Hard money loans are a type of alternative financing that is commonly used for real estate investments. They allow borrowers to access funds quickly for projects like flipping houses or financing commercial real estate purchases. Hard money loans have some key differences from traditional mortgages and personal loans that borrowers should understand before applying for one.
What Is A Hard Money Loan?
A hard money loan is a short-term loan that is provided by private investors rather than banks or traditional lenders. The loan is secured by real estate that the borrower is purchasing or investing in. Hard money loans are asset-based loans, meaning they are underwritten based on the value of the underlying asset being used as collateral rather than the borrower’s creditworthiness.
Some key features of hard money loans include:
- Collateral: Hard money loans are secured by real estate, which acts as collateral for the loan. This can include investment properties like fix-and-flips or commercial real estate.
- Short terms: Hard money loans typically have terms of 1 year or less, though some can go up to 3-5 years.
- High interest rates: Interest rates on hard money loans are usually quite high, often between 10-15%.
- Fast funding: Borrowers can often access funds within days or weeks, much faster than a traditional mortgage.
- Less stringent criteria: Hard money lenders focus more on the property’s value rather than the borrower’s credit score and income.
Hard money loans appeal to real estate investors who need to move quickly and may not qualify for bank financing. The quick access to capital comes with a price in the form of higher rates and costs compared to traditional lending.
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How Hard Money Loans Work
Hard money loans share some commonalities with other types of real estate financing but also have some distinct differences. Here is an overview of how they work:
Application Process
The application process for hard money loans focuses on the equity in the property rather than the borrower’s financial profile. Lenders will want to see:
- Purchase contract for the property
- Estimates of property value and rehab costs
- Scope of planned repairs/renovation
Many hard money lenders will also do a quick background check on the borrower’s experience with real estate investing. But extensive income and credit verification is not common.
Interest Rates & Fees
Interest rates on hard money loans often range from 10% to 15% but can sometimes be higher depending on the lender and project risk. There are also typically 2-5 points in origination fees charged.
Rates and fees are based on the loan-to-value ratio, creditworthiness of borrower, and perceived risk. Those with more real estate experience may qualify for lower rates.
Loan Amounts & Terms
Typical loan-to-value ratios on hard money loans range from 50% to 75% of the as-improved value. Terms are usually 6 months to 3 years, with 1 year being most common. Extensions may be available for an additional fee.
Loan amounts on a hard money loans often range from $50,000 to several million dollars. Lenders will want to see that the project makes sense and the borrower has the means to repay.
Collateral & Payments
The property being purchased serves as collateral on the loan. If the borrower defaults, the lender can foreclose and take possession of the property.
Payments on hard money loans are usually structured as interest-only over the loan term with a balloon payment of principal at maturity. Extensions may be granted if the project is delayed.
Hard Money Loans vs. Traditional Mortgages
Hard money loans differ in several key ways from mortgages provided by banks and credit unions:
Hard Money Loans
- Interest rates 10-15%+
- Up to 75% loan-to-value
- Approval in days/weeks
- Focus on property value
- Short terms (under 3 years)
Traditional Mortgages
- Current rates 3-6%
- Up to 97% loan-to-value
- 30+ days to close
- Focus on borrower’s profile
- Long terms (15/30 years)
As you can see, hard money loans provide faster access to capital but are more expensive than traditional mortgages. The higher rates and fees are the tradeoff for quicker approvals and funding.
Hard money loans are better suited for short-term projects where the borrower expects to repay quickly. Traditional mortgages make more sense for those planning to hold property long term.
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Drawbacks of Hard Money Loans
While hard money loans can be beneficial in certain situations, there are some potential downsides to be aware of:
Expensive
The high interest rates and fees can make hard money loans very expensive, especially for longer terms. This cuts into investor profits. Interest payments do not build equity like a traditional mortgage.
Risk of Default
If the project is delayed or flipped property does not sell as planned, the borrower faces greater risk of defaulting on the loan. The short repayment terms give little flexibility.
Potential Foreclosure
Defaulting on a hard money loan could mean the lender forecloses and takes possession of the property, leaving the borrower with nothing. Traditional lenders are more likely to modify or work out a payment plan.
Short Terms
Most hard money loans need to be repaid within 1 year or less. If the project runs into delays or problems selling, the borrower may need to refinance into a longer term product quickly to avoid default or foreclosure.
