The Complete Guide to Hard Money Loans
Life would be much simpler if everyone could easily fit into a standard, one-size-fits-all mortgage. Unfortunately, that’s not the case. Sometimes people need money ASAP for a real estate purchase. Some people aren’t able to qualify for a conventional mortgage.
Hard money loans are one solution for many of these outside-the-box mortgage problems. But are they right for you? And if not, what are some better options? Read on, and we’ll show you everything you need to know to make an informed decision.
Part I: Understanding Hard Money Loans
A hard money loan is a type of real estate loan. Hard money loans are made based off the value of your collateral (i.e., the property itself) rather than your ability to repay.
There are different kinds of hard money loans, including:
- Bridge loan. Bridge loans are intended to allow someone to buy a property quickly with the goal of reselling or refinancing it. Alternatively, they can allow someone to buy a new property now, before they get enough cash for a down payment from the sale of a currently owned property.
- Fix-and-flip loan. These loans allow someone to buy a rehab property and fix it up quickly so it can be resold and the loan paid off.
- Owner-occupied loan. These loans allow consumers who don’t qualify for other types of financing to purchase a property for themselves.
- Construction loan. These loans allow a real estate developer to quickly get started on a new construction project, with the goal of refinancing or selling it quickly.
- And more … Hard money lenders are private individuals and firms that consider loans on a case-by-case basis and are often open to lending money for different purposes.
How do hard money loans work?
Hard money loans aren’t available to everyone. Most lenders won’t give out hard loans for noninvestment purposes, meaning that if you’re banking on hard money loans to fund your own private home, you could be out of luck. Some lenders will make hard money loans to consumers; however, this opens a whole new can of regulatory worms, says Don Hensel, a California-based hard money lender with North Coast Financial, Inc.
Hard money loans are only given for a short period of time, usually less than a few years, and, according to the North Coast hard money FAQ, typically for a 12-month term. Rather than making equal payments each month toward principal and interest, however, most hard money loans will only require you to make interest-only payments, or possibly even no payments at all.
Hard money loans carry several perks that hold specific appeal to real estate investors: quick financing (sometimes within a week or less); short loan term lengths (often one year or less to accommodate quick turnaround times); and an easy hassle-free application process.
Commonly, you must come to the table with some of your own money. Each lender will require a certain amount of cash based on the Loan-To-Value (LTV) ratio, or the After-Repair-Value (ARV) ratio of the property. For example, if a lender will give a maximum loan based on an 80 percent LTV ratio and you want to buy a $100,000 house, you’ll need to come up with a minimum of $20,000 of your own cash first.
So, how is the loan paid off? In one giant fell swoop at the end, with a balloon payment. This will cover the entire principal of the loan, any remaining interest and any fees tacked on from the beginning of the loan. It’s when you settle your balance.
Hard money loans versus traditional bank loans
Hard money and traditional bank loans are as different as night and day. Sure, they’re both tools for buying property, but that’s where the similarities end.
Hard money loans are given out by private individuals or organizations. They carry wildly different terms than traditional bank loans, such as a super-short repayment period and high interest rates. But, compared with conventional loans, they are easy to apply for and easy to be approved for. The underwriting standards for consumer hard money loans are similar to more traditional mortgages. However, hard money lenders are likely to be much more forgiving of bad credit, recent foreclosures or bankruptcies, or other situations that might preclude you from getting a traditional mortgage. Of primary concern to the hard money lender is the the value of the real estate that will serve as collateral for the loan and the loan to value ratio, while regular banks focus more on the borrower’s credit rating and income.
Of course, if you’re using a hard money loan to purchase your own home, lenders must now abide by Dodd-Frank regulations, which do require them to verify a borrower’s ability to repay a loan. “We have to analyze the person’s income and expenses and make sure that that debt-to-income ratio isn’t too high,” says Hensel.
Additionally, if lenders loan to private individuals (as opposed to businesses), they are now required to undergo certain licensing requirements with the National Multistate Licensing System & Registry.
“That requires both federal test and licensing, and a state test, so it’s a fairly expensive process to get that license. I think that’s probably a significant reason why, at least in California I think, probably 90 percent of the private money lenders do not do owner-occupied consumer loans,” says Hensel.
Part II: Should You Use a Hard Money Loan?
Benefits of hard money loans
In a way, the “hard” in hard money is a misnomer. These loan types actually provide a lot of simple, straightforward benefits for real estate investors:
- Quick money. Rather than spending weeks and months filling out forms and calling everyone and their uncle, a real estate investor can apply and get funding within a week or less, in some cases.
- Lenient requirements. Regular mortgages require a certain standard of income, debt and credit scores. Hard money lenders may check these things, too (and are legally required to for consumer loans), but generally they’re more interested in the collateral used for the loan. If you have the property, they will come.
- Flexible terms. Because you’re working with private individuals and firms and not massive cookie-cutter banks, lenders are much more likely to create custom loans that work for your situation.
- Increased investment opportunities. Having access to large amounts of fast, flexible cash can mean the difference between snagging a good real estate investment deal and missing out. Indeed, that kind of access can make or break a successful real estate investor.
Pitfalls of hard money loans
Although hard money loans can provide a lot of value, they also come with some distinct downsides:
- High interest rates. Interest rates for hard money loans regularly float into the double-digits. Just as a comparison, if you took out a $100,000 30-year mortgage at 7% APR, you’d pay $77,854 more in interest charges than a conventional mortgage with a 3.5% APR interest rate over the life of the loan.However, most hard money loans are typically made for 1-3 years, and very rarely are paid off over a 30-year term.
