If you have a hard money loan on your investment property, you are most likely paying a higher interest rate than you planned for in the long term. You might also be facing a looming payoff date with a large balloon payment. One way out of this situation is to sell your property. But what if you want to hold onto it for a longer period of time? You can do this by refinancing your hard money loan into a conventional loan.
Hard money loans can help you move quickly when you are purchasing a property. However, conventional loans are usually better for your long-term investment property ownership plans. Let’s dive into what these types of loans entail and how to switch from one to the other.
What Are Hard Money Loans?
A hard money loan, also known as a private money loan, is issued by private investors as opposed to traditional lending institutions like banks and mortgage companies. Since private lenders don’t have government oversight, they don’t have the same legal restrictions working against them. This allows them to be more creative with the loan terms they offer. Hard money loans offer a few advantages over conventional loans, but there are some drawbacks as well.
Hard money loans usually require less upfront money compared to traditional loans. This includes smaller down payments and lower closing costs. This allows income property real estate investors to enjoy higher returns on their investment.
Hard money loans don’t require extensive loan approval processes like the underwriting that accompany conventional loans. While conventional loans can take 30 days or more to approve, hard money loans can be done in a matter of days.
The requirements for the borrower are much more lenient for hard money loans compared to conventional loans. Credit score, debt to income ratio, savings, and income requirements are all at the discretion of the private money lender. This can increase the likelihood of approval and also speed up the process.
The terms for a hard money loan usually differ greatly from conventional loans. In most cases, the loan term is on the short end (6 to 12 months). In addition, the mortgage interest rate is usually higher. The speed, lack of borrower requirements, and lack of regulatory oversight allow hard money lenders to charge a higher interest rate than conventional lenders.
What Are Conventional Loans?
Conventional loans are mortgages that meet the requirements of government-sponsored organizations called Freddie Mac and Fannie Mae. These companies purchase mortgages from lending companies and then sell them to mortgage investors. Conventional loans are sometimes called conforming loans because they conform to the standards set by Fannie Mae and Freddie Mac.
Conventional loans can vary, but there are a number of minimum requirements they must adhere to. These include minimum down payment amounts, the need for private mortgage insurance in some cases, credit score requirements, and debt-to-income ratio (DTI) requirements.
Down Payment Requirements for Conventional Loans
Some borrowers can get a conventional loan and only put down 3 percent of the sales price as a down payment. This is usually only for first-time home buyers who purchase a single-family residence. The interest rate is higher for other types of borrowers.
If you are not purchasing your first home and your income is more than 80 percent of the median income where you live, you will be required to put 5 percent of the sales price as a down payment. This is the same amount required if you are purchasing a second home, like a vacation house.
If you are buying a multi-family investment property the down payment requirement will usually be higher than loans used to purchase a single-family home. You may have to put down 15 percent.
Credit Score Requirements for Conventional Loans
Usually, but not always, a credit score of 620 or higher is required for conventional loan approval. A credit check performed by your lender will occur at the beginning of your loan application process. If your score is too low and your loan isn’t approved, you may need to consider a hard money loan where credit score requirements are flexible.
Private Mortgage Insurance (PMI) for Conventional Loans
For conventional loans that have a down payment amount that is under 20 percent of the purchase price, private mortgage insurance (PMI) will be required. This insurance protects the people investing in your mortgage in case you default. The amount varies based on loan type and your borrower’s creditworthiness. PMI is usually rolled into your monthly mortgage payment.
Debt-to-Income Ratio Requirements for Conventional Loans
Your debt-to-income ratio is a measurement of how much debt you have compared to how much income you have coming in each month. Add up all of your monthly minimum loan payments (credit cards, car loans, etc.) and divide that by your gross monthly income and you have your DTI. Most conventional loans require a DTI under 50 percent.
Why Switch From a Hard Money Loan to a Conventional Loan?
Hard money loans provide funds to purchase properties for borrowers that might not otherwise be approved for a loan. They allow you to close on a loan on a property quickly without the requirements and red tape of a conventional loan.
However, hard money loans are rarely a long-term solution. Their term length is usually only 6 to 12 months, so when that timeline is nearing its end you are going to need to pay off the loan or explore other options.
Hard money loans also tend to have higher interest rates than conventional loans, so switching can help you save money each month.
For the first few months (or even a year) of owning an investment property, a hard money loan can work, but eventually, you will need to sell the property or pay off the loan. If you want to keep the property and continue enjoying rental income, but don’t have the funds to buy it outright, switching to a conventional loan is usually your best option.
How to Switch from a Hard Money Loan to a Conventional Loan
Refinancing a hard money loan with a conventional mortgage loan starts with going through the same process you would to secure a conventional loan to buy a home.
The first step is meeting with various lenders to discuss getting pre-approved for a loan. They will take some information reported by you regarding your income, debts, credit score, savings, assets, and more. This is not a loan approval, but it is a chance for the lender to estimate whether or not they think you will be able to get final approval for a refinance loan. Be sure to meet with multiple lenders so you can choose one that will approve you and give you the most favorable refinance terms.
If you decide to proceed with a lender, they will begin to verify the information you provided during the pre-approval process. Pay stubs, bank statements, retirement account statements, credit card statements, and rental property income statements are just a few of the documents you will need to provide. They will also do a hard pull on your credit to verify your credit worthiness.
They will also look closely at your payments on the hard money loan you used to purchase the property. If you have late or missed payments on that loan, they are likely going to deny your refinance to a conventional loan.
Since conventional loan requirements for purchasing a property are similar to conventional loan refinance requirements, it can be hard to qualify if you used a hard money loan to buy a property initially because you didn’t qualify for a conventional loan. Unless your credit score and other factors have changed substantially since you bought the property, you are likely to be denied again. In this situation, consider having a co-signer on the loan with you who has a better credit profile.
If you meet the aforementioned financial requirements, there is still another hurdle to clear: the property requirements. To switch your hard money loan to a conventional loan, the property must be ready to rent.
If your rental property is under construction or undergoing renovations, it won’t qualify for a conventional loan. This is also true of land purchased for a “to be built” property. The property must be completed and ready for tenants to move in.
In addition, lenders will often want to see that it has been rented for a considerable amount of time and generates a healthy amount of rental income each month. Lenders don’t want to invest in unknown properties and prefer to lend money on properties that have a history of adequate monthly rental income. The bottom line is that it’s a safer investment for them.
What To Do if You Get Denied For a Conventional Loan
If you can’t secure a conventional loan to replace your hard money loan, you aren’t out of options. One option is to sell the property quickly to cover the balance of your hard money loan.
If you don’t want to lose the property, you can also work with your hard money lender (or a new one) to extend the term. Lastly, you can consider a second mortgage on a different property to help pay off your hard money loan.
Pros and Cons for Refinancing a Hard Money Loan to a Conventional Loan
- Lower interest rates if you have good credit
- Longer loan terms
- The ability to keep your property if you can’t afford to pay off your hard money loan
- Stricter eligibility requirements
- Higher interest rates if you have bad credit
- Lengthy process with a lot of paperwork
Taking out a hard money loan to purchase property has benefits and drawbacks. It is easier to qualify for than conventional loans can be closed faster, and requires a lot less paperwork. However, the interest rates are usually higher than conventional loans and the term is short.
Switching to a conventional loan often allows you to reduce your interest rate and get a loan for a longer period of time. This can be the difference between keeping your investment property and losing it. Crunch the numbers, do your research, and decide if refinancing a hard money loan to a conventional loan is right for you.