It is critical that you have a working understanding of the loan jargon that is used by lenders and mortgage brokers. They spew out these terms like it’s a second language that everyone should comprehend. Without a solid understanding of their meaning, you will not be able to make informed decisions about your financing. Here are definitions of some of the most commonly used terms.
LTV is the Loan-To-Value: the percentage of the value of the house that the loan represents. It is calculated by dividing the loan amount by the value, and the use of quick bridging finance is great to get loans as well. For instance, if the loan is $62,000 on a house valued at $100,000, then the LTV is 62%. Every lender has some LTV that they will not exceed, so you need to always know this figure. You also need to know whether they are using “as-is” value, Purchase price value; or After Repaired Value (ARV).
For example, assume a property has an ARV of $150,000, but is only worth $80,000 “as-is”. You are comparing two lenders’ programs. One advertises LTVs of 90% while the other advertises LTVs of 65%. At first glance, it appears that the first lender has a better program. Upon closer examination, however, you find that the second lender will actually lend more dollars on the same house.
The lender advertising the 90% LTV is working off of “as-is” values. Therefore in this example, the maximum loan would be $72,000 ($80,000*.90). The other lender offering 65% LTV is working off of the ARV with a maximum loan amount of $97,500 ($150,000*.65). That’s over a $15,000 difference. Do not just compare LTV figures between lenders, but also find out whether they are working off of “as-is” values, purchase price, or ARV.
Hard Money Lenders are also using another way to determine the amount of the loan. They’ll say 90% of purchase; 100% of rehab; and 70% of ARV. Translated, this means that they’ll loan you up to 90% of the purchase price (so you have to have a 10% down payment; plus they’ll loan the entire rehab amount provided that the total of both of those combined does not exceed 70% of the ARV.
CLTV is the combined loan-to-value ratio of all loans on the property. It is calculated by adding all of the loans together, and dividing by the value of the property. Lenders use this to determine how leveraged is the property with loans. When attempting to obtain loans other than first position, the lender will want to know the CLTV of their loan. For example, if you accepted the $97,500 loan above, then applied for another $10,000 loan from another lender, they would want to calculate their CLTV which would be 71.6% ($97,500+$10,000 / $150,000).
Equity is the difference in the current value of a property and the total of all loans and liens. It is the amount that is left over for the owner of a property after all the debts are paid. In this last example with $107,500 in loans on the property, after it’s repaired, the owner will have $42,500 ($150,000- $107,500) in equity assuming no other liens exist.
As you evaluate the cost of loans, the two major components are points and interest. Points, or loan origination fees, are the percentage of the loan that the lender charges for making the loan available. They are paid in full at the inception of the loan, and are fully earned, so even if the loan is re-paid the next day, the loan origination fees are not rebated nor prorated. One point is equal to one percent of the loan value. A lender charging three points on a loan of $80,000 is charging a $2,400 fee ($80,000 * .03).
Interest is the amount that is charged on a periodic basis while the loan is outstanding. It is expressed as an annual interest rate. Interest on most loans is paid in arrears meaning that the interest is paid for the period of time since the last payment was due. Interest is not typically (but can be) paid in advance for the next period of time. Some loans are re-paid with interest only payments due monthly, and a balloon payment (the full balance of the loan – all principal and accrued interest – paid in one lump sum) due at maturity (the expiration date of the loan). Others are amortized (equal installment payments of principal and interest made over a specific period of time). Interest can be “simple” meaning that is calculated based on the outstanding principal only; or it can be “compound” so that interest is charged on not only the principal balance, but also on any outstanding interest due.
Let’s try some variations on interest and see how the payments are affected. The principal balance for the loan is $74,000. Interest is charged at 12%.
Simple interest only payments for 10 years, with a balloon payment at maturity:
Monthly payments of $740, with a balloon payment of $74,740 due in 10 years. The calculation is $74,000 * .12 = $8,880 which is total annual interest. Then $8,880 divided by 12 (months) equals the monthly payment. The balloon is equal to the principal balance, plus the one month of interest arrearage which would still be due.
Loan amortized over 10 years:
$74,000 amortized for 10 years at 12% has monthly payments of $1,061.68 principal and interest with no balloon payment due at maturity.
Loan amortized over 30 years with a balloon payment after 10 years:
In this example, the monthly payments are reduced by amortizing them over a longer period, but the loan still matures in 10 years. The monthly amortized payments are $761.17 with a balloon balance of approximately $69,000 due.