Variable Rates
Most hard money loans have variable rates that fluctuate over the course of the loan. Monthly payments could rise if rates go up, straining cash flow.
For these reasons, hard money loans are usually best utilized by experienced investors on projects allowing quick payback. Novices should approach with caution.
How To Qualify for a Hard Money Loan
Since hard money lenders focus on the real estate rather than the borrower profile, loan qualification is based mainly on:
Property Value
Lenders will want to see appraisals or comparables validating the purchase price and projected after-repaired value of the property. Higher ARVs allow for more financing.
Scope of Work
Plans for renovations and repairs need to make sense and align with budgets. Unrealistic scopes can raise doubts.
Experience
Some lenders may want to see that the borrower has successfully executed similar projects in the past. New investors face more scrutiny.
Downpayment
Most lenders require 20-30% down from the borrower’s own funds, not from financing. More is better to reduce risk.
Exit Strategy
For flip projects, the borrower should clearly explain their plans to sell the property once renovated and the anticipated profit.
As long as the deal makes sense on paper, hard money lenders are less concerned about your income, credit score, or employment status. Sufficient equity in the property is the key factor.
How To Get a Hard Money Loan
Hard money loans are offered by specialized lenders, not banks or credit unions. Here are some tips for securing a loan:
Research lenders – Many lenders operate locally or regionally. Search online and talk to real estate agents for referrals. Look for an established reputation.
Compare options – Weigh factors like rates, fees, LTV ratios, and requirements. A good fit depends on your project.
Prepare your package – Gather purchase documents, rehab budgets, comparables, and information about your experience. Make your case.
Apply and get pre-approved – Many lenders have a short online application to initially qualify before undergoing full underwriting.
Lock in commitment early – For flipping projects, try to get formal approval weeks before you want to purchase the property.
Be ready to close quickly – Approval can come in days, so be prepared with funds for deposit and fees to complete closing.
With the right property and preparation, hard money loans provide fast access to capital for real estate investments and projects. Just make sure to shop around for the best rates and terms.
Conclusion
Hard money loans fill a niche for real estate investors who need quick financing that traditional lenders may not provide. By focusing on the value of the collateral property rather than the borrower’s financials, deals can close in weeks rather than months.
However, these loans come at a price – namely higher rates, large down payments, and short repayment terms. For the right project executed by an experienced investor, a hard money loan can provide the capital needed to get a deal done.
Novices should exercise caution and understand the risks before pursuing this type of financing for flipping properties or funding acquisitions. Hard money loans are more forgiving than traditional mortgages if something goes wrong. Thoroughly researching lenders, comparing offers, and having a solid exit plan are key to success when venturing into hard money lending.
Frequently Asked Questions About Hard Money Loans
What are typical interest rates on hard money loans?
Interest rates typically range from 10% to 15% but can exceed 15% for riskier projects or borrowers with less experience. Rates depend on factors like loan amount, loan-to-value ratio, borrower’s credit, and perceived risk.
What are some typical terms and fees?
Hard money loans usually have terms of 6 months to 3 years, with 1 year being most common. There are origination fees of 2-5 points and closing costs similar to traditional mortgages. Some lenders charge prepayment penalties if paid off early.
What loan amounts are possible?
Loan amounts can range from $50,000 into the millions, depending on the project and borrower’s track record. Most lenders limit lending to a percentage of the as-improved property value, such as 70%. Higher amounts involve more risk.
How long does it take to get approved and funded?
Many lenders advertise 1-2 weeks from application to funding, but some may be willing to close even faster for the right deal. The smoothness of underwriting and appraisal completions impact overall timelines.
Who are good candidates for hard money loans?
Experienced real estate investors who regularly execute projects like flips or commercial deals are ideal candidates. Hard money loans are riskier for novice investors or homeowner-occupants due to the high costs and short repayment terms.
What happens if you default on the loan?
As with other loans secured by collateral, defaulting gives the hard money lender the right to foreclose and take ownership of the property to recoup their investment. The borrower loses any equity they had built up.
Should you use a hard money loan to buy your primary residence?
Hard money loans are seldom a good idea for buying a primary residence due to the short terms and high costs. Traditional mortgages make more sense for home buyers planning to live in the home long term.
Are hard money loans risky for lenders?
Yes – hard money loans involve more risk, which is why the rates are so high. However, experienced lenders mitigate this by carefully evaluating projects, requiring substantial borrower equity, and maintaining strong legal position in case they must foreclose on a defaulted loan.
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