Hard money loans are a great option on for certain types of real estate investors. However, lurking beneath are some hidden pitfalls. In this post we discuss 10 dangers of hard money loans.
1. Hard Money Loans Are Expensive
Hard money loans can be expensive in comparison to other loan types. There are many reasons for this, but mostl have to do with borrower risk and the type of real estate collateral.
Consider the following potentially significant costs when looking into hard money loans:
These are often shown in the promissory note and other lender, investor, and third party documents. These costs include the down payment, points, referral fee, underwriting, processing, document prep fees, and other interim costs. These are all often higher than traditional bank loans.
Additional costs may be dispersed throughout the hard money loan process. These costs include interest payments, balloon payment, amortization, taxes, insurance fees, late fees, renewal fee, and advances.
The hard money loan process can be expensive. Making a profit using this type of financing means having an effective property rehab and sales plan.
2. Higher Interest Rates Than Other Loan Types
Hard money loans usually have higher interest rates than other types of bank loans.
An APR of more than 10% should be expected, and even higher is not uncommon. These loans are designed for short term use when you need them, and not for holding a property longer term.
Lenders set high interest rates to offset their risk and drive borrowers to move quickly and pay back the loans.
Most loans have a firm payback date that can be as low as 6 months. Home buyers who are not flipping a property, or who don’t have a plan to refinance and pay back the loan, should not seek a hard money loan.
Hard money lenders also charge higher points. The number of points can vary, but you can expect 5 points higher than other types of loans, at the least.
These additional points are amortized relatively quickly in the payment schedule, making short-term costs higher. Also, terms are not standardized across the hard money industry.
3. Bad Credit Rating Might be Leveraged By the Lender
A low credit rating is typically not a barrier to qualifying for a hard money loan. Lenders primarily look to sell the property to recover if you default.
However, if there are red flags in your credit history, your lender will likely uncover them and potentially use this as negotiating leverage to get a higher interest rate.
In most states hard money loans are made to a company (an LLC or corporation) set up by the real estate investor. This insulates the investor from taking a personal loss and having his or her credit destroyed on a failed deal. But it also leaves the lender with no past credit history to rely on for repayment.
Bottom line, expect to pay more for a hard money loan if you can’t present a solid credit profile.
4. Hard Money Lenders Value Property Conservatively
Hard money lenders tend to value a property more conservatively than traditional mortgage lenders do.
Valuing the property conservatively protects the interests of the lender.
Hard Money Loan-to-Value (LTV)
The interest rate, amortization schedule, penalties, and points will all be set up to protect the lender’s interests. The lender will not value the property in the same way a traditional mortgage lender would, because they are not protected in the same way.
A conservative property valuation forces the borrower to provide more up-front capital. It also forces borrowers to be more frugal on their renovations, which can reduce the ultimate profits on the deal.
Hard Money Loan After-Repair-Value (ARV)
Hard money lenders will often cover up to 60-70% of the after repair value (ARV) of a property.
The other 30-40% will be left to the borrower to cover. Getting approved for a renovation project may depend on how much of the ARV you have on hand in cash.
There are ways a lender can cover this part of the ARV by separating the purchase loan from the construction loan. But this may require putting a lien on another valuable asset you own.
While relying on ARV to finance a rehab project can get it moving quickly, it also puts you at significant risk to pay back the loan if there are construction problems or your ARV calculation is off.
5. Beware of Loan Sharks
Hard money lending can be a dangerous method of financing for unwary borrowers.
There are hard money lenders in the market whose primary intent is to repossess the property and either sell it or keep it for a big profit.
If you see any of these loan shark signs, beware!
- Extremely limited loan documentation that is not done on a standard state legal form
- Interest rates, fees and penalties that ratchet up quickly if a payment is missed or delayed slightly
- No requirement for the lender to fund the loan in a timely manner
- Failure to use standard bank wires, ACH and escrow steps (i.e. paying with bitcoin, Paypal, cash or trades)
If you are inexperienced, it’s advisable have an attorney help you to review the documents and meet with the hard money lender in person. You don’t want anything about the deal to be lacking or misunderstood.
Here are some ways to protect yourself from unscrupulous hard money lenders:
- Review ALL the documents carefully
- Get the assistance of an attorney
- Apply for a smaller hard money loan you can handle paying back in a worst case scenario
- Negotiate for lower terms, rates, and fees
- Shop around before choosing a lender
Use common sense and keep your eyes open. This is especially true when working with large hard money loans.
6. Potential Wealth Destruction
If you are a new real estate investor or house flipper, you should never put too much of your funds into one investment. The same is true for putting too much of your reliance on a single financing partner.
