Exactly what is a hard money loan? In this article, we explain concisely what a hard money loan is, along with the pros and cons of this type of financing.
Hard Money Loan Basics
A hard money loan is a sort of loan that is collaterized strictly by real estate property as insurance for the lender. This type of loan is often considered as a last resort or an option for quick problem resolving in emergency cases.
Hard money loans are most prevalent in real estate transactions. Hard money lenders are mostly companies, investment funds or wealthy individuals, not banks. Traditional lenders like banks and credit unions do not offer hard money loans, as this type of financing carries significant risk of nonpayment.
Hard money loans are typically made from the lending company to another company formed specifically for real estate investment purposes. Most states prohibit hard money lending to individual homeowners.
Hard money loan amounts are based on the value of the specific property used as collateral. The lender’s decision is strictly based on the estimated market value of the property, and is not based on the borrower’s credit rating.
Hard money lenders are not as concerned with getting repayment because they know there is a chance to make money reselling the property if the borrower fails to meet its obligations.
Who Are Hard Money Borrowers?
Typical hard money borrowers include investors and house flippers who use the funds to renovate a house, which is used as collateral, then resell it within the first year. Since the cost of a hard money loan is higher than a traditional mortgage, the intention is for the borrower to repay the loan as soon as possible. Hard money loans are generally offered with a repayment period of one to three years.
Hard money loans are used for:
- House flipping
- Fix & Flips
- Short-term financing
- Construction projects
- Bridge loans
- Foreclosures and other situations that require a property to be purchased, fixed up and made marketable quickly
Higher Interest Rates
Hard money lenders bear significantly more default risk than traditional mortgage banks. This requires a higher rate of return (interest rate) on the loan to offset the increased risk born by the lender.
Another factor affecting the interest rate of the loan is the need for quick access to money. Hard money loan approval processes and paperwork are much shorter and simpler than a traditional loan. Naturally this prohibits the in-depth documentation, insurance and proof of creditworthiness required by traditional mortgages.
Advantages of Hard Money Loans
A major advantage of a hard money loan is that you can access the money a lot faster than applying for a mortgage with a bank. It’s possible to obtain funds within 24-48 hours. Private individuals who offer hard money loans will make a quick decision based on their own estimate of the property’s worth and marketability.
Another advantage of hard money is the general lack of credit checks. If you default, then the lender will immediately foreclose and take possession of the property. In essence, there is very little “credit” being granted, and therefore minimal credit default risk. This allows lenders to work with risky businesses and still get their money back. In comparison, banks have strict credit rating policies for traditional mortage loans that cannot be circumvented.
A third benefit is that hard money lenders do not use a standard loan contract. The loan contract and supporting documents are significantly simpler, with minimal disclosures, riders, guarantees, proof of credit, personal assets, etc.
Disadvantages of Hard Money Loans
Hard money loans also have some downsides.
Since the real estate is the only protection in default, hard money loans require a higher loan-to-value (LTV) ratio over traditional loans. A traditional mortgage can often be obtained for an amount equal to, or even greater than, the current market value of a house. Most hard money loans require at least a 10-20% LTV buffer to ensure the lender can recover the loan balance by quickly selling the property (often at a discount).
Another drawback is that the interest rates can be extremely high, even higher than subprime loans. For the sake of comparison, in 2019, the average interest rate for a traditional mortgage was 5.25%, while for hard money loans, it was between 7.5% and 15%.
Hopefully this gives you a good overview of what a hard money loan is, and how it works.