Hard Money Loans Explained Step-by-Step

Today we're breaking down how hard money loans actually work, what they are, why people use them, who funds them, and if you want to get in the game, how fund managers can set up hard money lending funds. This is one of the simplest fund models out there, and if I was going to launch a first-time fund, this is the exact structure I would use. So let's pull out the whiteboard of truth and justice and break this down. So what is a hard money loan? A hard money loan is a short-term asset-backed loan usually secured by real estate. Now I put private money lending here because a lot of hard money lenders call themselves private money lenders, but in reality it's the same thing. It just sounds nicer to be a private money lender. Now here's the big distinction. If you went to a traditional bank, they're going to underwrite your credit score, your income, job history, tax returns, etc. A hard money lender just underwrites the property and the plan. So instead of asking, is this person perfect on paper, they ask, is this property worth enough that if something goes wrong, we can take the property back and still make a profit? That's why they call it hard money lending, because the loan is backed by a hard asset, the real estate. They also call it hard because they take the asset when it's done, and sometimes the points, fees, and other things with hard money lenders are kind of expensive. Hence why people that are hard money lenders call themselves private money lenders, so it sounds a little bit nicer. So why would someone use a hard money loan? Well, there's 2 main reasons someone would do this. Reason number one is speed. Traditional banks can take anywhere from 30 to 60 days to approve and close a loan. On the other hand, hard money lenders can fund in as little as 24 to 72 hours. So if you're trying to buy a property fast, compete in an auction, or lock in a deal before somebody else grabs it, speed is everything. Now, reason number 2 is flexibility. Banks have pretty rigid rules on how they lend. Hard money lenders, on the other hand, can structure deals however they want. They can do things like, if you want interest-only payments, great. If you want a balloon payment at the end, great. They can do sometimes no income verification. Some groups do no credit checks or rehab budgets are included, or even a higher loan to value if the deal makes sense. Now these things change on every single lender. But again, the idea is it's creative, you can find something that fits a solution for both parties. This flexibility is why real estate investors, especially house flippers, use hard money loans all the time. So let me walk you through a quick example on an actual deal. So this makes sense. Let's say Sarah is a real estate flipper and she wants to flip this house. Sarah can buy this property today for $180,000. She believes she could sell it for $300,000 after repairs, or ARV, which stands for the after rehab value. She can buy it today for $180,000, but she needs to close fast because this is an awesome deal and this is faster than a bank can move. So she calls up a hard money lender. The hard money lender over here says, we can do 70% of the ARV, after rehab value. So that brings it to, we'll make a loan for $210,000 to Sarah. This will cover her purchase price and up to about $40,000 in rehab costs. And the lender is going to obviously go check to really make sure this house exists and actually that the ARV isn't some bloated number, that we actually could get $300,000 after rehab. So they sign a contract, they go to a title company, and boom, bada bing, Sarah gets her $180,000 to buy the house and can start doing the rehab. Now, in exchange for this loan, they charge anywhere from a 10 to 12% interest rate. They're going to charge anywhere from 2 to 4 points or percentage points up front. And loans like this are typically 6 to 12 months. Let's call it a 6-month loan because Sarah is going to move quick on this rehab. So $210,000 on a 12% interest rate over 6 months, and this is an annualized interest rate, so really it's only 6 points. That brings us to $12,600 that are owed as interest. Now let's say this lender charges— let's take the middle of this— 3 points. 3 points on $210,000 equals $6,300. So if you add up $12,600, $6,300, Plus $6,300, you get a grand total of $18,900 that has to be paid back in addition to the $210,000 that was originally loaned, which comes to a grand total of $228,900 is the total payback that Sarah needs to pay to this hard money lender after her 6-month term is over. And I'm assuming a full balloon payment all due at the end. Sometimes they do them in different tranches. This time we're assuming a full balloon payment at the end of that amount. So if Sarah can do well and she actually sells the property for— she thinks she sell it for $300,000, Sarah pays back her loan and she'll be left with $71,100 after doing this flip. Not a bad deal for Sarah. Also not a bad deal for the hard money lender. So how much money did the hard money lender make? Well, they made a total right here of $18,900. How does that work for their Portfolio. So if they made $18,900 on a $210,000 investment, they made a 9% return. Not too bad, but they also did it in a 6-month time period. That would mean that their APY, annual percentage yield, is an 18% APY that they produced as a fund or fund manager because this only took 6 months. Annual percentage yield is an annualized number. So not too bad for the hard money lender. Sarah obviously made $71,000. She did well on this deal. Everyone's happy, right? Well, this is a pretty good deal if everything works, but did you catch one nuance? If this deal went bad, let's walk through what that would look like right now. So let's say zooming in on our house here, Sarah got this loan for $210,000 and we didn't do a credit check on Sarah. We don't know who Sarah is. Let's say Sarah Takes off or gets injured or flies to Alaska. Heck, Sarah Palin, okay? She leaves, she leaves the state. We don't know where she is. 6 months go by, we haven't heard from her, her phone's dead. We now have to foreclose on the property. So the lender has to go then and foreclose on the property that's only worth $180,000. And Sarah just took