Being prepared is key
The following article has been supplied by RCN Capital.
One constant theme that all successful investors have in common is having multiple options for how their loans get funded. Not every deal is going to be a perfect fit for one lender, bank, or investment group every time.
An investor that has numerous options to get their loan funded has the ability to shop around and find the best fit for that specific project. One of those options that every investor should know about and use regularly is a private lender.
In order to get the best out of the private lender or lenders that an investor chooses to work with, being prepared and knowing what to expect is a huge key to continuity and efficiency. When it comes to investment loans with a private lender there are a few terms and best practices to familiarize oneself with to hit the ground running as it pertains to getting files started and loans closing.
Terminology to know
DSCR
The mortgage industry loves acronyms and private lenders that deal with investment property financing are no different. DSCR, a short-hand way to refer to debt service coverage ratio, is one for investors to be aware of and understand. As an equation it can be simplified to net operating income divided by debt service.
When working with lenders, the equation is typically monthly loan payment vs. monthly rent charged for the property on a 30-year long-term rental loan. Lenders will sometimes require a minimum DSCR in order to proceed with the loan so this is important to know when you are gauging what you will charge for rent as an investor. Look for properties that will ensure a comfortable margin to avoid any DSCR disqualifications from the lender.
Prepayment penalties
A prepayment penalty period (PPP) is another term that is used regularly when working with a private lender. The PPP is typically applied to long-term loans, but some lenders have short-term loan prepayment penalties as well. Never hesitate to ask your contact at a lender about the PPP and what options you may have as a borrower.
There should be options to set the prepayment penalty period anywhere from 1-5 years and the penalty is usually a small percentage of the unpaid loan balance. Based on preference and plans for the property, investors should set the prepayment penalty period where they see fit and try their best to avoid having to pay the fee. Knowing what loans the PPP is applied to and how to get them changed to specific preferences are all important considerations when sending your deals to a private lender.
Loan-to-Value
Usually referred to as LTV, Loan-to-Value is an important term to know when sending loans to a private lender. It refers to the ratio between the loan amount and the appraised value or purchase price of a property. LTV is expressed as a percentage and is an important factor for lenders when determining the risk associated with a loan.
LTV is also the contrast of the down payment the investor will have to bring to a lender in order for the loan to close. For instance, if loan terms were 80% LTV, then the investor would need a 20% down payment to secure the property. Lenders do this to ensure that the borrower has equity or stake in the property and it lessens the risk for them. This combination allows peace of mind for the lender and they will work with investors on a much more frequent basis. Typically, with more experience, an investor can get a much better LTV so there is an incentive to keep investing to earn better deals.
Loan-to-Cost
Loan-to-cost (LTC) is another important financial term in real estate investing. It is similar to loan-to-value but focuses on the ratio between the loan amount and the total cost of a property, including both the purchase price and any associated renovation or construction costs.
LTC is used by lenders to assess the level of financing they are providing in relation to the total cost of the project. It helps them evaluate the risk associated with the loan and the borrower's ability to complete the project successfully.
For instance, if you are considering purchasing a property for $200,000 and plan to spend an additional $50,000 on renovations, resulting in a total cost of $250,000, and you need a loan of $200,000, the loan-to-cost ratio would be 80% ($200,000 divided by $250,000).
As a new real estate investor, understanding loan-to-cost is crucial when planning your financing strategy. It allows you to determine the amount of funding you need to cover both the property acquisition and any additional costs. Lenders typically have maximum LTC ratios they are willing to lend on, so it's important to be aware of these limits and ensure your project falls within them. Some lenders choose between LTV or LTC depending on the loan program so it’s important to understand these nuances to be better prepared when working with a lender.
Investment loan preparation
Business entity
Most private lenders will only lend to business entities when dealing with investment property financing. This allows for a level of separation that alleviates investors from any personal liability. The most common entity for investors to use is an LLC. There are also trusts, C-corps, S-corps, etc., but LLCs are the most utilized business entity in the industry.
Usually, if an investor doesn’t have one set up by the time they bring a deal to a private lender, the lender will give them a grace period to get that situated before the loan closes. Being aware of the fact that this business entity is important because it can save time on the initial loan closing but there are also numerous benefits that investors can take advantage of.
The benefits include tax advantages, building business credit and the aforementioned personal protection of assets. All of these benefits allow for investors to expand at a more rapid pace and earn better deals from lenders due to experience, more cash reserves due to tax breaks and better credit.
Document collection
When it comes to working with a private lender, or any lender for that matter, there are always guidelines in place for the investor to adhere to. These guidelines are set up to ensure the lender is financing the best deals that make sense for all parties involved. This means that the private money backing lenders must be comfortable with the loans that these lenders are closing with real estate investors.
RE investors can operate much more efficiently if they know the documents that lenders are expecting to collect ahead of time. One of the benefits of working with a private lender is less documentation than conventional lenders, but it’s still important for investors to do their homework and know what to submit. Most of the common documents such as entity docs, credit checks, and loan applications are standard, but each private lender may have subtle differences in what they need in order to get a loan from processing to closing so investors can always reach out to their point of contact at a lender and get ahead of the curve by finding out what the complete document list really is.
Private lender guidelines
Last but certainly not least are the guidelines of the specific private lender that an investor chooses to work with. When an investor sends a deal to a lender, they should always be aware of what that lender actually does. If an investor sends a deal to a lender that is in a state they don’t lend in or is at a dollar amount that doesn’t coincide with the lender’s guidelines then time can start to be wasted and that adds up.
Being proactive when possible as an investor is always the best practice. Efficiency is one of the biggest ways to make and save money in this industry, so being aware of what a private lender can actually close on is very important. This is another instance where establishing that relationship with a loan officer at a private lender can lead to long-term benefits. Guidelines are the most important aspect to comprehend when working with a lender so having someone from the company on the side of an investor is a big asset.
Final thoughts
It can seem overwhelming when an investor decides to add another lender to their contact book, but it is an essential part of expanding as an investor and closing more loans. These terms and practices are a great place to start when it comes to being prepared and starting off on the right foot with a private lender. There are always going to be employees at a lender who want to help educate lenders and improve their business and bottom line. Taking the time to study and be prepared to work with a private lender will never go unnoticed and investors should never hesitate to reach out!
