What Is a Hard Money Loan?
Last updated 02/06/2023 byElizabeth Jordan
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Picture this: you are a seasoned home renovator with a credit score of 680, and you recently found a property in which you believe you can increase the value. You know exactly where to place new windows, you know that you will fix the cracks in the driveway, and you even have a plan to demolish that dreadful dividing wall and open up the living room to let in more light. There’s only one problem: you can’t figure out how to reach the $100,000 down payment, and all your other loan options won’t take the risk.
If these circumstances sound familiar, you may want to consider taking out a hard money loan. While these loans are incredibly expensive, they can make a high-risk project possible for those who don’t qualify for other, less expensive loan options.
What is a hard money loan?
A hard money loan, also known as a short-term bridge loan, is a loan secured by real property. Typically, hard money loans are offered by individuals or investment companies for real estate transactions.
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How do hard money loans typically work?
Hard money loans have a short approval process, creating a smoother transition time for the borrower to purchase the property and begin work. This approval process generally lasts only a few days, which is often preferable to the 30-60 day process that traditional loans operate under.
Additionally, hard money loans work under an incredibly short timeframe, the most common being within a 6-18 month range, with 12 months being the average term. The tradeoff of such a high risk for the lender is a higher interest rate for the borrower. A typical traditional mortgage will offer loans for a duration of 15 or 30 years with 3-5% interest rates, whereas hard money loan rates will look more like a 9% interest rate on a one-year term.
Because hard money loans come with a high risk for the lenders, the interest rates are also dependent on the borrower’s ability to increase the value of a property. For this reason, first-time property flippers can expect to pay up to 12% or more on interest.
LTV and ARV
Most hard money loans will provide a percentage of the unrenovated cost of the house, which usually falls between 70-90%. This is referred to as the LTV (loan to value). Alternatively, some of these loans use ARV (after repair value) to determine the loan value. ARV estimates a property’s value after repairs and sets a loan amount ranging from 60-80% of this expected value.
One important note is that ARV can provide a larger loan to cover both the cost of the property and possible repair costs, whereas LTV always requires the borrower to invest at least 10% into the project.
Who provides hard money loans?
Hard money loans are usually offered by private investors and nonbank lenders. This is connected to the original design of the hard money loan that compensates for the loan lender’s high risk. Those looking to flip a home often have trouble finding a traditional loan that will support the buying of certain, undesirable properties; however, a hard money loan can make this purchase profitable for the lender, even if the borrower defaults.
“Hard money lenders are more interested in the property’s value rather than your credit history.”
While most hard money lenders will require a minimum FICO score of 600 that proves the borrower’s creditworthiness, the lender’s security primarily comes from the required collateral. Because hard money loans have the standard of being asset-based, this usually means that the real estate itself is put up as collateral.
Under these terms, hard money loans allow for the lender to take the property when the borrower defaults, which they can sell, often for a greater profit than the original loan amount. This is especially true when an experienced house flipper defaults after completing repairs on said property.
Risks when considering a hard money loan
The obvious risk with a hard money loan is you can lose the property if you default on payments. The high interest rates and short repayment terms make defaults more likely than with traditional home financing products. Borrowers should also plan for higher than average origination fees and closing costs, as well as varied limitations such as withholding financing (due to regulatory oversight and compliance rules) for property flippers who live in the house they are remodeling.
Most importantly, hard money loans aren’t fully amortizing, which means that they are designed to have smaller monthly payments in favor of keeping a larger balloon payment at the end. This makes the borrower’s preconceived exit strategy especially crucial to the process, as most borrowers cannot afford to make such a large lump-sum payment.
Due to the high risk, any person who is going into house flipping should have a clear idea of how to pay back the bulk of the loan at the end of their term. This is known as an “exit strategy.”
WEIGH THE RISKS AND BENEFITS
Here is a list of the benefits and the drawbacks to consider.
- Fast approval time
- Loan term is only 6-18 months
- Smaller monthly payments
- Generally expensive
- Minimum loan amount of $75,000 in most cases
- Minimum credit score of 600 is required in most cases
- Extremely high interest fees
- Risk of losing assets in the event of a default
- Balloon payment at the end
Planning an exit strategy
In terms of choosing an exit strategy, there are many options depending on the borrower’s financial position and the nature of the real estate project. Selling is definitely the most common exit strategy for house flippers, given that the loan amount is generally set with the intent of increasing the value and selling it back, but it certainly isn’t the only one.
Those who take out hard money loans may also choose to refinance, get a new loan to buy more time, switch to a traditional mortgage or a subprime mortgage, or use business capital to exit the hard money loan.
Hard money loan alternatives
In the right hands, hard money loans can be a useful tool for investors who require nontraditional financing. However, the interest rates are steep and there is a high risk of default if your investment isn’t as successful as you’d hoped. Typically, hard money loans are a better option for pros.
If you’re considering a hard money loan because your mortgage application has been denied or you don’t think you will qualify, there are alternatives.
For starters, you could try to rebuild your credit or increase your revenue so you can qualify for a regular mortgage. Alternatively, you could apply for a mortgage with a lender that supports government-subsidized mortgages, such as the FHA loan program. Remember to apply to multiple (three or more) lenders to make sure you are getting competitive rates and terms.
If you are already a homeowner, you can leverage the value of your home to finance another property. There are several options, such as a cash-out mortgage refinance, home equity loans, HELOCs, and home equity investments. This list of the best ways to tap your home equity for investing is a great place to start.
Is a hard money loan the same as cash?
No. Hard money loans are definitely not the same as cash. However, they are sometimes considered as a cash equivalent because they differ from traditional loans. Investors use hard money loans to purchase properties with a significant upside. The difference between the hard money loan, which is usually based on the post-repair property value, and the current market value represents the anticipated profit on the investment.
Does a hard money loan show up on credit report?
It varies depending on the lender, but most hard money loans do not show up on a credit report.
What are the requirements for a hard money loan?
The requirements vary widely depending on the lender, but here are some common requirements among lenders.
- A credit score of 600 or higher.
- Cash reserves to make the monthly payments.
- Enough money to secure the down payment. The more money that can be put into this as collateral, the better (at least for the lender).
- Real estate experience.
- Hard money loans are a loan of last resort for short-term real estate projects.
- Hard money loans often have a higher risk than traditional financing, so it’s crucial to have a solid exit strategy.
- Alternatives to hard money loans include personal loans, portfolio loans, signature loans, and conventional mortgages.
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