When most people hear the term “hard money loans,” images of bankers resembling the likes of Gordon Gekko often come to mind. But oh how times have changed!
Hard money loans are now a key funding source for many real estate investors and for good reason.
What are hard money loans?
In general terms, a loan is when a person borrows money and has a contractual obligation to pay back the money with interest (the interest being the fee / how the lender makes money). Loans are generally predicated on a person’s creditworthiness, meaning the likelihood that he will be able to pay back the loan without hardship. Hard money loans are loans that are secured by a “hard” asset, generally a piece of real estate.
How are hard money loans different than traditional loans?
As stated above, traditional loans are generally made based on a person’s creditworthiness, so the borrower has to provide proof that the loan can be paid back. This proof is often in the form of income verification, asset verification, credit reports, etc. The lender makes money by charging various fees to apply for the loan, as well as through interest, which is the charge of borrowing money. The actual interest rate will depend on a number of factors such as economic conditions, benchmark rates, and the borrower’s calculated credit risk. Traditional loans can be taken out for any number of reasons, such as buying a house (mortgage), buying a car (car loan), paying for education (student loan), consolidating debt (personal finance loan), etc. and generally the lenders are institutions such as banks and credit unions. Additionally, traditional loans tend to be paid back over longer periods of time (up to 30 years) and monthly payments consist of principal plus interest.
Hard money loans are virtually the opposite of traditional loans. Hard money loans are not necessarily made based on a borrower’s creditworthiness, but they are based on the value of a particular asset, most often a piece of property. Hard money loans are not provided by institutions such as banks but instead are offered by individuals or small private companies. Hard money loans need to happen quickly, and the interest rates are often considerably higher than traditional loans. With the higher interest rates, the loan term is subsequently shorter term, like 12 months, though some hard money loans can be for as long as five years. Hard money loan payments are generally interest only initially, and then balloon towards the loan maturity (which is the loan end date).
In summary, the main differences between hard money loans and traditional loans are:
- Hard money loans are usually for real estate transactions only
- Hard money lenders are usually individuals or companies, and not banks
- Hard money loans are short-term and have higher interest rates
- Lack of repayment can result in loss of the hard asset
Why use hard money loans?
If hard money loans have higher interest rates and there is a chance borrowers could lose the property, then why does anyone use them? Because time is money! Seasoned real estate investors may come across a deal and must have access to cash as fast as possible so that they don’t lose it.
Here are some other reasons why hard money loans are used:
- Fast. Hard money lenders don’t have the same restrictions or considerations as most banks or credit unions, so the application process is much faster than a traditional loan application. A hard money lender really wants to verify the asset value and a borrower’s historical business performance. And if borrowers have an existing relationship with a hard money lender, then it makes the hard money loan process even faster. On average, it can take a week to apply for hard money loans, versus the 30 to 60 days it takes to complete the traditional loan application process.
- Collateral. Most hard money lenders don’t look at a borrower’s individual income. Instead, they want to know that there is a desirable hard asset as collateral, whether that hard asset is an investment property or the borrower’s personal residence. The hard money lender will assess the loan-to-value (LTV) ratio which is the ratio of the loan to the value of the asset. The lender will want a low ratio which means that the value of the property is worth much more than the loan value.
- Flexibility. Similar to speed, because hard money lenders don’t have the same underwriting requirements as do the banks, they can be flexible in the process. This flexibility may also be in the interest rate or other terms. Flexibility is very desirable for investors and is another reason why hard money loans are used.
- Timing. Sometimes life circumstances are such that a traditional lender will not consider a borrower’s application. Past credit issues, a brand new job, even foreclosures might mean a traditional lender rejects the borrower’s application. Or perhaps a borrower is buying a new house before the settlement or even the sale of the current primary residence. Hard money loans can be used to help borrowers in this timing gap, whether borrowers need a year or two to rebuild credit or show consistent employment history, or they need a month (or even a day) before their first home is sold.
