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As an aspiring investor, you’ve probably come across hard money loans that grabbed your attention, even if you’ve only ever heard of the last resort hard money examples.
Yet, you still want to dip your toes into this area but don’t know how. You may have a property of interest with multiple offers and want to ensure you’re able to close on it fast.
Sounds too good to be true? Let’s dive in.
A hard money loan is a non-conformal and asset-based loan secured by non-owner occupied real estate and provided by a private investor or a company. In short: it’s money loaned from an individual or company rather than a bank.
Considering that it’s money borrowed from individuals, the property you buy is the collateral in case you don’t pay the loan back in the agreed-upon timeframe, which reduces the potential risk for these non-traditional lenders.
Primarily used by real estate investors, developers, flippers, and buy and hold investors, it allows them to obtain a loan much faster than traditional methods with banks and lenders — often in as little as 10 business days, compared to transitional banks and lenders which take on average 30-50 days.
To sum up the main differences and characteristics of what a hard money loan is, here’s a quick overview:
Private lenders – individuals or private companies, no middle man
Faster approval times
Less restrictive underwriting
Property is collateral
A relationship-based loan that improves chances for more funding in the future
Licensed in some way
Often require large down payments, though this depends on the lender as there are some that don’t need any down payment at all
Some lenders have a minimum credit score used for the underwriting process of the loan
Hard money differs from soft money because it is more challenging to get and repay, with higher interest rates and a shorter repayment period reflecting the increased risk for the lender.
Whereas hard money loans are based on the value of the collateral (the property), soft money loans are based on the borrower’s credit history alone. While the borrower must still keep the property as collateral, easier approval and lower interest rates are the benefits.
In simple terms, hard money is used primarily for short-term solutions, namely if you:
Also known as a “relationship-based loan” – when you take out a hard money loan, you’re essentially building a relationship of trust with the lender, which may help you get financing for investments more quickly in the future.
This is an especially beneficial relationship when it comes to hot markets and multiple offer situations surrounding popular neighborhoods and properties.
Hard money loans differ significantly from conventional loans in many key respects, the most obvious being that they are provided by a person or company rather than a financial institution like a bank. Hard money lenders also use the value of the asset to determine the loan amount and the rate.
Private money, on the other hand, is often obtained via personal connections, such as those with friends, family, coworkers, business associates, or organizations.
Another key distinction between hard money and private money is that hard money lenders are organized and usually licensed in some form to loan money with defined criteria and interest rates, whereas private money lenders are typically not. Private lenders can choose their own criteria when deciding whether or not to lend funds.
Hard money and private money loans do have several things in common:
Whether a person chooses to borrow from a regulated hard money lender or private money via a friend or family member is a matter of choice and preferences. The loan is based on a relationship and may or may not have an impact on an existing relationship.
This asset-based loan acts as a gap between the initial purchase and long-term financing, which is why it’s a great opportunity for investors and buyers who want to quickly purchase a property with little complication.
This type of loan is often used by real estate investors to secure a property before a conventional loan is approved, especially in light of the current competitive market. It is especially popular among fixer-uppers and house flippers since they can close the property fast, fix it up quickly, and sell it quickly.
Some real estate investors use hard money loans for commercial and rental properties as a temporary measure with a high-interest rate while they look for a more permanent source of funding.
On the other hand, banks that provide conventional loans must be “conforming” loans, which means that they meet the requirements for Freddie Mac or Fannie Mae. Freddie Mac and Fannie Mae are government-sponsored enterprises that guarantee most of the mortgages in the U.S. They purchase mortgages from lenders and sell them to investors.
Lenders can reduce their level of risk by offering guaranteed loans. This also makes mortgages more affordable and increases availability. However, this does mean conventional mortgages come with more regulations and limitations that hard money loans don’t have.
Considering this is only a short-term or bridge-type of loan, you may be wondering what happens if you can’t sell it in time or if you’re not approved for a traditional loan.
However, a major advantage is that a private lender is going to be handling the financing for this loan. Since they have fewer constraints, policies, and limitations than a bank, they will have the last say on whether or not to grant an extension.
Fortunately, many mortgage lenders are flexible and willing to give loan extensions when borrowers demonstrate they have done all they can to sell the home but are still unable to do so. However, if you’ve exhausted your extensions and still weren’t able to sell the property, you’ll be in default.
The bulk of hard money lenders will have some wiggle room and emergency forbearance options if you wind up defaulting on the loan.
As you won’t be touching the loan’s principal balance at any point throughout the repayment process, instead, your payments will go toward the interest accrued on the loan during the time period determined by the interest rate offered by the lender.
So, if you’re no longer able to make even the smallest payments towards the interest or you weren’t able to sell the property, you may face court-mandated foreclosure proceedings, in which your home is legally repossessed as collateral and sold to repay the loan balance.
