Real estate, similar to many aspects of life, operates in cycles. As investors, it’s our responsibility to be flexible and adapt to the ever-changing dynamics of real estate markets. Recent rate hikes and softening markets have put a damper on projected profits, especially for those investors using hard money loans.
In this article, I’ll provide you with a comprehensive guide on how to refinance a hard money loan. From understanding what a hard money loan entails to exploring various refinancing options such as bridge, conventional, and DSCR loans, I’ll equip you with the knowledge you need to make the best decision for your business. Additionally, I’ll discuss alternatives to refinancing and help you evaluate the best course of action. Let’s dive in!
What is a Hard Money Loan?
A hard money loan, also known as a fix and flip loan, is a short-term mortgage loan specifically designed for purchasing and rehabbing fixer-upper investment properties. While the specific terms and qualifications for hard money loans can vary among lenders, there are several common characteristics typically associated with these loans:
Short Loan Terms:
Hard money loans typically have short loan terms, usually only up to 12 months, much shorter than traditional mortgage financing. A hard money loan is also structured as an interest-only loan with a large balloon payment. Each monthly payment you make will only go towards the interest on the loan. At the end of the term, the entire principal balance is due.
Loan Scenario
As an example, let’s say you borrow $120,000 to purchase and repair a fixer-upper. The loan is for 12 months, and the interest rate is 10%. Each month you will pay $1,000. This $1,000 only goes towards the interest on the loan. At the end of the 12-month term, a balloon payment of $120,000 will be due in full.
Construction Financing:
As previously mentioned, a hard money loan will fund both the purchase price and the costs of construction related to the property.
Simplified Loan Approval:
When it comes to approving hard money loans, what matters most to the lender is the property’s after-repair value (which is how they determine your loan amount). Unlike traditional loans that mainly consider personal income and credit scores, hard money lenders focus on the property. This means that even if you have bad credit or don’t have significant income, you may still get approved for a hard money loan.
Higher Interest Rates:
Hard money lenders charge higher interest rates and origination fees due to the shorter loan terms. This helps them ensure they earn enough profit within this short time frame.
Emphasis on Real Estate Investor Experience:
Hard money lenders typically look at your experience and track record as a real estate investor. The more experience you have, the better loan terms you can expect.
Next, we’ll dive into who may need to refinance a hard money loan and explore the different alternatives for refinancing that are out there.
Who May Need to Refinance a Hard Money Loan?
Suppose you are approaching the maturity date for your hard money loan. In that case, you may have realized that market conditions have changed since last year. The after-repair value listed on the initial appraisal you received may no longer be a realistic selling price. Since the start of 2022, the Fed has hiked rates ten times to combat rising inflation. And, although the federal reserve doesn’t set mortgage rates outright, their actions have a trickle-down effect on the housing market. A fixed-rate mortgage is tied to the 10-year Treasury yield. When that rate goes up or down, fixed-rate mortgages tend to follow suit.
With owner-occupied mortgage rates hovering around 7.7% as of the publication date of this article, housing values have taken a dip in many areas of the country (values in Austin, TX, declined 11.2% year over year in June) in response to increased interest rates depleting a prospective buyer’s purchasing power.
If you intended to flip your property, it may no longer be viable to exit your position through a sale from a profitability standpoint. Or, maybe supply chain issues and labor shortages have created a construction timeline nightmare that has pushed you uncomfortably close to your loan’s maturity date. In either scenario, a refinance may buy you more time or turn what would have been a case of losing money on a flip into a cash-flowing rental.
Different Refinancing Options for Hard Money Loans
When refinancing a hard money loan, various options are available to suit the specific needs of real estate investors. Let’s take a closer look at three common refinancing options:
Bridge Loans:
A bridge loan is a temporary financing solution that “bridges” the gap between your current hard money loan and a long-term loan. This option provides immediate funds to pay off the existing hard money loan while allowing more time to secure permanent financing. Bridge loans are particularly beneficial when you anticipate a delay in qualifying for a refinance or have yet to be able to re-negotiate loan terms with your hard money lender.
Conventional Loans:
Refinancing your hard money loan into a conventional mortgage loan can be viable if you meet the eligibility criteria. Conventional loans, offered by traditional lenders such as major banks or credit unions, typically come with longer loan terms, competitive LTV (loan-to-value) ratios, lower interest rates, and more favorable repayment terms. To qualify for a conventional loan, you must demonstrate stable income, a good credit score, and meet other requirements, such as having a good debt-to-income ratio.
