Getting financing for your first few flips can be quite expensive. As I’ve mentioned in earlier posts, banks and federal banking regulators absolutely hate to lend to smaller real estate investors. The struggle that many newer investors have is that they are accustomed to seeing the rates that are being charged to owner-occupant home buyers. They fail to take into account the level of relative risk to a lender that a real estate investor imposes on the institution, therefore, they struggle to understand why rates for real estate investors are higher than they are for owner-occupants.
If you were to do a study of the default rates for borrowers that are buying a home that they will live in, you would find that the default numbers are very, very low in a normal economy. Banks and institutional lenders have done all sorts of studies on default rates for mortgages. Those studies, however, show that the default rates jump dramatically for a borrower that purchasing the real estate for an investment. The less the buyer puts down on the property, the higher that average default rate goes. Investor loans, regardless of whether or not those loans are considered “hard money” loans, will carry a much higher “risk premium” than an owner-occupied loan, therefore, they will normally have a much higher interest rate and fees.
Hard money lenders will make their money in three different ways, the up-front fees (or points) that they charge, on the interest rate, their “junk fees”, and, if applicable, their yield-spread premium.
The points that are charged are simply a fee that is fully earned when the loan paperwork is signed. It is usually stated in terms of a percentage of the amount that is being financed with one point equaling one percent of the loan amount being financed. In other words, if you are borrowing $100,000 with 3 points, you would be paying $3000 in “points” on the loan. Sometimes, lenders like to use fancy terms other than points to describe that fee in softer terms, but make no mistake, points are points. The key to understand with points is that they are fully earned by the lender as soon as you sign the loan documents, so if you sign today and pay it off tomorrow, you still owe those points to the lender. On their balance sheet, the lender will typically label the points as “prepaid interest”, “unearned finance charge”, or something of the sort. They will sometimes stretch out how they account for the income over the term of the loan. That seems trivial until we talk about the higher interest rate.
Most people think that the interest rate is pretty straight forward. It is, but many lenders purposely charge a high interest rate to get you to pay it off early. Why would they want you to pay it off early you might ask? The answer has everything to do with the points and fees. As we have mentioned earlier, on many lenders balance sheets, they income from the points is amortized throughout the terms of the loan (or at least over a period of time). Believe it or not, when lots of points are charged, they actually WANT you to pay it off early. That doesn’t seem to make sense until you understand that if you pay it off early, they can compress those points into a shorter period of time rather than spread it over a longer term loan. That makes the percentage that they show on their income statement and, therefore, to their investors shoot through the roof. Paying it off early saves you money, but it makes the percentage that the lender makes skyrocket.
Junk Fees are simply fees that are charged on a loan that are for nonsensical things. Processing fees, underwriting fees, basket weaving fees, or whatever fee they charge on the loan simply goes straight to their bottom line. Are they paying anything out for these junk fees? No, they aren’t. It’s simply a money maker for the lender.
The yield spread premium is something that lenders who are selling your loan off will get for bumping the interest rate up a bit over what the loan purchasers base rate, or “par rate” is. Let’s say that you go to a lender to borrow money. The lender reaches out to some of their funding sources and they discover that the lender will buy the loan at “par” at 8% interest. They further put out a grid that allows the lender to move up or even drop the base interest rate for a premium or discount. Let’s say the lender is lending out $100,000 at 10% where the final investor has a par rate set at 8%. For 10%, that final investor might be willing to pay an additional 1.5% or whatever they deem appropriate for the lender to bump that rate up from 8% to 10%. You as the borrower sign the loan papers for a 10% loan and the final investor then purchases the $100,000 loan for $101,500 due to the higher interest rate that the lender charged you. Lenders normally don’t have to disclose the yield spread premium to the customer. Most mortgage brokers, however, usually have to disclose it. Yield spread premiums vary from lender to lender with some lenders not allowing yield spreads at all. Understanding how lenders make their money can be very confusing for the borrower. If you have any questions regarding how loans work