Getting a loan could be an excellent alternative if you need extra cash to fund your next project or get through a period of financial difficulties. However, with so many loan alternatives to choose from, selecting the correct one for your needs can be difficult.
If you need money quickly or don’t qualify for other types of lending, hard money loans are an excellent option for real estate investors to fund their acquisitions. In the first quarter of 2021, real estate investors financed around 40.8 percent of the total number of residences flipped.
Although hard money loans have slightly higher interest rates than standard loans, the terms of the loan and the hard money lenders are not as strict as traditional lenders.
What is a hard money loan?
A hard money loan is a type of finance in which the borrower receives funds in exchange for the physical property as collateral. The loan is often used to offer relatively short-term finance and is most often provided by private investors or non-bank investment firms. Within one to five years, hard money lenders expect to receive their main loan amount, plus interest.
Because of the shorter term and higher risk involved with hard money loans, the interest rates are typically higher than those for more traditional property loans.
Hard money lenders: what to know about working with them
Private investors or companies that specialize in hard money lending are the most common hard money lenders. You won’t be able to get a hard money loan through your local bank.
Traditional, conforming loan lenders are subject to the same regulations as hard money lenders. This means companies can create their own criteria regarding what credit scores or debt-to-income ratios they anticipate their borrowers to have, for the most part.
Even if more traditional lenders have turned you down, you might be able to find a hard money lender who will grant you a loan. The value of the property being acquired is more essential to hard money lenders than the borrower’s creditworthiness.
How does a hard money loan work
A hard money loan is a type of real estate financing that avoids the use of typical mortgage lenders. Rather, the funds originate from individuals or investors who lend money mostly depending on the collateral you’re utilizing.
Traditional mortgage loans need proof that you will be able to return the debt in a timely manner. Lenders frequently examine your credit ratings as well as any available income when determining your trustworthiness. You may not need to be concerned if you have sufficient income, savings, or the ability to obtain another collateralized loan.
If you have a low credit score, a source of revenue that is hard to verify to your creditor’s satisfaction, or a high debt-to-income ratio, the process gets more complicated.
The valuation of the collateral used to secure the loan is of primary importance to hard money lenders. Unlike traditional residential mortgage lenders, they are less concerned with your credit score and income.
If you can’t pay back the loan due to any reason, hard money lenders hope to recoup their investment by selling the collateral. Hard money loans are usually short-term, ranging from one to three years in duration. You use them to receive money quickly for purchase.
However, because hard money interest rates are often high, you wouldn’t want to hold one of these loans for a long time. In 2020, for example, the average interest rate on hard money loans was 11.25 percent.
What are hard money loans used for
Hard money loans are usually best used for property and real estate transactions. Almost all hard money loans are secured by some form of real estate.
They may, however, be backed by other physical assets on occasion. The actual attractiveness of the loans is that they can be used as a source of funding when regular loans aren’t available or when a borrower needs money quickly.
The loans should be utilized for the following purposes:
- If the borrower has a poor credit score (hard money lenders are more concerned with the property’s worth than with the borrower’s credit score).
- When you need money for a project right now (hard money lenders offer loan funds substantially faster than bank loans).
- When a person or a group intends to buy a house, fix it up, and sell it as soon as possible.
Hard money loan rates – what to expect
The approval procedure for any loan works like this: the lender looks over all of your background information to see if you can commit to making the required payments.
Because the lender does not look into your financial history when making a hard money loan, they are naturally accepting a bigger chance that you will default on the loan. Because the residence is posted as collateral, hard loan lenders assume this risk because they can resell the property if the borrower defaults on their loan payments.
The fundamental reason for higher interest rates on hard money loans is the increased risk. Interest rates on these loans are typically 2–10 percentage points higher than on standard mortgages. Hard money loans have an average interest rate of 11.25 percent as of 2020.
Pros and cons of hard money loans
Hard money loans, like any other loan, have pros and cons. Here are a few to look at before making any decision:
- Lenders and borrowers can complete transactions swiftly. In a competitive market, this is critical since you may access cash for hot projects without having to wait for traditional finance clearance.
- The value of the property serves as the sole security for the loans. You may not be personally liable for loan repayment in many instances.
- Creditworthiness isn’t taken into account when approving a loan.
- Because hard money loans have a lower loan-to-value ratio than traditional investor financing, you won’t need the typical 20% down payment.
- It can be used as a bridge loan to fund an investment until longer-term financing is secured.
- Interest rates are higher than for other types of finance.
- Additional expenses, such as loan origination fees ranging from 1% to 3%, are frequent.
- You must complete the rehab program on schedule. This short-term funding becomes highly pricey if you run into unforeseen problems.
- The property deed is held as loan collateral by the lender. If you are unable to complete the therapy and repay the loan, you will be left with nothing.
- Builders’ risk insurance, which is substantially more expensive than the standard property and casualty insurance required for mortgages, will be required by the lender.
- Because the loan only covers the amount projected by the contractor, unforeseen costs will likely prevent the renovation from being completed.
Alternatives to hard money loans
There are different alternative options available to you. These solutions may have a more stringent application process, but they usually have cheaper upfront expenses and interest rates.
If hard money loans aren’t suited for you, stay reading to learn about other loan forms!
Federal Housing Administration Loans (FHA)
The Federal Housing Administration (FHA) insures, that protects lenders from payment defaults, making it easier for applicants to qualify and allowing lenders to provide cheaper interest rates.
This is an important option for folks who do not meet the credit requirements for standard mortgages. Furthermore, previous bankruptcies and other financial troubles will not preclude you from qualifying.
