Investors who want to purchase and rehabilitate distressed properties often make use of a hard money loan because they are short-term and interest-only.
Although these loans command higher interest rates of up to 12% p.a., investors grab them because the funds become available in as early as 15 days. This helps investors compete with cash buyers for their desired properties. These loans carry a term anywhere from 1 to 3 years.
What is a Hard Money Loan?
A hard money loan is a short-term loan that a private lender or a group of lenders give out to individuals or businesses with specific conditions. Usually, they are “asset-based” loans, meaning the borrower will receive the funds but uses the real estate property in which they are investing as its security.
Some players in the financial world call these loans as ‘private money loans’ because funding comes from private investors and not from traditional banks or financial institutions.
Private lenders determine the loan amount primarily according to the value of the property, as against traditional lenders who look at the borrower’s credit score and financial history. They put more emphasis on the loan-to-value ratio (LTV). You get this ratio by dividing the loan amount by the value of the collateral property.
Even though it is generally easier and quicker to get a hard money loan than conventional loans, borrowers still need to go through the underwriting process and comply with specific requirements.
Hard Money Loan – Example
Let’s say Kevin needs money to pay his monthly bills but his next paycheck won’t come until two weeks. And because Kevin does not have a sterling credit history, several traditional lenders have already turned him down.
Even if Kevin does not have a strong cash flow, he has a clean $150,000 equity in his home. So, Kevin approaches a lender who agrees to give him a hard money loan of up to $75,000 but in return, Kevin pledges his home as collateral for his loan.
Why Hard Money Loan?
Here are a few situations when you can use a hard money loan instead of traditional financing:
- You’re in the middle of a property investment deal but you don’t have the time to comply with a bank’s paper-based and tedious application process;
- Your credit score is not high enough and/or your income history does pass the requirements of the bank and other traditional lenders. If you’ve just started a new job, you might not have a sufficient income history and the bank may deny your loan request even if you’re making good money. Hard money lenders often look beyond these factors. What is important for them is that you can repay the loan and you have built up enough equity in the property.
- You don’t have enough cash on hand and you can’t borrow from family or friends.
- You want to fix and flip properties and need quick but reliable financing. Hard money lenders are not as conservative as traditional lenders so, they will be more willing to work with you to arrive at the best-fitted loan program for your project. Often, they will offer more benefits as you develop your business relationship with them through more projects.
Here's a summary of the main pros & cons (click to see explanation or scroll down):
|Quick Approval Process||Borrowers Pay Higher Interest Rates|
|Low Requirements||Down Payments|
|Flexibility||Default / Foreclosure Risk|
|Fix and Flip Properties||Short Term Loan|
Hard Money Loan – Advantages
People mistakenly perceive hard money loans as financing for investors with bad credit history. This is not an all-encompassing truth but a hard money loan can benefit any borrower – excellent or poor credit alike. Here are the other benefits of using a hard money loan:
Quick Approval Process
Probably the best advantage of using a hard money loan is the timing – it has a fast approval process and funding the loan doesn’t take very long. In some cases, lenders grant their approval for the loan application in just one day. This is because lenders use simple evaluation criteria to make their decision.
They consider the property, the borrower’s experience in the business, the amount of down payment or borrower’s equity, and the exit strategy for the property.
Of course, they will also determine if the borrower would be able to raise the money to meet the monthly payments. As long as all these things seem reasonable, most lenders would likely grant a loan.
As we’ve said before, hard money lenders often ask for just a few requirements unlike banks and other traditional lenders. Mostly, they just want to see if the borrower has sufficient equity in the property, enough cash on hand to meet the monthly payments, a practical exit strategy, and, in some instances, adequate business experience.
Banks follow a borrower qualification system that flags certain issues and automatically stops them from further processing an application. These are recent foreclosures, short sales, loan modifications, and bankruptcies.
Another restriction for them is lending to a borrower with a bad credit history. Most banks will avoid giving another loan to an applicant who already has 4 mortgages regardless of the borrower having perfect credit and no negative issues.
Take note of this: hard money lenders are unconventional, so they generally don’t use a standard underwriting process.
Borrowers will notice that hard money agreements tend to be more flexible than the widely-used loan agreements by banks. Instead of following standard underwriting processes, hard money lenders evaluate each deal on a case-to-case basis.
