Should Real Estate Investors Use Loans for House Flipping?
As you work hard to grow your house flipping business, you might be questioning whether using loans for house flipping is a good idea. As you are carefully planning your project-related spending, keeping your project turnaround times as short as possible, and working hard to maximize your ROI, does adding loan interest payments, points and fees to the cost column of your fix-and-flip project make sense?
When it comes to your overall house flipping business model, and more specifically your house flipping business plan, it is important to consider whether using loans for house flipping will raise or lower your company's ROI.
Of course, there are pros and cons that come with borrowing capital to finance your house flipping business. You probably have already considered the cons:
Interest and loan fees paid to the lender
If you rely on your own cash on hand, you will not have to worry about the cost of borrowed capital. Paying interest to your bank or hard money lender adds a significant cost to your project -- especially if you have construction delays, or other delays to your project completion that necessitate extending your loan terms.
Lender's oversight
When you bring a lender on board to help finance your construction costs, you may need to submit requests for reimbursement of payments you've made to your contractors. Many, if not most, lenders will want to send an inspector out to your project site to verify that the funds they are reimbursing to you correspond with the scope of work completed.
3 very good reasons fix-and-flip investors use borrowed capital to flip houses:
1. Using a loan to flip a house can help you snag the best deals
In the house flipping business it is often said that "cash is king.” A fix-and-flip investor operating in a hot market has no time to wait for family members, partners or other private investors to come to the table with the cash needed to pounce on cash-only and auction deals.
An investor who does not have cash reserves to participate in cash deals is missing out on the opportunity to snap up properties that often have a substantial profit margin built in. The cash-only seller is often selling the property under duress, making them highly motivated to let it go for less than its market value. For the fix-and-flip investor, these deals can mean a significant return on investment.
Even if you already have plenty of cash reserves to buy and renovate your next investment property, partnering with a lender who is able to fund fix-and-flip investment deals quickly means you can leverage your cash reserves with borrowed capital to snag additional deals you would otherwise miss out on. In this case, the cost of borrowed capital can be well worth the leverage benefits.
2. Fix-and-flip loans can help you scale up your business quickly
Leveraging cash on hand with borrowed capital can yield great results for fix-and-flip investors who would otherwise be constrained to just a few projects a year.
Taking into account the added cost of interest and fees, you may find your per-project ROI is lowered when you use borrowed capital, however, across multiple projects, your overall ROI can be significantly higher. Here is an example:
Last year, John & Jane Doe Company purchased 2 homes using their $600,000 cash reserves and rehabbed and sold them to yield a net profit per flip of $45,000. Their net profit was $90,000—a 15% ROI.
This year, John & Jane Doe Company leveraged $600,000 with hard money loans and purchased 9 homes, snapping up bargains they would have missed out on before. After costs they averaged $35,000 profit per flip. Their net profit was $315,000 —a 52% ROI.
3. Getting a loan to flip a house flip lets you hold on to your cash for use elsewhere
The worst case scenario every real estate investor dreads is finding that they have stretched their cash reserves thin across multiple deals—then unexpected operating expenses arise that they never saw coming.
Using a fix-and-flip loan ( also called a hard money loan ) is an excellent way to hang on to more of your cash reserves and let borrowed capital do the heavy lifting. When you factor in the cost of borrowed capital, interest and loan fees can be a small price to pay to avoid the catastrophic effect unexpected costs can have on your house flipping company's overall ROI.
What Kind of Loan is Best for a House Flip?
A Hard Money Loan Funds Faster
The goal of fix-and-flip investing is to purchase a property at a great price and quickly renovate and resell it for profit. This means time is always a critical factor. When it comes to financing a fix-and-flip project, hard money loans (also called "fix-and-flip loans" or "private direct loans") are faster and more flexible than traditional bank loans.
Where a traditional bank loan generally takes 30 to 60 days to close, a hard money loan can be approved and funded in as little as 5 to 10 days—or possibly even faster for existing borrowers on rush deals.
Some hard money lenders even offer a "close as cash" loan program which allows the borrower to purchase the property and "close as cash" with the lender funding the purchase and assigning Title to the borrower, then recording a Grant Deed after close of escrow. This type of loan product is used by experienced borrowers who are skilled at acquiring auctioned properties and need to be able to compete at auctions with cash buyers.
Hard Money Lenders Relax Qualifying Rules
One of the reasons a traditional bank takes longer to fund property investment loans is their lengthy borrower application process. The bank will take a microscopic look at your credit worthiness and financial history. If anything sets off a red flag, they will ask for more and more documentation, prolonging the approval process.
With a hard money loan, the property serves as collateral on the loan. A hard money lender is less concerned with your FICO (although good credit has its perks), and more interested in your skill as a house flipper and your track record with successful flips.
Although there will likely be a minimum credit score a fix-and-flip lender will prefer, with this type of asset-based loan, if you hold a significant equity position in a property, or you have a few successful flips under your belt, hard money lenders often will take that into account for loan approval—even if your credit score is lower than their preferred minimum.
Hard Money Loan Lengths are Shorter
While a conventional home loan is typically amortized over 15 or 30 years, with a fix-and-flip loan you will make monthly interest-only payments for a term of 6 months to two years.
Many hard money lenders don't charge penalty fees for early pay off of the loan. You can pay off the balance as soon as your property sells. Conversely, if you need more time, some hard money lenders will offer 3 to 6-month extensions for their qualified borrowers. Before choosing a lender, be sure you know if they offer these options.
Hard Money Lenders Expect Poor Property Condition
A conventional bank will likely have strict requirements regarding the condition of the property you are looking to finance. The loan amount you can qualify for with a bank will usually be limited by the property’s as-is value.
For fix-and-flip loans, the as-is condition of the property is irrelevant if there is sufficient after-repair value (ARV) to justify the loan amount. Since the property is being purchased with the intent to fix it up, the property condition is expected to be sub-par and will not be disqualifying to the hard money lender.
Hard Money Loan Costs are Typically Higher
When you borrow from a traditional mortgage lender, your interest rate will be significantly lower than with a hard money lender. With a bank, origination fees will usually be no more than one or two points (1% to 2% of the loan amount). With a fix-and-flip loan, you will typically be charged a much higher interest rate, and two to four (or more) points for the origination fee.
With either type of loan you’ll need to bring a down payment to the deal, which will typically be between 15-25% of the amount you are borrowing. Some lenders are more flexible than others with the amount of "skin in the game" (monetary risk) they expect borrowers to share.
Feel free to contact us with any questions you may have about flipping houses with hard money financing, and we’ll do all that we can to answer them.
