One of the most common questions prospective clients ask is, “What are the requirements for a hard money loan?”
Hard money lenders’ primary concern is typically the asset they’re lending against. However, there are a few other factors they consider before agreeing to fund a deal.
In the lending world these factors are called the 4 C’s and they stand for character, collateral, capacity and credit.
Different lenders will weigh the importance of each of these factors differently.
At Sharper Capital Partners, we consider them in the following order.
Character
We believe a client’s character is the foundation of a successful partnership.
It’s first on our list because some investors have great deals, plenty of cash and perfect credit, which is great. But if they don’t have strong character then the likelihood of a successful outcome is low.
One way we assess character is by asking ourselves: “If something goes wrong on this project, is this person going to make it a ‘we’ problem or a ‘me’ problem?”
Hopefully, the answer is they’ll make it a “we” problem so we can work together to try and find a solution. If the answer is they’ll make it a “me” problem, then they’re probably not someone we want to work with.
Qualifying Questions
Here are some other questions we ask to assess character:
- Do they treat people with respect?
- Do they respond to communication?
- Do they follow through on their promises?
If the answer to these questions is yes, then we move on to the second “C” on the list, which is collateral.
Collateral
Collateral refers to the property or asset the client pledges as security for the loan.
This is what the word “hard” in “hard money lender” refers to: the hard, tangible assets such as real estate or other physical property that secure the loan.
This is where most of the time is spent in the underwriting process.
Loan to Value
Hard money lenders will typically cap their loan amount based on a percentage of the property’s after repair value (ARV). The ARV is the price the property will sell for after it’s fixed up.
This cap is called the lender’s maximum loan to value (LTV) and it’s calculated using the following formula:
Loan Amount / Property ARV = LTV.
A lender’s maximum LTV will vary based on a number of factors such as market, asset class, etc. A common range is between 60 – 80% of the ARV.
A higher LTV means higher risk and vice versa. Lenders have to do their due diligence so they can be confident that the property’s ARV is accurate.
If the underwriting goes well, the lender will offer a loan at an LTV they feel comfortable with and then move on to the next “C” which is capacity.
Capacity
Capacity refers to a client’s ability to pay for the cost of the loan, including (but not limited to) the following items:
- Down payment
- Points & fees
- Closing costs
- Interest payments
- Initial rehab (before reimbursement)
Lenders require a down payment from their clients because it means they’ll enter the project with “skin in the game.” (There are other ways to put “skin in the game,” such as pledging cross collateral.)
Having skin in the game means the client is less likely to walk away from the project when they run into problems. They are more likely to make them “we” problems rather than “me” problems like we discussed earlier.
Best for Both Parties
Ensuring clients have the capacity to cover the costs associated with a project isn’t only important for the lender. It’s also important for the client.
If a lender offers a loan to a client knowing they can’t afford it, then the lender is setting that client up for failure.
The lender will likely be fine if things go south because their loan is secured by property, but the client will be in much worse shape financially – not to mention legally and emotionally.
If the client has enough capital to comfortably afford the project then it’s a win-win for both parties. The lender will then move on to the fourth “C” which is credit.
Credit
Credit refers to a client’s credit score.
This is usually the first thing a conventional lender, such as a bank or credit union, will consider when a client applies for a loan with them.
To a conventional lender, the lower a borrower’s credit score the higher risk they pose of defaulting on the loan and vice versa.
Conventional lenders will typically only approve loans for borrowers that are considered “low risk.” That lower risk is reflected in their lower interest rates.
Hard money lenders will generally approve loans for clients that are considered “high risk” by conventional lending standards. That higher risk is reflected in their higher interest rates.
There are a lot of factors that affect someone’s credit score. Knowing the full—and honest—story behind a client’s score is important. (Once again, that’s why character is number one on this list.)
When It Really Matters
Good credit is important for clients whose exit strategy is to refinance out of their hard money loan. If clients plan on selling the property then their credit score is less important.
This is because the ability to refinance typically requires good credit. That means both the client’s and the hard money lender’s exit strategy is dependent on the client having a healthy credit score.
If a client has good credit, or if they have low / no credit but their story makes sense and they check the three boxes above, then they’re likely to be approved for a hard money loan.
For a more detailed look at the process of obtaining a hard money loan, read our article by Grant Smith called How To Get A Hard Money Loan.
