Hard money lenders are often taking on a bigger risk in a real estate investment than a traditional lender. Since hard money loans are based on after repair value (ARV), the lender is providing capital above and beyond the current value of a property. Unlike conventional lenders, where the borrowed amount is up to the current value of the property, private lenders are trusting the borrower to have the skills necessary to make repairs to the investment property and turn it into a profit. It’s a big reason why hard money loans have higher interest rates and shorter repayment terms than a traditional mortgage. Since the risk is greater, a hard money loan will have different requirements for the types of insurance a borrower must get on the investment property.
Depending on the hard money lender, your experience, loan amount, and the property itself, the types of insurance you may be required to purchase may vary. One thing that won’t, though, is your need for hazard insurance. Simply put, hazard insurance is a basic type of homeowners insurance that insures the property itself against damage or total loss. Hazard insurance does not cover other things such as personal property or liability coverage like in a normal homeowners policy required for a mortgage loan. Please note, that a normal homeowners policy does require hazard insurance and is likely sufficient for a hard money loan. Hazard insurance and title insurance are both paramount when it comes to any property loan program.
Actual Cash Value (ACV) vs. Replacement Value (RV)
When it comes to obtaining private loans, there are a variety of terms related to the value that you should be familiar with. After repair value (ARV) is simply the estimated value of a property after it has been repaired, renovated, or improved. ARV is what your loan amount will be determined by in a hard money loan situation (also credit score and money down). Actual cash value is the replacement cost minus depreciation, and replacement value is the cost to replace the property new. Let’s go deeper into what these values mean and how it affects your insurance costs.
If you own a car, you probably have some cash value insurance. This type of insurance pays out the value of your vehicle on today’s market, not its original price new. Likewise, if your homeowner’s policy is based on actual cash value, in the event of a catastrophe, the policy would only pay out a fraction of your initial investment. This is why ACV insurance policies are cheaper than RC policies. The amount the insurance company must pay out is much less therefore so are the premiums. However, this is also why a private lender may not accept an ACV policy since their investment amount of private money is based on ARV which is higher than even the current replacement cost.
Replacement value insurance policies pay out actual replacement value for like kind and quality. Therefore, if your property were to be destroyed by a storm, insurance would pay for it to be rebuilt as it was at the time of policy purchase. In this case, the insurer and the policy owner agree on a property value before the policy goes into place. It is important to revisit your policy annually in case your property goes up in value so you can adjust your policy accordingly. Replacement cost policies are more expensive than ACV policies since they pay out more, but they provide substantially more protection. Therefore, a private lender may require this type of policy to provide the most protection as an investor since private money lending comes with a lot of risks.
Importance of After Repair Value (ARV) for a Private Money Loan
After repair value in hard money financing is the estimated value of a property after repairs are made, and is not a fixed value. It is an opinion-based valuation based on market comparisons and as well as property similarities such as location, size, features, style, condition, and age. ARV is used by a hard money lender to mitigate risk and maximize profitability. In short, it is one of the major determining factors by which a private money lender will determine if your investment provides value, how much they will be willing to lend, and possibly your interest rate. Each loan term can be important to your bottom line. It is important to keep the concept of ARV in mind when thinking about why a private money lender might require certain types of insurance. The property they are investing in through you is their only collateral to mitigate their risk. If it is not properly insured and something happens to it, then they would be the party with the most to lose. Give One West Hard Money Lenders a call today to start the process on your next real estate investment!