It can be difficult to get a traditional loan on an investment property because traditional banks are hesitant to lend money when a property is in such bad condition. Hard money loans are one way real estate investors can obtain financing. Here are the basics of the hard money and the pros and cons of this type of loan.
What Is Hard Money?
Hard money is an amount of money that is loaned from a borrower to a lender. The exact loan terms will vary based on the specific contract between borrower and lender.
The borrower receives the money, while the lender receives monthly interest on the loan until it is paid back in full. The lender will also often charge the borrower an up-front, one-time fee in order to process the loan.
A hard money loan is backed by the physical asset, which is the property being purchased. More traditional loans are based on the borrower’s credit score.
Where Can You Get a Hard Money Loan?
Who Needs It?
Real Estate Investors:
Hard money loans are common in real estate investing. Banks and other traditional lenders are not comfortable lending on risky investments. They prefer lending on stable investments which they feel are more likely to pay the loan back.
Therefore, real estate investors who need financing to purchase distressed property have limited options. Investors who want to do a gut rehab or a quick property flip commonly use hard money loans.
Other real estate investors, who may be purchasing income properties, may use a hard money loan initially until they can stabilize the property. Once the property is stable, these investors will secure a more traditional mortgage at a lower interest rate and pay off the higher interest hard money loan.
Hard money loans are also used by individuals with a poor credit score who are unable to get a mortgage from a bank. Despite the poor credit, they may still have enough equity in their property to have the hard money lender interested in making a loan. This scenario can be seen when an owner is facing foreclosure on a property.
Pros of Hard Money Loans
Here are four benefits of getting a hard money loan:
- Since you are working with one individual lender or a small group of lenders, there are fewer hoops to jump through. Hard money lenders are not interested in your credit score or how much debt you have. They are only interested in how much value they see in the property since the property is the asset that will be backing the loan.
- Depending on your lender, you could have your loan in a few days or a few weeks. It could take one to three months to secure a more traditional mortgage.
Can Borrow More:
- Traditional mortgages require you to put down a minimum of 5 percent of the purchase price. Banks prefer you to put down 20 percent of the purchase price, which will often give you better terms on the loan. If you put down less than 20 percent, you will often have to purchase mortgage insurance, which will increase your monthly mortgage payment.
- With a hard money loan, the lender may be willing to lend you 100 percent of the purchase price. Without a down payment, you would only be responsible for paying the origination fee and the monthly interest until you pay the loan off in full.
- If you have shown a history of honoring the terms of the contract and paying your loan back on time, or even early, the lender will likely want to work with you in the future. The lender may be willing to loan a greater percentage of the purchase price, reduce the origination fee or reduce the amount of time it would take to receive the loan.
Good When Starting Out:
- When you are just starting out, hard money loans allow you to purchase property with very little money of your own. Once you have established yourself as an investor, you may be able to secure a line of credit from a bank instead of using a hard money loan, which will have a much lower interest rate.
Hard money loans process quickly and can be for as much as 100% of the purchase price.
Cons of Hard Money Loans
While there are benefits to obtaining a hard money loan, here are 4 risks you must also consider:
- Hard money loans have much higher interest rates than traditional loans. Lenders are able to charge these rates because they know the borrowers have few options for financing. Interest rates between 10 percent and 20 percent are common.
- Since the lender is also taking a risk by loaning so much money, they want to make sure you have an incentive to pay it back quickly.
High Origination Fee:
- An origination fee is a fee the lender will charge to process the loan. It is a percentage of the loan.
- Again, this is a riskier investment, so the hard money lender is trying to protect themselves. A lender may charge as much as five times the amount of a normal lender. For example, if a typical bank charges one percent of the total loan as an origination fee, a hard money lender could charge five percent of the total loan.
Not Long Term:
- While it is common to have a 15-year mortgage or a 30-year mortgage, this is not the case with hard money loans. While every contract is different, these loans often have to be paid back within a few months or a few years. If the loan is not paid back within the first few months or year, the already high-interest rate could increase.
Losing the Property:
- Since the physical property is the guarantor of the loan, not you personally, if you cannot pay off the loan, you will lose the property.
Hard money loans have high interest rates, origination fees and are usually short term.