Buying real estate in California has many advantages, especially when you buy during a down market. Real estate investment generates cash flow, gains value over time, and is a tax write-off. Most often, real estate is purchased through traditional lending practices, such as banks, mortgage companies, and credit unions. However, since the 2008 market crash in California and other parts of the United States, these lenders have made their guidelines stricter than ever. For example, you’ll need a credit score of at least 740 or more to invest in real estate, along with low debt-to-income ratio, a history of steady employment, and at least six months of liquid funds in reserve to qualify for one of these traditional loans.
For those who don’t meet these strict guidelines, there are alternatives, such as paying for the property in cash or gaining a hard money loan to finance the property. These two alternatives to traditional loans have both advantages and disadvantages. First of all, it should be noted that when pursuing these alternative methods to invest in commercial or residential property in California, it’s important to work with a trusted and reputable lender. Too many times newcomers find themselves with little experience when it comes to securing hard money loans and end up in a bad situation.
As interest rates steadily rise, many real estate investors in California are turning to hard money loans to secure a property. However, there are many factors borrowers need to take into consideration before seeking this type of alternative loan. Hard money lenders are seeking borrowers who have the collateral or equity to back up the loan rather than looking at credit. With so much on line, it’s important to be aware that there are risks that come with securing hard money loans and with higher risk often comes higher interest rates.
Read on to learn everything you need to know about hard money loans for your first or next property investment in California.
What are Hard Money Loans?
Hard money lenders are private lenders who are either companies or individuals who have money to lend. But don’t let the title fool you. Hard money loan doesn’t mean it will be hard for you to get this type of loan. What you need is somewhere between 30% to 50% equity or a substantial down payment. If you have this, you’re good to go. What “hard” actually means in the term “hard money loan” is that the real estate you are purchasing is considered a hard asset.
Some Advantages of Hard Money Loans
Whether you are borrowing money from an individual, such a family member, or from a company, the process takes much less time than borrowing from a traditional lender. Overall, a hard money loan takes about a week to 10 days to acquire, while a traditional loan can take up to a month or longer. This means there is a lot less paperwork to deal with when getting a hard money loan because the underwriter who is reviewing the loan is not as concerned with satisfying the investor since the lender is the investor. Also, hard money loans are concerned with the property’s value after it has been renovated or repaired while a traditional lender is concerned with the value of the property at the time of purchase.
While hard money loans typically have a higher interest rate than a traditional loan, this is not a problem since the loan is for a much shorter period. Most investors use this type of loan to quickly flip a property for profit, making the higher interest rate a non-issue.
The Types of Lenders You Should Avoid
In the past, hard money lenders focused on a borrower’s equity in the property. However, since 2015 when the TILA-RESPA Integrated Disclosure rules took effect, hard money lenders are now looking at the borrower’s ability to repay the loan. These rules were put into place to avoid predatory loans. To illustrate further, in the past, when a borrower could not pay back the loan, they typically lost their investment through foreclosure.
Other predatory loans include the bait-and-switch scheme. This means that the lender would guarantee a loan at a fixed rate only to then switch to a different loan at a different rate. Borrowers oftentimes went unaware of the switch until well after closing when they realized their payment was much higher than originally agreed upon. The higher payment was due to an interest rate adjustment that the hard money lender failed to disclose.
When seeking a hard money loan, it is important not to fall prey to a predatory loan. In the excitement of getting a loan quickly through a hard money lender, the borrower must work with a lender who is transparent throughout the process. All documents must be consistent with what was agreed upon by both the lender and the borrower to avoid a predatory loan.
Changes in Traditional and Hard Money Lending
Since the time of the housing crisis in 2008, there have been changes in the mortgage industry every year or two. This is a result of many factors, including a larger customer base and advances in technology. Another change is in the peer-to-peer lending sector that emerged when the LendingClub became a publicly traded company back in 2014. The point of this was to bypass traditional lending with a lending marketplace that uses an online platform to join lenders and borrowers.
Since the popularity of property flipping reality TV shows, we have seen an increase in hard money loans. In fact, these TV shows pretty much promise that anyone can make a substantial profit by flipping a property, whether they do this once or choose to do this as a career. On the other hand, when you use traditional lending, you can only expect a profit of somewhere around 1% to 5%, as opposed to the lucrative profits promised, about 7% to 20%, by quickly flipping a property and using a hard money loan to make this happen.
By using the information above, you should have a better idea of how hard money loans work, as well as the advantages and disadvantages that go along with them. Most importantly, a real estate investor must protect themselves from predatory loans and seek out only the most trusted and reputable private money lenders in California.