How to Obtain House Flip Financing
Securing financing ensures a fast cash payment. The seller will be paid in full at the time of closing without a long wait or hassle. This distinguishes the way investors buy houses from an ordinary homeowner. The ability to pay in full at the time of closing is part of your unique value proposition.
While securing payment ahead of time, you bring fast cash to the table without hassle, presenting maximum value to a motivated seller. You also gain an advantage over other buyers by having your cash offer ready.
To attract lenders, investors, or partners your main objective is to demonstrate that the reward is worth the risk they are taking.
There are several risks that lenders or investors take, such as:
- Accuracy of projected selling costs
- Accuracy of estimate of improvement costs
- Experience of the real estate investor
- Changes in the housing market
Incorrect estimates or mistakes by an inexperienced house flipper could lead to losses for the investors. You need to convince your investors that you can return their investment with adequate rewards - and then do it.
Create an Investment Summary
To provide a professional impression, create an investment summary to address each of these risks for your potential investors.
The investment summary should provide a detailed explanation of four main areas:
- Property details. This includes address, layout, square footage, year built, and any relevant or interesting features.
- Maximum offer formula. In this, you want to include:
- Eventual selling price: Mention how you determined the eventual selling price, including an analysis of the target neighborhood and historical price values.
- Operational costs: Include a detailed calculation of operational costs, or have it ready to show if they ask.
- Improvement costs: Mention the improvement costs and how you obtained those figures. Have detailed analysis available if needed.
- Return on investment. Investors need to know how and when they are going to receive their return on investment.
- Your qualifications. This includes your qualifications as an investor, including relevant credentials and experience.
Your investment summary should be one to two pages long and give a brief overview. Be prepared, and have detailed information to address any questions related to the above four points.
Network to Find Potential Investors
One excellent way to prepare to attract financing is to join local investment clubs. Plan to arrive early and stay late to build your network. When you make connections, especially with people who have house-flipping experience, you have a great opportunity to learn and grow your business. You can ask for their business cards and discuss goals.
You will be able to find and connect with other local investors with similar goals and interests. These connections can grow into lenders or partners on future house-flipping projects. Networking is important to your long-term success, regardless of whether you plan to start securing financing through borrowing or partnering. Build your network from the beginning for future success.
Types of Financing for Flipping Houses
Fix and Flip Loans
Borrowing is one of two main ways to secure financing for house flipping. When borrowing, you take out a loan that will be repaid when the flip is complete. You can borrow either from an institutional lender or from private lenders. Private lenders can be either individuals or groups of individuals.
Institutional lenders are banks or mortgage companies. Their loans are government-backed which typically means low interest rates. The advantages of institutional lenders are the security of the loan and the low interest rate. The disadvantage of institutional lenders is that they take longer to process the loan, usually several weeks or more.
The other disadvantage of institutional lenders is that they base their decision on the person applying for the loan, rather than the project. To meet the criteria of institutional lenders you will need:
- Good credit history. They will look at your current credit score and also your credit history.
- Down payment. You will need to have 10% to 20% of the total purchase price in cash as a down payment. If the house costs $100,000, plan to have $10,000 to $20,000 ready.
- Steady income. You will need to prove that you have a steady income that is sufficient to pay off the loan. This can be an obstacle for first-time house flippers wanting to start out full time.
If you plan to use institutional lenders, working with a mortgage broker to get pre-approved for a mortgage will expedite the final closing. However, in the best-case scenario, this will still take two weeks.
If you are sure this is your best option, you can explain to the mortgage broker that you will need to close quickly and ask for their help. Once you have demonstrated your ability to repay previous loans in a timely manner, they can further expedite processing times.
Because of the slow closing times and strict requirements of banks and mortgage companies, it can be useful to also build relationships with private lenders.
Private lenders are individuals or groups that lend money for real estate investing projects. They provide cash when you need it. If you can demonstrate house-flipping skills and a reliable return on investment, you can build a mutually beneficial relationship with private lenders. They will become your regular sources of financing, and you will provide them with reliable returns.
There are important differences between individual private lenders and groups of private lenders.
Individual Private Lenders
Generally, individual private lenders will be more flexible with the terms of the loan and can work with you. If you can, find an individual private lender over groups. You will get more favorable, and usually more profitable, returns. You can also develop a working relationship that continues over many projects.
Groups of Lenders
Money invested from groups of lenders is called “hard money.” Groups of lenders have a general manager and criteria or rules for the investment of their funds. This can include the amount of money invested, time invested, and percentage of return. Hedge Funds are an example of a large group of lenders.
Groups of lenders will only be able to agree to terms that meet their criteria. These may not be the most favorable terms for you. Even after you have demonstrated your skill in multiple projects, they are usually unwilling to renegotiate a more favorable loan. For this reason, while groups of lenders are an option, if you can get an individual lender, it will be better for your business in the long run.
Criteria for Private Lenders
Unlike banks, private lenders are more interested in the current and future value of the property. They will want to know about the price history of the neighborhood, the average price per square foot, and the price per square foot you expect on the final sale of the house.
Private lenders are less concerned about credit history, income, or tax returns. Some private lenders might require credit scores, which you should be prepared to provide but many do not. However, you will need to demonstrate competence and credibility.
