When you hear the phrase “hard money loans,” you may think of a steely, shady man who hunts down borrowers and sharks them with high interest rates. Or, maybe you think of people in desperate times looking to make money fast.
While those financial predators did exist at one time, thankfully, that’s not so much the case anymore. Now, hard money loans typically come from investors or private individuals, as opposed to a traditional mortgage lender.
However, hard money lending still often gets a bad rep.
What is a hard money loan?
To put it in simple terms, when you take out a hard money loan, you’re borrowing money for a significantly shorter period of time, backed by real estate. This means that you may take out a hard money loan with a term of 12 months and use a house as collateral.
Typically, someone who takes out a hard money loan is paying only interest, or almost only interest with a small amount of principal, month over month.
You may be asking yourself why anyone would want to do that, right?
Well, hard money loans may be right for you if you know a thing or two about real estate.
What is Hard Money, and is it Safe?
The best way to explain hard money is to compare it to a traditional loan. Let’s say you’ve just paid in cash for a house that’s in rough shape; you want to fix it up and flip it for a nice profit, but you need some extra capital to do that. You may walk into, say, JP Morgan & Chase, sit down in front of a banker, and ask for a loan.
What happens next?
The answer is a whole boatload of things. Your banker will investigate your credit, inquire about your payment history, consider your debt to income ratio, and grill you about your other monthly expenses.
Traditional lenders look hard and long at the lender to decide if they’re an acceptable risk. Hard money lenders, on the other hand, don’t care much about how much of a risk you are at all.
The reason for that is because you’re backing up a hard money loan with the deed to your house that you just bought. So, they don’t care if your credit score is embarrassingly low or if you’re up to your eyeballs in debt.
As long as the house you’re backing your loan with is up to snuff, your hard money loan will be approved, because if you don’t pay, the lender will just take your house to call it even.
So, hard money loans are typically safe as long as you’re confident that you can meet your monthly payments.
What Should (and Shouldn’t) I Use a Hard Money Loan For?
Hard money loans can be used for just about any property, including single-family homes, multi-family homes such as duplexes and apartment buildings, commercial properties, undeveloped lands, and industrial properties.
You shouldn’t use a hard money loan on your own personal home, or a property that you plan on owning for an extended period of time.
Some hard money lenders have a property type preference. For example, some will only lend out funds for single family residential homes, while others specialize in apartment complex developments.
Additionally, most lenders will not lend on a property that the owner intends to occupy. You can find out why here.
What Extra Costs Should I Plan For?
To sum it up in one word: interest. Your hard loan lender will slap a hefty interest rate on your loan; usually a minimum of 10%, with a high of 15% and an average of 12%.
Comparatively, depending on your credit score, a traditional lender might grant you a more modest interest rate of anywhere between 2% and 5% lower.
You may be able to coax funding out of a hard money lender for the full price of the house and even some of the rehabilitation costs, but you may be spooked in turn by the consequent jump in interest rates, usually by up to 3%.
The good news there is that, in areas with a lot of hard money lenders, they have to compete with each other by vying for the lowest interest rates. If you’re lucky enough to live where there are plentiful hard lenders, you get the privilege of shopping around for the most agreeable rates.
A hard money lender is taking on a substantially higher risk by loaning money regardless of someone’s credit history. For this reason, they will also carve out a lender’s fee on your contract. These fees are usually referred to as points, and each point is typically equal to one percent of the loan.
These fees will surface around closing time. Lenders commonly require a payment of around three points at the time of closing.
Your lender will probably only provide you with up to 75% of what your collateral property is worth (or sometimes what it will be worth after repairs, also known as After Repair Value). So, for example, if you need $80,000 in funding and are backing it up with a house valued at $100,000, you’re going to need to have an extra $5,000 in assets ready.
It’s important to note that 75% is a pretty high maximum on that loan to value ratio, with most lenders averaging about 65% of your collateral’s value.
Why won’t they loan you the full amount of what your property is worth?
Well, if they have to repossess your collateral due to nonpayment, they need to ensure that they can break even with the sale of the property. Everyone needs to make money somehow, right?
Why Would I Take Out a Loan With Such High Interest?
