If you’ve never invested in real estate, you likely haven't heard about hard money loans. But they can be very useful if you’re interested in buying properties.
Let's start with the basics:
What is a hard money loan?
A hard money loan is a loan backed by a "hard" asset -- a tangible property that produces a profit to repay the loan quickly. In contrast, a traditional mortgage is secured by the value of the home and backed by the borrower’s ability to repay the loan in monthly installments over 15 to 30 years.
Hard money loans are a form of private loans -- the funding is provided by private lenders, as opposed to government-regulated financial institutions. Hard money lenders essentially do what banks do: loan money.
The difference is in loan terms, the approval process, and the purpose of the loan.
Who uses hard money loans and why?
Hard money financing is used by real estate investors who need short-term funding for an investment deal. Good deals go fast and cash is king. If you have don’t have access to enough cash to fully fund the deal, your offer to purchase a property won’t be competitive.
Hard money loans are typically used for one of two short-term purposes:
- To finance fix-and-flip deals where the goal is to quickly get your money back and repay the loan.
- To bridge the gap between an investment property purchase and longer-term financing. Buy-and-hold rental property investors often use hard money to acquire and renovate a property and then refinance the debt with a traditional lender to pay off the hard money lender.
Hard money loans have become the go-to for house flippers who can't borrow money from a bank. It could be that their credit isn't great or because the deal doesn’t pass a traditional lender’s strict guidelines.
The borrower’s cost of hard money -- the interest rate and the loan origination fee -- is higher for these reasons. The rates are higher to compensate the lender for the increased risk of the deal.
How are hard money loans different from traditional loans?
There are several notable differences between hard money and more traditional loans:
- Hard money loans have terms of 6 to 18 months, while traditional loans are typically amortized over 30 years.
- Hard money loans usually carry an interest rate that's 4% to 10% higher than traditional loans.
- Hard money loans are intended for short-term investors, while traditional loans are for owner-occupied properties.
- Hard money loans are backed only by property as collateral, while traditional loans are backed by the property and the borrower’s personal credit.
It's important to keep these differences in mind when you're considering different ways of financing your real estate investment.
What hard money loans pay for
A hard money loan is a "rehab loan," which means it includes the cost of the property plus the cost of renovation. Lenders require that rehab cost estimates are provided by the contractor who will complete the renovation. And hard money lenders will typically only approve expenses that directly increase the value of the property (luxury items like an extravagant swimming pool wouldn't qualify).
How hard money loans are disbursed
Funds are distributed in predetermined disbursements or "draws" as needed by the contractor. The initial disbursement covers the property acquisition cost. Subsequent draws meet the needs of the renovation schedule. For example, there might be a draw to purchase materials and several draws over several weeks to pay for the labor.
How lenders approve borrowers for hard money loans
When applying for a bank mortgage, underwriters make sure you can afford the monthly payments. A property appraiser also needs to make sure the mortgage doesn’t exceed the value of the property. Traditional lenders issue mortgages for owner-occupied homes, not investment properties. And it takes 30 to 45 days for the loan to be underwritten by a review committee.
With a hard money loan, the lender is focused on the deal. Do the financials make sense? Are you buying at a discount? Did you budget appropriately for renovations? Have you accurately determined the after-repair value (ARV) to make sure you can sell the property for a profit and repay the loan on time? Typically, a hard money loan can get approved and funded in 7 to 14 days.
What are the typical hard money loan terms?
Hard money loan terms vary geographically and by lender, but you can expect an interest rate of 7% to 12% and a loan origination fee of 1% to 3%.
Here’s a hard money loan example. You want to buy a fixer-upper for $115,000 with renovation estimates of $25,000. You need to borrow $126,000 after putting 10% down. A hard money lender would likely charge you 2%, or $2,520, as a setup fee, plus 10% interest, or $6,300, over the life of the loan. Your total financing cost is $8,820.
You don’t need to have great credit or provide personal information to qualify, as the loan is backed by the property. But a hard money lender wants you to have some skin in the game -- typically at least 10% of your own money. That way the lender knows their interests are protected because you don’t want to lose your money.
Loan terms between hard money lenders are generally very competitive. Here are a couple purchase and rehab flip loan options recently published by IMN Direct Capital, LLC, a hard money lender providing real estate and unsecured funding solutions.
With a FICO score of at least 620, you can qualify for this loan:
- Up to 90% of an investment property purchase (with no rehab budget) OR up to 100% for a fix-and-flip (including property purchase and rehab budget).
