Lots of people have money to invest and are disenchanted with interest rates offered by banks and even the returns on their stocks and bonds. Convince them of your ability to turn a profit from flipping properties, and they just may loan you the capital you need to get started.
Loans from private lenders are often referred to as hard money loans — high-interest loans that typically require an upfront payment and scheduled balloon (lump sum) payments. The property and any future improvements function as collateral for the loan.
The big benefit to hard money loans is that you avoid the hassles associated with traditional bank loans. In fact, you can often qualify for a hard money loan when you can’t qualify for traditional loans. But it’s called hard money for a reason — actually, for several reasons:
Hard money lenders don’t care as much about your personal income and expenses or your credit score. They want to know that if you default on the loan, they get a property they can sell for 20 to 40 percent or more than what you borrowed.
As the borrower, you typically pay two to ten points up front — money you’ll never see again — so if you borrow $200,000, you can expect to pay $4,000 to $20,000 up front, just for the privilege of gaining access to cash.
Private lenders charge much higher interest rates than banks do — sometimes double or triple what banks charge — so if bank loans are at 4 percent, you might be paying a private lender 8 to 12 percent. Private lenders can charge these high rates because they’re loaning money to you as an investment opportunity. If you were living in the property, private lenders couldn’t charge you these rates. Lending at those rates is considered to be usury, which is illegal (unless you’re a major credit card company).
You have significantly less time to pay off the loan — a few months to a few years, as opposed to traditional mortgage loans with payback periods of 15 to 30 years. If you can’t sell the property or refinance the loan by the deadline, you risk losing the property.
Hard money typically requires a larger down payment than traditional bank loans — 10 to 20 percent or more — so if the property has a current market value of $200,000, the maximum you can borrow is $160,000 to $180,000. You need to come up with the other $20,000 to $40,000 yourself, along with money to cover holding costs and the costs of repairs and renovations. (See the next section for info about gap loans, which can help you make up the difference.)
You may be required to make scheduled balloon payments over the term of the loan. Miss a payment, and you risk losing the property.
The approach for persuading a private lender to loan you hard money is the same as the approach for persuading a bank to finance your flips. See the earlier section “Persuading a bank to finance your flips” for details.
You can often locate private lenders via real estate agents and mortgage brokers; by attending landlord meetings or investment seminars; or by joining a real estate investment group and doing a little networking. Most private lenders loan money through mortgage brokers because most states require that lenders be licensed.
Making up the difference with a gap loan
One of the big drawbacks to hard money loans is that they come up short — you may not get all the money you need to buy, hold, and fix the property. This is where gap loans come into play. With a gap loan, a private investor or partner puts up the rest of the money in exchange for a cut of the profits. The gap loan covers any remainder of the purchase price, all carrying costs (including payments to the hard money lender), and the costs of repairs and renovations.
The benefit of a gap loan is that you get to flip a property with zero out-of-pocket expenses. The drawback is that it costs you a significant chunk of any profit you earn.
Partnering with an investor
Partnering with one or more friends or family members may be an option, especially if you have rich friends whose house flipping skills complement your own or if you have the skills and they have the money. With their financial backing and your combined knowledge and skills, you may be able to form a long-lasting and financially rewarding partnership. You may also consider taking on a partner in the following situations:
Your credit is damaged, and you need someone who has a better credit rating to help you secure the loan.
You can obtain a loan for purchasing the property, but you need a partner to provide funds for renovating it.
If you partner with someone for access to cash, you typically split the profits. Unfortunately, when you’re just getting started, your negotiating muscle is a little flabby. The person with the cash usually calls the shots. A 50/50 deal is about the most you can expect, but that can be overly optimistic. With each successful flip, you strengthen your position and eventually can offer the people who front you the money slightly more than what they can make by investing their money elsewhere, so you keep most of the profit. Early on, however, you may need to give your more affluent partner a bigger chunk of the profits.
Using Conventional Financing (for Longer-Term Real Estate Deals)
Technically, flipping is quick — you buy, rehab, and sell a house in a matter of weeks or months. But not everyone’s in such a big hurry, especially when they’re just starting out. You may want to take your time with your first flip to develop a feel for how it’s done. Maybe you want to live in the house for two years so that you can avoid paying income tax on a good chunk of your profit. Whatever the reason, if you plan to take your time flipping a house, you may have other financing options — traditional financing, such as taking out a mortgage to buy the property.
If you’re thinking of going with traditional financing, take a closer look at your creditworthiness and examine your financial