If you wind up in foreclosure, it will have a negative influence on your credit score, which is something you’ll want to prevent by using other options such as deed in lieu, for instance.
Hard money loans are short-term loans, typically between 6 months and 18 months, used as a bridge until the borrower can qualify for a more traditional loan and refinance.
Although some hard money loans have terms of up to three years, most investors utilize them for far shorter periods of time, often just long enough to make the purchase, make any necessary repairs, and then sell the property again.
Even though a borrower’s credit score isn’t a determining factor for a hard money loan, lenders might still run a credit check to verify the applicant’s ability to repay the loan as well as evaluate the borrower’s track record with loans and payments.
While not a dealbreaker, some lenders use this information for the underwriting of the loan, while others have a minimum score requirement of 600.
Here’s a list of potential costs involved with hard money loans:
Title policy and escrow fees
Origination fee (2-5% of the entire loan amount)
Project feasibility studies
Interest (~ 10% of the entire loan amount)
Closing cost (and attorney costs if needed)
Staging and marketing costs if it’ll be flipped
Because hard money loans typically range from six months to three years in length, rather than the conventional thirty years, the interest rate is naturally higher to compensate for the fact that the private lender still has to make a profit despite the shorter loan term.
Interest rates may also vary depending on the kind of loan, its purpose, the associated risk, how much money is borrowed, and how much of a down payment the borrower makes. On the other hand, some lenders provide lower interest rates depending on your relationship with the lender while others have fixed rates.
Traditional loans often have set or variable interest rates; however, how does interest work on short-term hard money loans? Unlike conventional loans, you do not pay anything towards the loan’s principal amount each month, but rather pay interest on a monthly basis.
Once your term is over, you pay the entire principal amount back.
Here’s a hard money loan example on total interest paid:
If you have a traditional loan of $200,000 with an interest rate of 5% for 30 years (360 months), you will have a monthly repayment of $1,073.00 with a total interest paid of $186,815.32.
With a hard money loan where the loan amount is also $200,000 with an interest rate of 10% for 2 years (24 months) and a holding time of 12 months, your monthly payment will be $1,666.67 with a total interest of $20,000.04 paid.
Here’s an example of how a hard money loan works. Let’s say an investor is planning to purchase a fixer-upper for $100,000 with renovation estimates of $60,000. The investor decided to make a 10% down payment and fund the rest with a hard money loan for 12 months.
The lender quoted the investor an origination fee of 2% and an interest rate of 12%. What does the total financing cost?
Property Value = Purchase Price + Renovation Estimate
$100,000 + $60,000= $160,000
Loan Amount = Property Value * (1 – Down Payment)
$160,000 * (1 – 10%) = $144,000
LTV Ratio = Loan Amount / Property Value
$144,000 / $160,000 = 90%
Financing Cost = (Origination Fee + Interest Rate) * Loan Amount
(2% + 12%) * $160,000 = $22,400
The total financing cost of the hard money loan is $22,400.
Whether the hard money loan is worth it likely depends on how you want to use it and whether the benefits outweigh the drawbacks of the high-interest rate in the end.
During the duration of the term, you’re only paying interest rather than the principal amount, which means in the end you will either have to get a traditional loan or pay back the entire amount because you flipped and sold the property.
The biggest benefits of a hard money loan are a less rigorous underwriting process and lenders paying less attention to your credit score and debt-to-income (DTI) ratio.
However, while that may benefit you if you’d have a hard time getting approved for the traditional loan, you will have to have a larger down payment ready as well as more money for the renovation process.
Despite the higher interest rate and the fact that it is a short-term and collateral-based loan, hard money lenders are often the preferred choice of real estate investors. Real estate investors may take advantage of this loan by making a quick purchase in a hot market and then, depending on their goals, refinance with a conventional loan.
As there is little to no underwriting and little if any credit criteria, investors can have a better shot at buying property regardless of their financial situation and no matter their level of expertise.
Despite the higher risk involved, hard money loans are preferred by real estate investors because they allow for a quicker closing and often without the need for costly appraisals or inspections.
Despite the benefits of quick turnaround times and faster approvals, hard money loans can be riskier than traditional routes as they often come with high rates and more risk if the investment doesn’t turn out in your favor. Generally speaking, hard money loans are used by more experienced investors that have an eye for properties that they know will have a high ROI.
Nonetheless, if you’re looking for a fast process and have the perfect property for this type of loan, what are you waiting for? Learn about no-hassle investment opportunities involving hard money or alternative loans. New Western offers off-market properties for a variety of investment strategies. We work with our customers to eliminate obstacles, deliver a clear title and provide a seamless closing process.
Disclaimer: The information provided on this website does not, and is not intended to, constitute legal advice; instead, all information, content, and materials available on this site are for general informational purposes only.