Veterans Administration Loans (VA Loans)
For qualified veterans, service members, and spouses, a VA loan is a more inexpensive financing choice. The Department of Veterans Affairs backs these loans, which have a less stringent approval process and lower upfront charges.
When compared to commercial loans, VA loans have lower credit score requirements and allow you to qualify with greater debt. You could even be able to skip paying a down payment if you qualify!
Home Equity Loans
House equity loans are second mortgage loans that allow you to borrow against the equity in your home and repay the lender with monthly payments in addition to your regular mortgage.
The applicant must have enough equity in their property to qualify. The difference between the value of your property and the amount you owe on your mortgage is called equity. When you owe $350,000 on your mortgage and the present value of the property is $500,000, you have $100000 in home equity.
Home equity loans also have lower, fixed interest rates than personal loans, which makes them a popular choice among homeowners.
Although tapping into your equity can be beneficial, it’s crucial to keep in mind that this will increase your monthly debt, therefore we recommend examining your monthly budget and speaking with a financial expert before committing!
Hard money loan approval guidelines
The requirements for hard money loans differ from one lender to the next. Because private persons or businesses frequently provide hard money loans, there is greater room for negotiation.
There are three primary prerequisites for hard money loans in general.
1. Down Payment/Equity
The most important condition for obtaining a hard money loan is to have the required down payment or equity in a specific property to utilize as collateral.
For residential properties, the minimum amount is normally between 25% and 30%, while it is usually between 30% and 40% for commercial properties.
A lender may allow you to use numerous properties to finance a single loan in some cases. “Cross-collateralizing” is the phrase for this.
2. Financial Strength in General
Another frequent criterion for a hard money loan is that the borrower has sufficient cash reserves to cover holding expenses and monthly loan installments. Taxes, HOA payments, and insurance are examples of holding costs.
The greater a borrower’s cash reserves, the more likely he or she is to be authorized for a hard money loan.
An applicant who does not have any cash reserves will have a difficult time securing a loan. However, a lender may be ready to increase the loan amount and hold back some of the borrower’s funds to meet loan payments, taxes, insurance, and other holding charges in some circumstances.
The borrower still receives their loan, but the lender ensures that monthly payments are made.
3. Real Estate Experience
Most hard money lenders want to know about the borrower’s previous real estate experience.
A first-time fixer-upper borrower may have a harder time obtaining a hard money loan than a seasoned real estate investor.
If the borrower has no prior expertise, the lender will inquire about the project’s details, including an exit strategy for the current property. They’ll primarily be interested in learning how the borrower intends to repay the loan.
Hard money loan funding timelines
A short-term loan secured by real estate is known as a hard money loan. Rather than traditional lenders like banks or credit unions, they are supported by private investors (or a fund of investors).
The loan length is normally around 12 months, but it can be extended to 2-5 years if necessary. The loan requires interest-only or interest and some principal payments each month, with a balloon payment at the end of the period.
How are hard money loans different from bank loans
Let’s look at how hard money loans differ from a conventional loan.
This category encompasses a wide range of loans, including mortgage loans, vehicle loans, personal loans, and home equity loans. Though private lenders that don’t have the same restrictions as traditional lenders can normally provide these types of loans, they can be more expensive and less favorable for borrowers because the risk is significantly higher.
Traditional lenders will examine your whole financial condition, including your income, existing debt to other lenders, credit history, other assets (including cash reserves), and the size of your down payment.
These lenders go through this often time-consuming process to reduce the amount of risk they take on when lending money to a person. Lenders can give you better rates and overall more cheap loans by ensuring their consumers are creditworthy.
Hard money loan
The lender authorizes a borrower for a hard money loan depending on the value of the property being acquired. The lender may run a fast credit or financial check, but the process will be far less stringent than it would be with a typical loan. This speeds up the process, allowing borrowers to receive their funds in a matter of days rather than weeks or months.
Hard money loans are also known for their short repayment terms, which are generally only a few years. When compared to regular mortgages, which typically have durations of 15 or 30 years, this is a significant difference.
Hard money loan to value ratios
The loan to value (LTV) ratio is used by hard money lenders to estimate how much they may provide a borrower. The whole loan amount is divided by the value of the property used to secure the loan, yielding the LTV measure.
The LTV ratio is significant to investors and lenders because it allows them to mathematically communicate the loan’s strength.
The typical loan amount offered by hard money lenders is 65 percent to 75 percent of the value of the secured asset. As a result, if the loan is a mortgage loan, the borrower will be required to make a 25% to 35% down payment.
Using conservative loan-to-value ratios allows hard money lenders to feel pretty certain that if they need to foreclose, they will be able to resell the property for a profit rapidly – that is, for much more than they borrowed against it.
Borrower requirements for a hard money loan
Hard money lenders are mainly worried about the number of equity the borrower has put in the asset that will be utilized as security, as previously stated. They don’t care about the borrower’s credit score. If the applicant has the wealth to cover the interest on the loan, concerns on the consumer’s record such as a short sale or foreclosure can be excused.
The borrower’s plan for the property must also be considered by the hard money lender. The applicant must submit a credible repayment plan that demonstrates how they expect to repay the loan in the long run. This usually entails upgrading the property and then selling it or subsequently receiving long-term financing.
Hopefully, this article has given you enough information and confidence to explore taking out a hard money loan to finance one of your potential real estate transactions.
The increase in interest rates may appear frightening at first, but the advantages of getting a loan authorized swiftly and obtaining financing when all other banks have said “No” will far outweigh the additional cost.