Borrowing Against the House Youre Buying

Lenders always require some collateral to secure the loan — something of value they can take from you and sell if you happen to default on the loan. You can use your own house, possessions, and retirement savings as collateral, but that places your current possessions at risk. A safer way to borrow money is through a hard-money lender who's willing to accept the investment property as collateral. You can often locate hard-money lenders through your mortgage broker.

Hard money is a high-interest, short-term loan that offers three big benefits:

^ You get access to cash you may not be able to get through a conventional lender.

^ Hard-money lenders often accept the future value of a property as collateral, so you don't have to borrow against your own home.

^ You can often set up a separate escrow account with a hard-money lender to pay for repairs and renovations.

Now for the bad news. Hard money is called "hard" for several reasons. Before choosing the hard-money option, be aware of the following key areas of hard-money loans.

^ Points or discount points: You can expect to pay anywhere from

2-6 points for the loan up front. A point is 1 percent of the loan amount, so if you're paying 6 points on a $200,000 loan, you're paying $12,000 up front to get your hands on the money.

^ Interest rates: Hard-money lenders often charge nearly double the interest rates of conventional loans. If the going interest rate for conventional loans is 6.5 percent, for example, a hard-money lender may charge 10-15 percent.

^ Loan-to-value (LTV): Hard-money lenders typically approve you for a loan of only 50—70 percent of the expected sales price of the property, so you need to be sure that you're buying the property for 30 percent or more below what you expect to sell it for, and you may need additional funds to cover holding and renovation costs. When buying into a declining market, LTV becomes even more critical, because your loan amount stays the same while housing values are declining. If the value of the house dips below what you owe on it, you place yourself in a situation of owing more on a property than what you can sell it for.

^ Amortization: Hard-money lenders often want to amortize the loan over 5-15 years instead of the standard 30 years, which ends up increasing your monthly payments, because you're paying down the principle on the loan faster.

To lower the monthly payments, amortize over 30 years or negotiate for interest-only payments. You want to have enough free-flowing cash to finance renovations and cover your holding costs.

^ Balloon payment: Hard money typically has balloon payments or cash calls after so many months, or you may be required to pay off the loan in full in a matter of 6—36 months. This isn't a problem as long as you have a solid plan in place and sufficient funds on hand for when the balloon payment is due.

^ Prepayment penalties: Avoid any loans that stipulate a prepayment penalty — extra money you have to pay if you choose to pay off the loan early. I've seen investors lose thousands of dollars when they sold a house because they agreed to pay a 2-3 percent prepayment penalty.

^ Closing costs: As with any lender, you have to close on a loan from a hard-money lender. Figure in the cost of the title insurance, closing fee, credit report, and appraisal survey. Be particularly careful of any discount points or loan origination fees — these are areas where the lender and mortgage broker can really jack up the cost of the loan.

Putting the cost of hard money in perspective

Hard-money loans may be the most costly, but don't worry so much about what the hard-money lender is charging and how much profit he's earning. Calculate the cost of the loan into your investment, just as you calculate in repair and renovation costs.

If you calculate in all your costs and can still make a 20 percent or higher return, who cares what the other guy is making? See "Comparison Shopping for Low-Cost Loans," near the end of this chapter for instructions on how to calculate the total cost of a loan over the life of the loan.

i Cross-collateralization: If you're investing in two or more properties, the hard-money lender may want to cross-collateralize the properties. If you sell one property for a $10,000 profit, for example, the lender may want to use the profit to pay down the loan on the other property. This isn't terrible and may even benefit you by reducing your interest on the second loan, but it's something you should be aware of. Cross-collateralization simply secures the lender's position.

Some hard-money lenders offer something called a bullet loan, in which you make no monthly payments. Interest accrues and is rolled back into the loan's principal, which increases the total amount required to pay off the loan and can significantly increase the total amount of interest you end up paying. However, a bullet loan frees up your cash flow, so you have more money on hand for renovations and other investment properties.

(ftNG/ Don't borrow money from a hard-money lender and give her a deed in advance in case you do not perform. This takes away some of your rights. Hard-money lenders are normally not licensed to provide loans. They purchase loans through others. If you default on the loan, they won't send Guido to break your legs. They just repossess the rehabbed property you put up as collateral.

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