In most hard money deals, if you default on the loan — even partially — you could lose BOTH the property AND cash you put up.
You also need to consider other potential liabilities if you default.
In most cases the property needs to be renovated. Which means you probably have contractors that need to get paid.
If you come up short on cash during a rehab project, you can end up with contractor bills and lawsuits that you have to pay off out of your own pocket.
This can happen even if you no longer own the property!
Taking out a large hard money loan you can’t pay off can put your savings at risk. It’s essential to have a worst-case scenario backup plan in case the property deal goes bad and you need to pay your way out of it.
Sticking to financing 20-30% of your total real estate portfolio with hard money loans is a good idea. This gives you a safety cushion in case things go awry on a particular project.
Beware of being too exuberant when starting out and taking on too much debt for complex rehab projects. Market conditions can change, lowering your resale value. Unforseen costs and delays can eat up your funds.
7. Not Having Enough Money to Finish the Project
A hard money loan can really help get that rehab project done faster. But if things go wrong down the line, you may still need to come up with extra cash to get the project done.
The last thing a legitimate hard money lender wants is for you to run out of cash and come to them looking for more.
Inexperienced real estate investors, flippers, and rehabbers are more likely to run into this problem. It’s caused by not having a solid plan and not keeping a cash contingency fund of 20% on hand.
Hard money loans get approved a lot faster than other types of loans. This has pluses and minuses. The upside is you can get into profitable fix & flip deals quickly before your competitors snap them up. The downside is you can misjudge your budget badly and lose a lot of money quickly.
Borrowers should have the following in place before financing a project with hard money:
- A realistic valuation of the property, both currently and the after renovation value (ARV)
- A detailed rehab plan
- A detailed renovation cashflow worksheet
- The amount of cash needed to buy and rehab the property
- Cash to cover downpayment and fees
If you’re not sure you can take on the risks of a hard money-financed project, then a traditional loan may be best. If you’re new to rehabbing houses and are not sure how long a project will take, then hard money loans are very risky.
Bottom line is knowing what your cash flows are and keeping a cash cushion are essential.
8. Real Estate Market Conditions Can Change Rapidly
During unexpected market events, such as the 2008 financial crisis, real estate prices can drop rapidly. This can leave an investor with a property worth much less than it was previous to getting a real estate loan.
When real estate markets crash, the speed of downward price changes should not be underestimated. Market recovery time could take months or years. This is the reason why large-scale building projects tend to go on hold during economic downturns.
New investors are advised to consider the state of the local real estate market prior to taking on a hard money loan. Are houses selling quickly? Are there multiple offers? Or are properties in the area sitting for months with no takers? Are prices being reduced by eager sellers?
The good thing about hard money loans is you can back out quickly if you haven’t closed yet. If the market starts to turn down, you should consider selling the property quickly and taking a small loss. If you are stuck with a property you were planning on flipping it could mean losing the property to the hard money lender.
Alternately, you can refinance the hard money loan with a HELOC or traditional mortgage. This will give you far more cushion, both financially and time-wise if you end up holding the property longer than anticipated.
9. You Must Pay Hard Money Loans Back Quickly
Hard money loans are designed only for short term financing, with maturity typically between 6-12 months. If your project runs into unexpected delays or costs, you may be unable to pay the loan back before time runs out.
If you can’t pay back the loan by the maturity date, either by selling the property or refinancing, then you will lose the property and your cash investment. As discussed above, you may also be left with contractor bills to repay out of your own pocket.
10. High Down Payment Required
There is almost always a mandatory down payment to get a hard money loan. Typically this is 20-30% of the property’s current market value.
This means you have significant cash skin in the game from day 1. You WILL lose that down payment if you default.
The larger the down payment is, the less money you may have left for rehab. This can become a dangerous situation if unforeseen delays or costs show up during a property renovation.
11. You Now Owe a Lender Money
Hard money loans can provide you with a quick infusion of capital to buy that property and get to the rehab and flip process going.
However, if something goes wrong, you are left with owing a lender money that you must pay back. In some cases it may be a better idea to patiently build up your own capital or find another lending source such as friends or a business partner.
Each investor should consider his or her goals, risk tolerance, current capital needs, and experience level. New investors need to be careful about taking on debt they will struggle to pay back when unforeseen roadblocks appear in the flipping process.
Keep These Dangers in Mind
Using hard money loans can give house flippers and rehabbers a quick way to get the funds they need. However, there are financial and legal risks involved that must be considered.
If you are new to the process of getting hard money loans, it is best to get the assistance of an experienced attorney or other investor to mitigate the dangers of hard money loans.