House flipping entrepreneurs who are considering using a hard money loan for the first time often ask, "Why do hard money lenders require a down payment?" Many real estate investors, especially those who are just getting started in the house flipping business, are looking for 100% financing of their projects, and they may not understand why a down payment is required.
When it comes to financing a house flip, real estate investors can either use their own cash on hand, turn to private investors, friends, or family members, or borrow the funds they need from a conventional bank or a hard money lender.
With cash from private investors, your project could be 100% funded. In this financing scenario, your investors could be friends or family members or members of a real estate investing network who invest the cash to cover the entire cost of the fix and flip project. Private investors typically expect to receive an agreed-upon return on their investment after you have made improvements to the property and sold it to a home buyer.
Why Do Hard Money Lenders Require a Down Payment?
With a conventional bank loan or a loan from a hard money lender, you will usually be asked to bring a down payment to the deal. In the lending industry, this is called having "skin in the game," which simply means the borrower loses money along with the lender if the project fails or is abandoned.
If a hard money lender finances 100% of the cost to purchase and improve your fix and flip project, the funds they've lent to you are not fully secured by the as-is property. A borrower who defaults on the hard money loan is leaving the lender to either sell the property at auction (usually for less than the loan amount), or improve the property and sell it, with the hopes the lender receives enough from the sale to offset the defaulted loan amount. To mitigate these risks, the lender usually requires the borrower to bring a down payment to the deal. Although the amount required varies, most hard money lenders will ask for a down payment of anywhere from 10% to 50% --depending on the circumstances.
It's important to note that hard money lenders do not make their money on property foreclosures and they are not in the business of flipping houses. Reputable lenders provide fast, reliable funding to real estate investors, and their business is successful when your business is successful.
Why Use a Loan to Flip a House?
You might be questioning whether it is a good idea to add loan interest, points, and fees to the cost column of your fix-and-flip project. Will borrowing money raise or lower your ROI? These are good questions to ask. Read Why Use a Loan to Flip a House, to discover some very good reasons fix-and-flip investors use borrowed capital to flip houses.
For more information on your lending options, and information on how to select a lender, check out our blog article The Borrower-Lender Relationship: How to Choose the Lender That’s Right for You.