So, depending on the borrower’s situation (and negotiation skills), he may be able to bend some components of the loan terms like repayment schedules. In a lot of cases, hard money lenders will be willing to sit down and discuss with the applicant – something that you won’t experience with large corporate lenders who impose their strict policies to the letter.
Fix and Flip Properties
Most typical fix and flip properties are vacant or those with an outdated structure. These are the factors that drive their prices down and make them appealing to fix and flip investors. They may be riskier but hard money lenders know that these distressed and forsaken properties normally offer bigger margins. This is why lenders are willing to fund them because they look at the numbers and can see the potential for profit.
With banks, it’s a totally different ballgame altogether. They consider the risk as a huge factor so they won’t lend on a property that does not fit their lending criteria.
An example would be a property that they classify as ‘uninhabitable’ – these are not acceptable at all. More like comparing apples to oranges, hard money lenders concentrate specifically to investors who offer these types of properties. Banks turn their backs on them.
Hard Money Loan – Disadvantages
Now that you saw the most obvious hard money lending advantages, let’s look at its handicaps. Hard money loans have their own set of rules on the use of the funds and schedule of fees. If you’re considering a hard money loan to finance your project, you should take these disadvantages in your equation.
Borrowers Pay Higher Interest Rates
At the top of the list is that hard money loans command higher interest rates. The rates will always be higher than a prime interest rate from a conventional lender like a bank or credit union. Hard money interest rates for a 1st are around 8% to 11% per year. Interest rates for 2nds normally fall in the area of 10% to 12% per annum.
The interest rates of hard money loans reflect the risks that the lender perceives with the loan. The higher the rates, the higher the risks the lender is taking. Remember that hard money lenders do not ask for full documentation of the borrower’s income and credit history. This factor alone increases the risks that they take when they lend money.
We are talking about at least 25% to 30% down payment from the borrower. Or, if the borrower already owns the property and is asking for a refinance, he should have a 25% to 30% equity in the property.
Banks require a lower down payment of an average 20% and some programs such as FHA will accept a much smaller down payment.
Default / Foreclosure Risk
There is always a risk of foreclosure whether it’s a bank or a private lender who’s lending the money. If the borrower fails to pay the monthly interest or fails to maintain or repair the property or fails to pay the loan, he could face foreclosure. But lenders know that taking a property during mid-rehab is very costly, so most would agree to sit down and craft a game plan to finish the project according to the original scheme.
If you see that your project isn’t unfolding as it’s supposed to and you’re fearing default and foreclosure, communicate your issues at once with the lender. If you stop talking with your lender, you increase the likelihood of losing your property.
Short Term Loan
Another drawback of hard money loans is that they are short-term loans. Most lenders will only give the borrower 1 to 3 years before asking for full payment. Giving a longer term means more risks for the lender because it is hard to project what the interest rates will be at the end of the term.
So, the longer the term, the greater the uncertainty of how the rates will turn out. Should the rates go down, the borrower can refinance the loan to avail of the lower current interest rates. On the other hand, if the interest rates increase, the borrower can simply keep the original loan which leaves the lender waiting for the loan to become due.
An average hard money loan is just 12 months. Within this period, the borrower must complete their flip, sell the property, and pay back the lender. However, unforeseen events can delay the project and force the borrower to request for a loan extension.
Although most hard money lenders are flexible when it comes to granting extensions, there is a catch. The borrower should know there are consequences that come with a loan extension. Some of these consequences could be a higher monthly interest and payment of an extension fee.
Hard money is a quicker option of getting a real estate loan aside from going through institutional lenders. Funds for hard money loans come from private individuals or investors who have contracted hard money loan companies to manage their investment portfolios.
When banks have declined a loan application, or when time is of the essence, a hard money loan is a most suitable alternative.
It’s important though, to look at the pros and cons of hard money lending and if getting one would be the optimum choice according to your situation.
Protect yourself from all the risks we’ve mentioned by fully understanding your lender’s terms and charges. Prepare a strong exit strategy and make sure you can make on-time payments so you can build a stable relationship with a lender.
Lastly, if you prove to your lender that you’re a safe investment by completing your project successfully, it is not a far-fetched scenario that your lender will give you lowered rates and lowered origination charges.