- 6.99% to10% APR, based on your experience.
- 1.5% to 3% origination fee.
With a FICO score of 600 or more, you could get this one:
- Up to 75% of an investment property purchase (with no rehab budget) OR up to 100% for a fix-and-flip (includes property purchase and rehab budget).
- 7% to 10% APR, based on your experience.
- 1% to 3% origination fee.
- Can put up to 3 monthly payments in the loan.
There are other loans available, as well, including some for 100% of a purchase and some that are available to borrowers with lower credit scores.
Advantages and disadvantages of hard money loans
As with any loan, hard money options have both pros and cons. Here are some to consider:
The pros of hard money loans
- Lenders and borrowers can close quickly. This is important in a competitive marketplace, because you can get cash for hot deals without waiting for traditional financing approval.
- Loans are backed solely by property value. In many cases, you're not personally liable for loan repayment.
- Creditworthiness isn't a consideration for approval.
- Hard money loans require a lower loan-to-value ratio -- so you don't need the typical 20% down like you do with traditional investor financing.
- Can be useful as a bridge loan to fund the investment while securing longer-term financing.
The cons of hard money loans
- Higher interest rates than other forms of financing.
- Additional fees, such as 1% to 3% loan origination fees, are common.
- You must finish the rehab on time. If you run into unforeseen issues, this short-term financing becomes very expensive.
- The lender holds the property deed as loan collateral. If you can’t finish the rehab and repay the loan, you walk away with nothing.
- The lender will require builders risk insurance, which is much more expensive than the property and casualty insurance regularly required for mortgages
- Since the loan only includes the amount of money estimated by the contractor, it’s possible that it won’t be enough to complete the renovation if there are unforeseen expenses.
Are hard money loans legal?
In short, yes, hard money loans are legal.
If you visit a real estate investor meetup, you’ll notice hard money lenders have mixed reviews. The industry does seem tarnished by some predatory lenders who take advantage of newbie investors -- however, the majority of hard money lenders are legitimate businesses and investors looking for real estate projects to fund in exchange for a decent return on their money.
Like any lender, there are restrictions on the type of deal a hard money lender is interested in funding and it’s important to know what types of loans a hard money lender won't fund.
Are hard money loans a good idea?
With so many funding options for real estate investment deals, are hard money loans a good idea?
The answer has a lot to do with the hard money lender that you're considering. Look for these things in a lender:
- Extensive experience with the type of loan you’re seeking.
- Reasonable interest rates and fees. Hard money lenders aren't subject to the strict requirements that traditional financial institutions are held to, so conduct your due diligence. Compare interest rates and loan fees to be sure you’re getting competitive terms.
- Enough funding for your loan. I've heard stories of lenders who didn’t have the promised cash available for a scheduled draw. This is a big problem, as finishing on time is crucial for most investors.
- A good reputation. Check those online reviews. Ask other investors for recommendations and if there are lenders you should avoid.
If you can find a reputable lender with good terms, hard money loans can be a good idea. Just make sure you know what you're getting into and that you can repay the loan quickly after your fix-and-flip.
How to improve your chances of qualifying for a hard money loan
Like any loan, you'll need to apply and be approved for a hard money loan. While your credit score doesn’t qualify you for the money, a good one tells a hard money lender that you’re a lower risk.
Most hard money lenders require rehab and real estate experience. Providing proof of your qualifications as a successful real estate investor will help your chances of loan approval and put you in a better position to negotiate a favorable interest rate.
Another thing to remember: Like traditional lenders, hard money lenders require property insurance. But, in most cases, you’ll need a builders risk policy rather than the more affordable property and casualty insurance a traditional mortgage requires. It’s more expensive, has unique coverage, and not all insurance brokers offer it.
Are hard money loans worth it?
Real estate investing is an expensive endeavor. Properties are expensive assets to buy and sell and to get the best deals, you need ready access to a lot of cash. Hard money loans have been around for decades because they provide a great source of funding for shorter-term real estate ventures like fix-and-flip properties. Using hard money can give investors leverage to do bigger deals and using leverage wisely is key to building wealth.
Real estate investing is all about the numbers. The cost of a hard money loan or any other form of financing, if you don’t have buckets of cash sitting around, is just another cost that needs to be added into your calculations when determining if the deal will deliver the profit you need to meet your investing goals.