Hard money loan deals
Now you know why it might be preferable to use a hard money loan, so let’s look at when you would use hard money loans. Hard money loans are not appropriate for every real estate transaction, but there are many real estate deals when hard money loans do make sense.
- House flipping. Hard money loans may make sense if the plan is to renovate and sell the property quickly.
- Timing issues. If a borrower is under an agreement to sell a property and will be buying a new property before the settlement of the first property, hard money loans will help bridge that gap in timing.
- Land loans. It is difficult to obtain a traditional loan when buying a piece of land for future development. Hard money loans are a good option until a physical building is completed and then sold.
- Construction loans. Similar to land loans, hard money loans can be used to finance a construction deal.
- Renovation projects. Rental property investors can use hard money loans to either purchase or renovate a buy-and-hold project that they will eventually refinance once renovated and rented.
Are there cons to hard money loans?
So you are excited about a hot real estate deal you just saw, and now that you know about hard money loans, you’re ready to sign on the dotted line. But not so fast! While hard money loans work for many real estate investors in many situations, there are some drawbacks.
- Because hard money lenders use an LTV ratio, they may use less traditional methods of determining the property value which results in a lower assessment of the property’s value.
- Hard money loans are more expensive than traditional loans. They have considerably higher interest rates and hard money lenders charge origination fees that can be much higher than what banks do.
- Owner-occupied properties generally don’t qualify for hard money loans.
- Timing and cash flow are key not only when applying for the loan, but also for ensuring the loan can be repaid. If the project is running behind schedule or over-budget, the borrower may risk not being able to repay the loan. The hard money loan may also not be enough to cover budget overruns.
- Hard money loans require a builder’s risk insurance, which is considerably more expensive than property and casualty insurance required for traditional loans.
Finding a hard money lender
Interested in applying for hard money loans but don’t know where to go? Hard money lenders are not federally regulated like banks or credit unions but instead are regulated state by state. State regulation is done either by the Bureau of Real Estate or Department of Financial Services, depending on the specific state.
Because regulation is not on a federal level, it is imperative to work only with reputable hard money lenders. Find reputable hard money lenders by getting recommendations from trusted partners such as real estate agents. Referrals can also be obtained from real estate investor groups and other real estate networking groups.
When looking for a lender who will work with you based on collateral, it is always recommended to speak to multiple lenders. Discuss your current and future needs for hard money loans, and hopefully, you will find a lender with whom you can develop a longterm relationship.
Other considerations for hard money loans
On the surface, hard money loans seem to be a simpler option than traditional loans. Even if the application process is simplified, there are some other considerations to take into account with hard money loans.
- Borrowing costs for hard money loans will vary depending on the lender and even the region. Lender competition and demand affect the lender’s fees, while the risk of the loan will affect the interest rate charged.
- Even though hard money lenders don’t have the same considerations and requirements as traditional lenders, they still have requirements for the borrower. As previously discussed, hard money loans are based in large part on the value of the property. Additionally, a hard money lender will want to see if the borrower has the capital to pay the interest on the hard money loan as hard money loans are generally “rehab” loans. The borrower will also have to provide a clear and acceptable plan for the property so the lender feels comfortable that the deal makes sense, and assumptions and budgets are reasonable. And some hard money lenders may require a certain amount of rehab or real estate experience and/or a proven track record of successful real estate transactions.
- Because hard money loans are expensive, it might be worthwhile to see if you qualify for other types of financing such as FHA loans. While FHA loans are administered by the government which can be off-putting, borrowers with credit issues can still qualify. And FHA loans offer some other advantages such as low down payments and closing costs.
- Hard money loans are not paid in one lump sum but are usually paid in installments known as “draws”. There may be an initial disbursement to cover acquisition costs, but subsequent draws are released based on milestones or a predetermined schedule.
- As previously explained, hard money loans are backed by the property value and so most hard money lenders don’t require perfect credit or even personal financial information to qualify for a loan. That being said, the hard money lender will require that the borrower have some interest in the deal, and will ask that you put up to 10% of your own money.
For any real estate investor, there are multiple financing options. Hard money loans are one, often attractive option that experienced investors like to consider.