our $210,000. So we just lost, again, pending that we could get this house, foreclose it, and then just turn around and sell it. sell it for $180,000, we would have lost negative $40,000. That's not a good position to be in as a hard money lender. So this deal, as I presented it, probably wasn't the right way to do it. So this is where things get interesting if you're a hard money lender. A few things they do with Sarah. Number one, they only give her $180,000 upfront. They don't give her the full $210,000. She then gets a $40,000 line of credit That she can draw down maybe $5,000 at a time. And we're going to go check on the property maybe once a week to make sure the money that she's— this $40 grand that she's pulling is actually being worked on on the asset that we control. So we know the money is going into the asset. That protects us. So if 3 months in, Sarah decides to leave, well, at least we spent maybe $20 grand on the house and it's in the rehab and we can step in and complete the rehab and maybe turn around and sell it for $300,000 after we foreclose. Protects us. Our investment a bit. But a different hard money lender would say, hey, Sarah, we can give you the $210,000 on this house, but also we want a backup asset just in case you flee the state and head to Alaska. We want to make sure there's another house that we can also foreclose on if you take and run with our money. So they will oftentimes overcollateralize the property and assets that are involved in a hard money lending fund because from the lender's point of view, they go, yeah, this all works when it works. But okay, number one, we mentioned Sarah might leave. What if the real estate market just crashes and we see a correction of 20% in the real estate market? We want to make sure we have enough meat on the bone that we're not losing money on these deals. This is how a hard money lender would think when sending out money to Sarah, who they only met 72 hours earlier. They want to make sure they have usually first deed of trust on an asset or multiple assets that they can collect on in case Sarah flees the country, Or the market crashes or other uncertain events happen. And that is how smart hard money lenders stay in business for a long period of time. They make sure they only do loans that they can capitalize on. Now let's talk about the deeper side of this game. How would someone like you or me set up one of these funds to do hard money lending? It's actually way simpler than you think. So step number 1, you would build your pool of capital. Just like any fund, you set up your, what I call a pool of money, or your GPLP structure. This is your general partner and limited partnership investors. Your limited partners contribute capital to this pool of money, and you as the general partner manage this pool. This is all governed by an LPA and PPM, and we talk a lot about these in the rest of my content on this channel. This becomes your war chest for issuing loans out of. Step number 2, you would create your lending box. Every successful lender has a box, the rules that they follow for every single deal. So for example, we just talked about a few of them. Max loan being maybe 60 or or 70%. The property type— maybe you're just doing fix and flip rentals, or you'll do commercial real estate space. The loan terms— how long or how short your duration is, what your interest rate is, and points. Those are all things you'll decide up front. This box keeps your fund disciplined to make sure you're only investing in the things you have expertise on. Number 3, work on underwriting assets. Even practice on a few assets before you do a live one. Underwrite the property value, the after-repair value, the rehab budget, time to completion, the exit strategy and assume the person telling you all these things is lying. You've been sad to say, but a lot of people looking for hard money loans sometimes aren't the most honest people. And you've got to assume, because you're putting your investor's money at work, that all these things are not as they seem. And you have got to fact-check every single detail of a deal. And you do this because if the deal is good enough and you get first deed of trust from a good title company, the borrow doesn't even matter at all. You're making secured loans backed by real collateral that you make sure that you can collect on if Sarah flees to Alaska and doesn't call us back. And then step number 4 is start building the process— how you're going to underwrite, service, fund, payoff, recycle capital. You can do that by yourself or start building a team around you. And finally, step number 5, you start returning capital So as these loans make profit, they flow back to the fund. You split your returns between the general partner and the limited partners in the fund. I have plenty of videos on my channel that talk about this waterfall breakdown distribution. Now, at the beginning of this video, I said this is a fund that I would launch and do because the loans are short-term and they're secured by real estate. Investors love the consistency. You can start paying returns to investors pretty darn quickly. My first fund I ever did was a lending fund. Not exactly like this, but pretty similar. My dad's first funds were lending funds, pretty similar to what I just explained to you. This is a great way to cut your teeth with doing small deals, getting returns for investors, and learning the ropes of being a fund manager. So in summary, hard money loans exist because the traditional banking system moves slow and plays by rigid rules. Real estate investors need speed, flexibility, and capital that understands these deals, and hard money lending fills that gap perfectly. Perfectly. And for fund managers, like I said earlier, this is one of the most straightforward asset-backed lending strategies you can build to produce returns fast to your investors and build your own track record as a good fund manager. So if you like today's video, please like and subscribe this video. Check the other videos out on our channel. We break down how funds are built, how we raise capital, how to find investors, how to structure with the SEC—the whole gambit around building funds. Go check them out on our channel, and we will see you later. Bye bye.