What Is a Hard Money Loan?
A hard money loan is a type of loan that is secured by real property. Hard money loans are considered loans of “last resort” or short-term bridge loans. These loans are primarily used in real estate transactions, with the lender generally being individuals or companies and not banks.
Borrowers may turn to hard money loans after a loan or mortgage application is denied, or to avoid the lengthy process of getting approved for a loan through traditional means.
Like a traditional mortgage, a hard money loan is a secured loan, guaranteed by the property it is being used to purchase. The “hard” part of “hard money” refers to the tangible asset being used to back the value of the loan. When a person defaults on a secured loan, the lender can take over ownership of the asset to recoup its losses.
Unlike traditional mortgages or other types of secured loans, hard money loans come with a fast and typically less stringent approval process, making them ideal if you need to make the purchase happen fairly quickly.
With a mortgage, it often takes more than a month, from application to close, to purchase a property. With hard money loans, it’s possible to close in just a few days.
How a Hard Money Loan Works
With hard money loans, the lender approves a borrower based on the value of the property being purchased. It is a way for you to borrow money for real estate without using traditional mortgage lenders.
The lender may do a quick check of your credit or finances, but in general, the process will be much less rigorous than it is with a traditional loan. This allows the process to happen more quickly, so borrowers can get their money in a matter of days as opposed to weeks or even months.
Traditional mortgage loans require proof that you can comfortably repay the debt. Lenders often review your credit scores and any income available to evaluate your creditworthiness. If you have plenty of income, savings, or can get another collateralized loan you might not need to worry.
However, the process becomes more challenging if you have a low credit score, an income source that is difficult to verify to your lender’s satisfaction, or a high debt-to-income ratio.
The downside of this process is that the lender takes on significantly more risk, which translates to a more expensive loan for the borrower. Hard money loans typically come with high-interest rates, and lenders might require larger-than-average down payments (though this isn’t always the case).
Hard money loans also tend to have short repayment periods, lasting from one to three years. Compare this to traditional mortgages, which commonly come with 15- or 30-year terms.
If anything goes wrong and you can’t repay the loan, hard money lenders expect to get their money back by taking the collateral and selling it.
How are hard money loans different from bank loans?
A bank loan is based on the credit score of the borrower and the income of the borrower. A hard money loan is a lot faster, from the time you apply until the time you’re funded. A hard money loan has fewer requirements than a bank loan because it is based on the “asset” versus your income or your credit.
The main difference between a hard money loan and a typical bank loan is the lender itself. Hard money loans are almost always given by a private lender, whether that’s an individual or a private lending company.
Since these loans are used for non-owner-occupied real estate, they aren’t regulated like consumer mortgages. This means hard money lenders can charge higher interest rates and fees and get away with terms that wouldn’t be allowed with traditional loans.
Even though the Truth in Lending Act (TILA) and the Real Estate Settlement Procedures Act (RESPA) don’t typically apply to commercial mortgages, there are still regulations that traditional financial institutions have to follow.
Federally insured banks are still regulated by the Federal Deposit Insurance Corporation (FDIC) and credit unions by the National Credit Union Administration (NCUA). Hard money lenders don’t have any regulations placed on them.
What Are Hard Money Loans Used For?
Here are some common reasons individuals seek out hard money loans.
Flipping A House
Real estate investors who make money by purchasing low-cost properties in need of fixing up, making value-boosting repairs and renovations, and then flipping the homes for profit may utilize hard money loans.
Because these projects typically happen fairly quickly, professional flippers often prefer faster forms of financing. Additionally, because house flippers generally try to sell the home within a short period of time typically less than a year they don’t need a lengthy loan term as you’d get with a traditional mortgage.
Purchasing Investment Property
Individuals who want to invest in rental property but don’t qualify for traditional financing might seek out a hard money loan to pay for their investment.
This method can be useful for those who either can’t get approved for a traditional loan due to their credit history or those who need more money than what a traditional lender will let them borrow.
Purchasing Commercial Property
Similarly, a business owner might use a hard money loan to fund the purchase of commercial real estate if they’re unable to secure traditional financing. Hard money loans can be useful for entrepreneurs purchasing a unique property that doesn’t qualify for conventional financing or those who find traditional commercial loan limits to be insufficient for their needs.
Hard Money Loan Rates
As we’ve said, hard money loans are expensive. Just how expensive are they? Let’s compare interest rates on these loans to more traditional loan types.
In September 2021, the average rate on a conventional 30-year fixed-rate mortgage was 3.01%, according to Freddie Mac. By contrast, hard money loans can have interest rates that are much higher, often 8 – 15%.
Hard money loans can also be more expensive depending on the preferred loan-to-value (LTV) ratio of the lender. If a lender will only finance 70 – 80% (or less) of the property’s value, you’ll likely have to bring a sizeable down payment to the closing table. If you don’t have the cash available to do this, you might have a hard time finding a hard money lender who will work with you.
How to Get Better Interest Rates on Hard Money Loans?
Even though interest rates or monthly payments for hard money loans are typically higher than conventional rates, one may be able to lower the interest rate by doing the following:
Increase Your Down Payment: A down payment helps a lender mitigate the risks associated with giving out loans to individuals when the lender funds the transaction at a lower Loan to Value Ratio (LTV). Increasing the down payment proves the borrower is committed to the project in question and that they will be less likely to default.
Improve Your Personal Credit: A healthy credit score is the measure of financial literacy. Months before applying, improve your credit so that the lender can be confident there will not be a default.
Complete and pay off multiple loans with a hard money lender: The better track record one has when dealing with the lender, the more open-minded they will be to adjusting the interest rate or origination charged since theoretically there should be less risk.
Pros of Hard Money Loans
As we’ve discussed, some of the pros of using a hard money loan include:
- They can be closed quicker than traditional loans due to collateral.
- They are flexible and do not use an underwriting process.
- Financial position is not the primary concern.
- Payment is not emphasized because the borrower provides collateral.
- The lender may benefit from default if the collateral is substantial.
Cons of Hard Money Loans
Some of the drawbacks of hard money loans include:
- They come with a lower loan-to-value ratio because of real property protection.
- They charge higher interest rates.
- The lender faces considerable risk.
- The lender may not provide financing for owner-occupied residence because of property rules and regulations.
- Often require large down payments.
- Shorter terms give you less time to repay.
- Riskier than traditional financing.
- May need to have proven track record of successful house flips.
How to Get a Hard Money Loan
To find a hard money loan, you’ll need to contact institutions specializing in this type of transaction. Quick internet searches for hard money lenders can generally reveal several lenders in your area.
Local real estate agents and real estate investor groups are a good sources for names. Reach out to several lenders, discuss your needs, and develop a relationship so that you can fund projects quickly and easily when you need to.
It helps to shop around since hard money loans are less regulated. You might be able to find lower rates or be able to negotiate different terms with different lenders.