Real estate investors have a myriad of financing options to leverage alongside their hard-earned cash when investing in properties.

This article will evaluate two of the primary borrowing options that real estate investors consider, whether it be conventional loans, or private (hard money) loans – specifically for those investors who purchase and improve residential and multifamily properties for an eventual sale (fix and flip) or converting into a rental property upon completion.

Again, there are numerous other options (and variations) of these, but it is crucial that real estate investors have a thorough understanding of these primary options to consider alongside their investment objectives. Continue reading to learn more about these specific financing options so you are better able to understand which option suits your needs.

What is private money lending?

A private money loan is a short-term loan secured by real estate and can also be referred to as a hard money loan. These loans are typically funded by Private Lenders who are ultimately backed by individual investors. Since Private Lenders understand that many real estate investors have a short-term business plan to get into and out of a property for a profit, loans of this nature typically have 12-month terms. Additionally, as Private Lenders understand that real estate investors aren’t the “typical $500,000 per year W-2 income earner,” the requirements are much more flexible:

• Higher leverage points
• Lower credit requirements
• No income requirements – since after all this is an investment, not a property that you’re looking to live in
• Higher interest rates, however, payments are Interest only Monthly payments

Now you may be thinking, how much money can lenders provide to the borrowers? It really comes down to a Private Lender’s ability to understand what real estate investors do to lend, not only against the current value of the property, but also the future value once the business plan is implemented.  Ultimately, the benefit of a private loan is that the Lender is willing to provide a loan not only against the as-is property value, but also understands that if the planned improvements are completed, the future value will be higher – so they are willing to consider that as well.

What is conventional financing?

Conventional Loans, such as those offered by banks and mortgage companies, have relatively stringent guidelines, so the popularity of this type of financing has limitations.  To qualify for the “cheapest” money out there, there are typically income and credit requirements that are a roadblock for many.

Since conventional lenders are typically looking at the borrower’s ability to afford the mortgage, having strong W-2 income and stellar credit are usually a pre-requisite that many full-time real estate investors can’t get around.  In addition, most banks provide a loan only against the as-is property value without any consideration to any planned improvements, which would be something that the real estate investor would need to self-fund.

Beyond leverage, time is money and speed is crucial to get a deal under contract.  In most cases, conventional lenders operate at slow pace when approving a mortgage, which could ruin your chance to secure a great deal on a property.

Misconceptions about private money lenders

The reality is that there was once a negative connotation tied to private money lending and the industry’s reputation was associated with high interest rates. However, critics overlook many benefits:

• Time-saver: Private lenders can typically decide on a loan application in 7 – 10 days
• Less red tape: private lenders are not required to abide by regulations created by the 2010 Dodd-Frank Act, providing borrowers an easier loan application process
• Value: conventional lenders must base loans on the property’s appraised value (LTV) while private lenders base their loans on the property’s after repair value (ARV). Making private lending an extremely attractive option for real estate projects that involve improvements

Make sure to do your own due diligence on all lenders to ensure they are reputable. Finding a private money lender that you can build a relationship with is an important key to potential investment success.

Cost-benefit Analysis: 5% bank loan vs. a 10% private money loan

Now that we have a general understanding of financing options, let’s look at the bottom line of a private money loan versus a conventional loan.

As an example, let’s say you’re a real estate investor that has found a property in a popular neighborhood in need of some improvements. You’ve determined you can purchase the property for $600,000, spend $200,000 to remodel and then sell for $1,000,000. It’s a great plan and now all you need is money to make it happen!

If you were to secure a conventional loan that doesn’t provide leverage toward the rehab, which requires a 20% down payment toward purchase, you would need to have $320,000 cash ($120,000 purchase cash + $200,000 for the remodel) alongside the lenders $480,000 loan. After a lengthy process of providing W-2 income, financial statements and more to prove you can afford the mortgage (even though you plan on selling the property quickly), you qualify for the loan and get started. At the end of six months, you sell the house for $1,000,000 with a gross profit of $200,000 and a net profit of $179,740. Not bad! Just keep in mind that this conventional loan requires $320,000 equity to be put into the deal.

Let’s see what this deal would look like if working with a private money lender. Because private lenders consider the future value of a property and provide a loan against it, this loan comes with a much more manageable $120,000 equity requirement as they will lend you 100% of your remodel budget. You save time as it takes on average 10 days for you to know if you’re approved and get started on your remodel. The project is finished, and you sell the house for $1,000,000 with a gross profit of $200,000 and a net profit of $159,200. Amazing!

At the end of the day, when you look at how much money you made, the conventional loan wins as it came with a lower interest rate.

However, a savvy investor will look at how much money you had to invest to make that money (the cash-on-cash return). From there you’ll quickly see that the cash-on-cash return for the private money loan is more than double and substantiated that from an investment standpoint. Private money can provide investors better cash on cash returns than conventional money any day of the week.