What is a Hard Money Loan?
Hard money loans, also known as private loans, are mainly used for real estate transactions that are secured by the property as a “hard” asset. These typically short-term loans are more easily obtained and close more quickly than a traditional loan. Hard money lenders can be an individual, a group of private investors, or a company who lends their own money. In contrast, traditional banks lend money obtained from its depositors.
The hard money loan market expanded substantially in 2009 in the wake of the real estate crash of the previous year. A record 3.1 million foreclosures in 2008 created a huge foreclosure inventory, leading to the 2009 mortgage crisis. The passing of the Dodd-Frank Act, meant to stabilize the market, imposed stricter regulations on traditional banks, making it difficult to secure a loan. As real estate investors sought out financing to rehab these foreclosed-on properties, private lenders soon became an alternative financing option for house flippers. Private money loans made it simpler for investors to get the cash needed to purchase and rehab foreclosures.
How do Hard Money Loans Work?
Hard money loans are short-term loans, normally 6 - 24 months, used primarily by real estate investors, flippers, builders, people with credit issues, or anyone looking to close quickly. Private loans are secured by the real estate itself with the amount of the loan determined by an amount divided by the value of the property, or loan to value (LTV). Most private lenders base the loan amount on an LTV at or around 65% of the appraised property value. If the “hard asset” or property is valued at around $250k, the hard money loan might be in the $150k to $165k range.
Other lenders might base their loans on the after repair value (ARV) or estimated value of the property after completion of the project. These types of loans are a bit riskier considering the loan amount includes estimated rehab costs and would be higher than the appraised asset. Private money lenders will charge a higher interest rate to offset the risk.
Borrowers should thoroughly research and compare several private lenders to find the best loan option, since loan programs vary, as well as interest rates and LTV percentages. Look for a lender who offers a fixed rate of interest with no pre-payment penalties.
When to use Hard Money Loans?
There is substantial competition for real estate investment deals. Savvy investors know to capture a great opportunity they will need to secure a real estate loan quickly.
Some borrowers may have poor credit, lack the necessary credit history, or not meet the income level required by traditional banks.
Hard money lenders are more lenient with approval qualifications and, once approved, can potentially close on a loan within as little as three days.
When a traditional bank decides a real estate investment project is too risky and denies funding a private lender would take that risk.
The borrower does not have credit in the U.S. and looks to secure a loan and/or build up a credit history.
The Pros and Cons of Hard Money Loans
Borrowing from a private lender is a much quicker process that might take as little as 3 - 5 days to close a loan, rather than the traditional 30-45 days.
Hard money lenders are more interested in the value of the asset guaranteeing the loan, rather than an individual’s credit or additional debt owed.
Even a less-seasoned investor could obtain a hard money loan to purchase a property, requiring little money from the borrower.
Traditional banks typically require a significant down payment for the loan, while a hard money loan might include a loan origination fee. However, a private lender might offer a larger loan amount that might be 100 percent of the purchase price.
The risk is higher for a hard money lender, which is why interest rates are higher than a conventional loan.
A hard money lender will charge a higher origination fee to process. This could be between 1% to and 5% of the loan in addition to the high-interest rates.
An investor’s short-term loan could become more costly if the rehab project is delayed by unforeseen circumstances and not repaid within the original loan period.
Since the lender holds the “hard asset” deed as collateral, the borrower could end up with nothing if the project is not completed and fails to repay the loan.
Finding a Hard Money Lender
Resist the temptation to sign-on with the first hard money lender. Make sure to do plenty of research into the lender or lending company. While many are reputable, there are plenty of hard money lenders who operate more like loan sharks.
1. Does the lender have a reputable website? Do they share testimonials from previous borrowers? Also, avoid a lender who tries to capture too much information on their site before making contact, as they may simply pass it along to a third-party operation.
2. What kind of projects has the lender financed in the past? Do they share this information on their website?
3. Borrowers should establish if the potential lender funds projects like theirs.
4. Is the lender in good standing or are there any pending lawsuits? It is easy to search for this information.
5. Will the lender close on the loan quickly? What is the estimated timeframe to close and have access to funds?
6. Lastly, cost. Hard money lenders can vary on affordability. Loan origination fees and interest rates differ, as well as how a lender determines the amount to be loaned. Does the lender determine the amount with a loan-to-value ratio, or an after repair value with a much higher interest rate?
Watch for predatory practices. If it begins to feel like paying back the loan might not be financially feasible, walk away, and find another lender.
Joining a local real estate investment association (REIA) is one of the best ways to find a reputable lender.
Most private lenders require the borrower to submit a scope of project, along with proof of experience or a list of past projects completed, and a list of licensed contractor bids.
Additional documents might include purchase and sales contracts, property appraisals, and proof of down payment funds for prepaid funds and costs.
Once all documentation is verified and the loan is approved, it moves to closing. The borrower then has access to the funds and can take possession of the property and/or begin rehab.