A hard money loan is a unique type of mortgage loan typically used in real estate investing. A traditional lender like a bank does not offer hard money mortgages. Instead, private money lenders and individuals serve as hard money lenders, offering these loans to real estate investors.
As with any method of financing, there are pros and cons to hard money loans. They are definitely better suited for certain investment scenarios over others. In order to determine if a hard money loan is right for you, it’s best to first understand how hard money loans work.
How Hard Money Loans Are Structured
The information below is very generalized. Because private lenders dealing with hard money lending are not regulated by the Federal Reserve as banks and other conventional loan creditors are, practices can vary significantly. Many times, rates, terms, fees, and other procedures for a private money loan are based on the particular lender’s preferences and whether or not they are willing and able to participate in a given investment venture.
Therefore, always conduct your own research with lenders who service your local area to ensure your calculations are correct before jumping into a real estate endeavor. But, if you’re wondering, “How do hard money loans work?” the following information may help you determine if they fit your needs.
Hard Money Loan Terms
Generally, a hard-money loan is a short-term loan intended to be paid back within 6 months. This is ideal for a real estate investor dealing in short-term investments who can quickly renovate and turn a property for a profit. It is imperative to get rehab work done rapidly and the property sold in an expeditious manner, as each additional monthly mortgage payment means a decrease in profit.
Hard money loan terms can range anywhere from a few months to a few years. But, they usually make the most sense in situations when investors only intend to hold on to the property for short period. Some hard money mortgage loans may include a balloon payment, which means that the loan principal will be due in full to the lender at the end of the loan term. If, for some reason, you are unable to repay the loan in full, you will need to refinance the loan or pay the penalties. Since the property itself is used as collateral in a hard money loan, the lender may be able to take over its ownership if you default.
Hard Money Loan Interest Rates
Most hard money loans carry high interest rates compared to a traditional loan like a conventional mortgage. Commonly, hard money loan rates are around 7-15 percent, which is about double or triple a bank loan. This is generally the case because real estate investment can be high-risk. Additionally, most hard money lenders do not require the same level of arduous vetting (including examining your financial history, credit score, and existing debt from things like credit cards) as traditional lenders, which makes this mortgage type more accessible to even those with poor credit.
Hard Money Loan Points
Points are an origination fee that a hard money lender charges to cover loan initiation, administrative costs, fees, and other expenses associated with the mortgage. Loan points can also be used to mitigate the risk of the lender (i.e., the higher the risk, the more points). Points are calculated on a percentage basis. Usually, one point equals 1 percent of the total loan amount. Hard money loan points can range from 2 to 10 percent depending on the lender and the borrower’s unique situation. Points are customarily paid by the borrower when the loan is initiated as part of the closing costs.
Hard Money Loan Down Payment Requirements
As with a conventional mortgage, most hard money lenders require a borrower to invest some of their own money in the property, usually in the form of a down payment. Down payments can vary, but a hard money lender generally requires an investor to pay 10 percent of the property’s appraised value. Down payments are calculated based on the loan-to-value (LTV) ratio of the property.
For example, if you want to purchase a property appraised at $100K, a hard money lender might offer a 90 percent LTV ratio. That means the size of the loan would be $90K, and you would be responsible for the remaining $10K as a down payment.
Instead of using the property’s purchase price when calculating the LTV, some hard money lenders apply the after-repair value (ARV). This can be beneficial when a borrower does not have the cash to fund the necessary property renovations. However, in most cases, when a lender uses the ARV, they employ higher interest rates and points to make up for the increased risk.
Not all hard money lenders require a down payment. Some will finance 100 percent of the purchase price. But, this type of financing agreement may come with exorbitantly high fees and interest rates unless the borrower is an expert investor, proven to make a profit and to handle hard money business loans responsibly.
Be wary of this kind of deal with hard money lenders unless you are absolutely sure you can quickly turn the property and repay the loan. With the property serving as collateral, you run the risk of losing it to the lender if you cannot make the monthly payments.
When Should I Use a Hard Money Lender?
If you’re still contemplating, “Do hard money loans work?” the simple answer is “Sometimes.” Hard money loans can open a door for borrowers wanting to get started in real estate investing. They are great for first-time flippers or investors in other unique situations, like those with bad credit.
One of the foremost benefits of working with hard money lenders is that they are fast. Conventional mortgage loans can take a month plus to fund, not to mention the arduous loan application process. Private investors can offer buyers funding in less than a week – most often within a few days. The ability to access financing quickly can be a competitive advantage in the real estate market, especially when there are many competing bids on a property and you want to impress with an all-cash offer.
Hard money lenders also offer a point of entry to real estate for borrowers who might have bad credit and have been rejected by banks specializing in conventional lending. Because the property itself serves as collateral in this type of asset-based financing, hard money lenders will often look past a sullied financial history or other individual risk indicators.
Ultimately, it can be more cost-effective as you become established in real estate investing to use traditional financing like conventional mortgage loans, business loans, construction loans, or a cash-out refinance. In order to qualify for these lending options, you will need to focus on building or repairing your personal and business credit score.
Traditional mortgage lenders provide much lower interest rates than hard money lenders. When you have a number of property flips under your belt or begin to deal with rental property, you’ll notice that interest payments can really add up. Improving your credit score so you can access these more attractive rates can save you significantly. To improve your bad credit, start paying down your existing debts, like credit cards, to improve your debt-to-income ratio. Make sure you pay all your bills on time and that you meet the minimum monthly payments.
By establishing yourself as a business and growing your business credit history, you can access a conventional loan, as well as a business line of credit, which is a much more affordable means to fund your real estate rehab enterprises. To build business credit, start by opening bank accounts and credit cards in the name of your business. Pay vendors and suppliers (like contractors) on credit, and always pay on time. Use a credit monitoring service like Nav’s Business Loan Builder plan to keep an eye on your scores and dispute any errors. And always make sure you are using financing responsibly, in both your business and personal endeavors.
This article was originally written on November 19, 2019 and updated on February 1, 2021.