Interest compounds annually, with no payments due until balloon at maturity:
In this example, no payments are made for ten years, but the balloon payment is almost $230,000. Whereas in the last example, the total of the payments over the ten years was $91,340 plus the balloon payment of $69,000 for a total of $160,340. That’s almost a $70,000 difference (or $7,000 per year) due to compounding. Compounding is great as the lender, but horrible as the Borrower.
Some loans have a pre-payment penalty which states that if the loan is re-paid at any time prior to a specified date, then a penalty is added. The penalty can be a specific amount, or a certain number of months’ worth of interest. Sometimes the penalty is worded such that if the loan is paid anytime in the first ninety days, then a minimum of three months’ interest is due. Be sure to check for pre-payment penalties in your loan, and consider the impact they may have on your overall costs. For instance, if you plan to keep the loan in place for at least six months through a renovation, and the loan has the minimum three months interest requirement, you know that it will have no financial impact. On the other hand, if the penalty is for the first three years, and the plan is to re-sell or refinance the home in one year, then a significant penalty could be incurred.
Lenders will often speak of seasoning, mostly in reference to loan seasoning or title seasoning. This term refers to the amount of time that something has been in place. Loan seasoning would be the age of the loan. Title seasoning would be how long the property has been owned. Some lenders require that a loan be “seasoned” for six months to a year before refinancing. Other lenders require that the sellers’ title be seasoned for one year before they will finance the new buyer. When selling a property, it is important for you to determine if your buyer’s lender has a title seasoning requirement which you do not meet.
A full doc loan refers to a loan application with full documentation of the Borrowers’ financial and employment situation. A full doc loan is required for Fannie Mae approval. Although harder to find these days, a stated doc loan refers to an application where only the credit and property value is verified; the rest of the information provided by the Borrowers is accepted as fact. This carries a slightly higher interest rate and requires good credit.
The two documents that create the loan are the Promissory Note and the Deed to Secure Debt. The Promissory Note defines all of the terms of the loan and is signed by the Borrower. The Deed to Secure Debt (also known as a Security Deed or a Trust Deed or simple a Mortgage) is the actual mortgage instrument which is recorded at the county court house and announces to the world that the lender has a secured interest in the property. It does not disclose the terms of the loan, only the face amount – or initial amount – of the loan. The Deed to Secure Debt must only be signed by the title owner of the property to be properly recorded at the court house. The Promissory Note is signed by all parties who are guaranteeing the loan.
Mortgage position refers to the sequential order in which the Deeds to Secure Debt were filed at the court house. The first to be filed (not necessarily to first to be signed or created) is in first position. The second filed is in second position, and so on. Mortgage position is really only important when the loans are not performing (the Borrower is not paying) and the mortgage holder must foreclose. After a foreclosure, all subordinate (lower position) mortgages and most subordinate liens except property tax liens and IRS liens are wiped off the books. Therefore, a second position mortgage holder can lose their secured interest if the first mortgage holder forecloses. Incidentally, foreclosure also wipes out an Affidavit of Purchase and Sales Agreement that you may have filed on a property.
Most Hard Money Lenders I have found will only loan in 1st position. Some require that they are first and only which means they do not allow additional mortgages to be placed on the property. Any additional funds you require for the project need to either come from your pocket or some other loan that is not secured with this property.
If a lender is afraid of not having enough security in a property, they may ask for cross collateralization. They want to place a Deed to Secure Debt on another piece of property. The Deed would read that if the Borrower does not adhere to the terms of the original loan, the lender has the right to foreclose on this property as well. A cross default clause indicates that if the Borrower defaults on one loan, they have defaulted on any and all other specified loans held with the same Lender.
As added protection, some lenders require Reserves which are funds you must have in the bank to cover their payments for a specified amount of time. For instance, if the monthly payment is $1000, and they require 6 months reserves, they want you to have $6,000 in the bank in addition to any other capital requirements for the loan (down payment; closing costs, etc.)
One final nuance to be aware of with Hard Money Lenders is that they escrow for repairs, meaning that the repair funds are not released to you at closing. Instead you must complete work, and then request a draw from the escrow account. It is important for you to determine the lender’s escrow draw process in advance. It can be as flexible as request a draw each week for work performed; to only 3 draws allowed throughout the entire project; or even huge draw fees. I have seen lenders charge $500 per draw. Know the answers before you take out the loan.
I hope this helps you to better navigate the lending world and provides you with more confidence as you speak with different lenders.
Expect abundance,
Lou Castillo