If you are a highly involved real estate investor, or want to be, the answer may simply be because there typically isn’t time for traditional loans. If you don’t want to wait around to be put under the microscope by a bank or lender, the hard loan bandwagon may be right for you.
Another bonus for you is that, the more of a relationship you establish with a lender, the quicker the process tends to go.
While a traditional bank may not shell out any cash to you for over a month, even up to two months depending on how much they want to evaluate your financial profile, hard money can be granted to you within a week, sometimes even within a few days.
If you asked your bank for approval on a loan on the day you walk in, you will probably be shown the door. But some hard money lenders can issue a commitment / approval same day.
A lot of real estate markets are overly saturated with investors who all want to jump onto the same property, because they see the profit potential in renovating it. So, you may want to utilize a hard money lender when you need to act fast and beat several other bidders to the finish line.
You also may not want the loans you take out for flipping houses to intermingle with your personal credit score, which you’d need for your own mortgage and credit cards, etc. Since hard money lenders don’t really have an interest in your personal finances as much as they do the price tag on the house, your private money life is less likely to get tangled up in your real estate loans.
In fact, many hard lenders are known to not pull your credit history at all. In essence, you’re paying for the convenience of all of these characteristics of a hard money loan. Some investors have more financial room for that convenience than others.
How do I Know When Hard Money Loans are the Right Move?
If you are looking to purchase a property just long enough to fix it up and increase its market value (redoing floors, upgrading kitchen, residing, etc.), you probably don’t want to hang on to that house for more than a year at maximum. Hard money loans are usually granted for terms between one and five years (with one year being most popular).
This is when hard money lending may fit right in the cards for you.
You don’t want to take out a hard money loan for a property that may be in your hands for more than five years at an absolute maximum. So, when you buy a fixer upper, you need to take into account how much you can manage to get done in a short amount of time.
You may want to ask yourself these questions: Do I have the time to make these repairs happen? Do I have the labor and capital to get it done? Do I have the financial freedom to do all of this right now, or will I run out of funds? Will there be a prime selling market by the time I’m ready to flip this property?
If all the answers tell you to “pass go,” then you’re in the right place to get a hard money loan, spend six to eight months renovating the property, sell it, and repay your lender. Then, you have the freedom to pocket your remaining profit.
What Drawbacks Can I Expect with Hard Money?
The idea of a hard money loan may seem simple enough. The loan is secured by a property, not my personal credit, so it feels secure.
However, in order for your hard money loan to go right, everything else in your life has to go right. All of those questions above about the right factors that make it a good time for a hard money loan are assuming that the answers remain a constant.
You may have financial freedom now, but what if you lose your job? You may have the time now, but what if you get injured? Can you work hiring extra labor into your budget?
A hard money lender may not be very sympathetic to the unknowns of your life that affect your capability to renovate the house and pay off the loan. Before pursuing the funding, you may want to make sure that you have several levels of backup plans in place.
Your Hard Money Loan Greenlight Checklist
Signing on to a loan of this nature can be a hard pill to swallow. It is called hard money, after all. Here is a checklist to simplify the question of whether or not you’d benefit from this type of lending. If you’ve checked at least one of these boxes, hard money lending may be right for you.
- Am I fixing up or flipping a house?
- Do I have enough capital and assets to ensure this property is sold within a year (or five years at an absolute maximum?
- Do I need money for construction or development of land?
- Do I have poor credit, or a lack of credit, that may prevent me from getting a traditional loan?
- Am I on a short timeline for this real estate investment, and don’t have time to wait around for a traditional lender?
- Am I one of multiple bidders?
- Will I profit enough from the sale of this property to pay back the loan?
Hard Money Plays for You and Against You
Yes, there’s a lot to consider when weighing the options of a hard money loan. You’d probably like to have the money right now, but can you afford the double digit interest rates? You just bought a property you’d like to turn around for a substantial profit, but can you ensure that the repairs are done in a timely window?
If you bought a fixer upper as hobby work and have a “I’ll get to it when I get to it” type of attitude, then a hard money loan would definitely play against you.
The good news is that there are many instances in which hard money loans play for you. You can get them quickly, they bypass your credit, and they tend to have more flexible negotiation terms than a traditional loan.
Once you take all of your investment goals and financial standing into account, you can decide if a hard money loan is right for you.