It’s important to note that, depending on how long ago you purchased the property, you may be unable to refinance with a conventional mortgage unless the property has been “seasoned.”
Conventional Loan Seasoning Requirements
Per the Fannie Mae selling guide, with a conventional loan, if you have an existing mortgage on a property, you can not do a cash-out refinance unless:
- The current loan is at least 12 months old and,
- The owner of the property has owned it for at least six months.
Delayed Financing Exception
Now, there is an exception to this rule. Although this would not apply to refinancing a hard money loan, this information would still be of value to you. Under the Delayed Financing Exception provisions of the Fannie Mae selling guide, you can perform a conventional cash-out refinance after only six months of ownership provided that:
- When you purchased the home, it was an arms-length transaction,
- You bought the property without mortgage financing and,
- There is documented proof of purchase funds source.
However, under the delayed financing exception, your cash-out refinance would be limited to your initial investment, not the newly appraised value.
DSCR Loans:
Debt Service Coverage Ratio (DSCR) loans tend to have easier underwriting guidelines. They focus on your property’s income potential rather than solely considering your creditworthiness, employment status, and/or debt-to-income ratio. This type of loan is known as a business purpose loan as it evaluates the property’s cash flow and ability to cover the monthly mortgage payments (formally known as debt service). DSCR loans can be attractive if you own income-generating properties, as DSCR lenders tend to offer more flexible eligibility requirements and terms. Additionally, there are usually no seasoning requirements associated with DSCR loans.
It’s important to carefully evaluate each refinancing option based on your situation, investment goals, and financial circumstances. When deciding, consider factors such as interest rates, loan terms, fees, and eligibility criteria. Additionally, consult with mortgage professionals specializing in refinancing to gain further insights and guidance tailored to your needs.
Next, we’ll explore alternatives to refinancing a hard money loan, providing you with a broader perspective on other strategies you may consider.
Alternatives to Refinancing a Hard Money Loan
While refinancing is a common exit strategy to transition from a hard money loan, exploring alternative strategies that may suit your specific situation is essential. Here are a few alternatives to consider:
Ask For an Extension:
If you find yourself in a position where the construction phase isn’t completed yet, or you need a little more time to close the sale with your buyer, you can ask your hard money lender for an extension. You’ll find that many lenders are willing to grant at least one extension. The cost of extending the loan term will vary. At the minimum, you should expect to continue making regular interest payments throughout the extension period. By opening up a dialogue with your lender, you may find a mutually beneficial solution to extend the term of your loan. As the old adage goes, the answer will always be no, unless you ask!
Partnering with Private Investors:
If you have a great deal, collaborating with other investors can provide an alternative means to repay the hard money loan. By forming a partnership with private investors, you can pool resources to pay off the loan, potentially securing much better terms, such as the interest rate and repayment period.
Selling the Property:
Lastly, it’s essential not to fall victim to sunk cost fallacy. As an investor, there may come a time when you’ll have to make a tough business decision. If refinancing options don’t align with your goals or circumstances, selling the property could be your only alternative. By selling the property, you can use the proceeds to pay off the hard money loan and potentially secure a new investment opportunity that better fits your objectives.
Each alternative carries its pros and cons. The key is to select the strategy that aligns best with your investment objectives, financial capabilities, and risk tolerance.
The Wrap Up
Now that you’ve gained valuable insights into refinancing a hard money loan and exploring alternative exit strategies for your real estate investments let’s summarize the key points we’ve discussed:
- What is a Hard Money Loan? Hard money loans are short-term financing options primarily based on property value rather than credit history. They provide quick access to funds for real estate investors, but they come with higher interest rates and shorter loan terms.
- Who May Benefit from Refinancing: Various scenarios can make refinancing a hard money loan advantageous. These include nearing the loan term, a shifting real estate market, and a change in investment strategy.
- Different Refinancing Options: When it comes to refinancing, you have several options to consider. These include bridge loans, or long-term financing such as, conventional loans, and DSCR loans. Each option has its own advantages and eligibility criteria, so carefully evaluate which aligns best with your goals.
- Alternatives to Refinancing: Refinancing is not the only path to consider. You can explore alternatives such as asking your hard money lender for an extension, partnering with private investors, or selling the property to repay the loan.
As you move forward, keep in mind the importance of conducting thorough research, evaluating your specific circumstances, and seeking advice from professionals in the real estate and financial industries. Doing so will enable you to make the right decisions to optimize your real estate investment strategy.