Be prepared to show private investors what you can do for them with clear calculations and demonstrable results. The main information required by private lenders is that there is a clear potential for return on investment within an agreed period of time. They want to see that you can deliver the results you promise.
Once you have built a reputation for success, you will have private lenders seeking you out. Private lenders are eager to get a profitable return on investment. If you can demonstrate reliable returns through house flipping, they will be ready to work with you.
Institutional Lending vs. Private Lending
Loan to Value Ratio
Most often, private lenders will evaluate their investment in a property with the loan to value ratio.
The loan to value ratio is the relationship between the value of the property and the amount of the loan.
Private lenders will typically not go above a 75% loan to value ratio (abbreviated LTV ratio). That means that if a property is worth $100,000 they will not loan more than $75,000. Some will even require a 65% LTV ratio.
Institutional lenders, in contrast, are not interested in the LTV ratio. They will only look at the person requesting the loan, including credit history, income, and downpayment.
One key difference between private lenders and institutional lenders is that the interest rates for private lenders are much higher. For private lenders, you can expect a range of 10% to 20% interest. In addition, private lenders usually expect 3 to 10 points due at closing.
A point is 1% of the value of the loan. So if an investor requires 10 points at closing, that means they require 10% of the value of the loan. On a loan of $100,000, this would be $10,000 in addition to repayment and the interest due.
Institutional lenders are government-backed and are therefore controlled and regulated. Interest rates from institutional lenders will follow the local norms. For example, if a typical mortgage in your area has an interest rate of 5% to 7%, expect the same on your house flipping mortgage.
You pay the price of higher interest rates from private lenders for one crucial advantage: the ability to close quickly. By using private lenders, you pay slightly more to obtain the cash. However, you can use this to your advantage to close in a matter of days. This allows you to deliver on your promise to the seller of a quick, no-hassle closing.
Private lenders provide the cash you need at the moment you need it, creating a win-win situation for all parties involved. Institutional lenders, in contrast, typically take two to six weeks to close, potentially delaying your closing time.
Other Benefits of Private Lenders
Private lenders often offer other benefits, such as deferred payments for the first six months. This can be a major perk for house flippers when cash is tight. By investing all your money into the renovations and selling in under six months, you can repay the loan with interest before the first interest payment is due.
Watch out for a prepayment penalty clause in private borrowing. This clause will charge a penalty if the loan is paid off before an agreed-upon date. This clause is usually written as a requirement to continue paying interest for a set period of time, even if the loan is repaid in full. Sometimes, there are additional penalty fees.
Prepayment clauses are rare in institutional lending, but it is still worth double-checking.
If you plan on a quick renovation and sale or a quick sale to another investor, you want to avoid a penalty clause. If you plan for renovation work to take longer than the time period of the penalty clause, your risk is minimal.
At a Glance: Institutional vs. Private Lending
Interest rate: 5%-7%
Closing time: four weeks or more
Qualifying: Personal credit and income
Interest rate: 10%-20%
Closing time: a few days
Qualifying: The value of the property
The second major way to finance house flipping is through partnerships. In partnering, you give the investor an ownership interest in the property. This is called equity. This way you do not pay for the cost of the money borrowed.
How much ownership to give will have to be negotiated between partners. Typically, if your partner is putting up the capital and you are doing the renovation work, the split will be 50-50. Each of you has 50% ownership of the property, and at the time of sale, you would share the profits equally.
However, if you are supplying a portion of the funds and doing all the work, then the split would not be equal. You can decide on what seems fair and reasonable to you both based on how the funds and work are divided.
How to Divide Ownership
Taking the 50-50 standard split as a base calculation, you can say that for every 20% of funds invested, an additional 10% of ownership is granted. So, if you put out 40% of the funds and do all the work, you would have 70% ownership. Your partner who supplied 60% of the funds would have 30% ownership equity.
In some cases, it is also possible to organize seller financing. Seller financing means that the seller provides some or all of the funds to purchase the house. In essence, the seller becomes your private lender. In this case, you will work out all the terms of the loan, including interest rate and payment schedule, with the seller.
This can be an attractive option when the house requires extensive structural renovations. However, there are many legalities to seller financing. These include lease options, lease purchases, and wraparound mortgages. You should thoroughly research the legalities in your state and consult with a local expert before buying with seller financing.
Putting It All Together
In summary, borrowing and partnering are both effective means of financing house flipping.
Borrowing can be done from institutional lenders or private lenders. Private lenders can be individuals or groups. Private money lenders are going to be the fastest way to get what you need with flexibility.
Institutional lenders and private lenders both offer advantages and disadvantages. It is worthwhile to cultivate relationships with private lenders and to be pre-qualified for mortgages so you have a number of financing options open to you. Depending on your personal situation and your house-flipping goals, you can use both private and institutional lenders.
Partnering allows you access to financing without spending money on interest and points. However, you will give the partner equity in the property thus paying with your profits. The advantage of partnering is that you not only share the profit but you also share the risk. If there are unexpected expenses or market changes, the loss is shared or minimized.
Which Should You Choose?
Both partnering and borrowing will give you new paths to finance properties and start flipping houses. Careful calculations and management ensure timely returns on investment for lenders. Cultivating your network and delivering results sets you up for future financing and greater success.
As you grow your business, you can use different channels for financing to perform multiple house flips.