down payment, you can be sure that the lender will charge you higher interest rates and lower terms to compensate for the added risk.
When dealing with private lenders, be sure to ask about their valuation method.
Also, with hard money lenders, you must be careful in your investigation and background check. While hard money loans are one of the most popular alternative financing options, they are often targeted by unscrupulous third parties. Before signing any loan paperwork, be sure to have all paperwork executed by a qualified real estate attorney and/or tax professional. If you suspect fraud or predatory lending, contact your state attorney general’s office.