- Lack of oversight. Compared with traditional consumer mortgages, there is very little government oversight of hard money loans, especially for business purposes. This is why it’s important to know what you’re doing before you get into one — it’s easy to fall prey to an unscrupulous lender.
- High fees. In addition to the high interest rates you’ll pay, many lenders also charge an array of fees such as origination fees, underwriting fees, construction draw fees, or early-payment penalties.
- Short terms. These loans come with short payback periods — often as short as a year or two. You’ll either need to sell the investment property before the loan is due, apply for an extension or refinance into a more traditional mortgage. Alternatively, some lenders will allow you to pay off your hard money loan over 30 years, but they may bump up the interest rate you pay, as a consequence.
- Refinancing red tape. Some traditional mortgage lenders require a “seasoning” period where you need to have owned the property for a certain minimum length of time before they’ll let you refinance. This can wreak havoc with your plans if your hard money loan comes due before you’re able to refinance your loan.
When to consider a hard money loan
Hard money loans are primarily used as business investment tools by real estate investors. They’re particularly handy in a few different situations:
- You can’t get financing elsewhere. Funding a real estate investment can be a tricky business. Traditional mortgages can be difficult to get under even normal circumstances, and many banks are leery of making loans for investments, as opposed to loans for someone’s primary residence.
- You have a poor credit score. Hard money loans are typically based off the collateral of the investment (i.e., the property), not a business’s ability to repay. (Note: For loans made to consumers and not businesses, lenders are required to verify your ability to repay the loan.) That means if you have a poor credit score and can’t get a traditional mortgage, you might be more likely to be approved for a hard money loan.
- You need money fast. Hard money loans can get you the money you need sooner than you would with a traditional loan. This is especially helpful in real estate markets that are moving very quickly. You might miss out on every investment opportunity if you have to wait weeks or months for the cash to make it to your bank account, as is typical with a traditional loan.
When to avoid hard money loans
Even though hard money loans can open a lot of doors, they can shut just as many. Here are a few situations in which you should avoid them:
- You are in a buyer’s market. If you plan to sell the home after fixing it up and homes just aren’t selling very fast in your current market, you could be setting yourself up for failure. If your hard money loan comes due before you’re able to sell it, you’ll either need to refinance it or be foreclosed upon by the lender.
- You don’t have a good refinancing plan in place. Unless you sell the home before the hard money loan comes due, you’ll need to refinance the loan. You should already have a plan in place for refinancing and know what the requirements are. Some programs, like certain ones for Freddie Mac loans, require that you live in the home yourself for a certain period of time before you’re eligible to refinance.
- When you have other options available. Hard money loans are expensive and can border on being predatory with some lenders. They should only be used as a last resort, and only by people who know what they’re doing. Make sure you fully investigate all of your alternatives.
Part III: How to Get a Hard Money Loan
If you’re looking for a hard money loan, there’s good news: Because the hard money loan industry operates mostly through private institutions and individuals with less regulation than you’ll find for traditional mortgages, there’s a lot of variability in what lenders are looking for.
If you’re using your new property purchase as collateral for the loan, this will be the biggest factor lenders are interested in. What is it worth now? If you’re doing a fix-and-flip, what will the after-repair value (ARV) be? Most lenders will want a full appraisal on the property.
Most lenders will also want to look at your financial situation,though the collateral property is the biggest factor in their lending decision. Even though many lenders won’t consider your credit score when making a lending decision, some will. Most lenders will also expect you to put at least some sort of down payment. Some will expect this down payment to be a percentage of the current value, while others may expect a down payment based on the ARV. If that’s the case, you’ll need a larger down payment, since the ARV will be greater than the current value (well, hopefully).
Keep in mind that each lender is different and may require you to meet other standards. The only way to know for sure is to visit a given lender’s website and ask directly.
Typical interest rates on hard money loans
If you thought credit card debt was bad, trying having credit-card-level interest rates on an entire mortgage. That’s basically what hard money loans charge, anywhere from 5.4% APR up to 15% APR or even more.
The saving grace of these high interest rates is that they’re only charged for a short period of time. This is in contrast with credit card companies that will let you pay off those high charges for years or even decades.
Let’s look at an example. Say you took out a $100,000 hard money loan with a 15 percent APR and only paid interest payments for a year until the loan was due. That’s a $1,250 monthly interest payment for 11 months, and at the end, you’d have to make one single payment of $101,250. And that’s assuming you haven’t even had to pay any points (i.e., origination fees).
Fees are another factor to consider when shopping for hard money loans. Many lenders will charge an origination fee of around two to four points (i.e., 2 to 4 percent). Some lenders may have a prepayment penalty fee, an underwriting fee, or other hidden fees. Keep an eye out for these as you shop around because they will affect your bottom line.
Where to find reputable hard money lenders
The best way to find hard money lenders is by asking other local real estate investors in your area. Word travels fast in the real estate investor community, and they’ll be able to point out the good hard money lenders and steer you away from the bad ones. See if you have a local real estate investing group that meets regularly, or visit the massive online community at blogs like Bigger Pockets.
Bigger Pockets also has an extensive directory of hard money lenders. And, of course, there’s Google.
Once you’ve narrowed down your list of potential lenders, it’s time to do some background research on each company. See if there are any complaints listed against them in the Better Business Bureau. Read reviews online. Ask people in your real estate investor network whether they know anything about them.
It’s important to get as much information as you can about the reputation and reliability of the company at this point. There are lots of good, honest hard money lenders out there, but because this industry is loosely regulated, there are also some shady lenders. It’s up to you to sort the wheat from the chaff.
Questions to ask your hard money lender
After you’ve done your background research on the hard money lenders available in your area and have narrowed the list down to just a few potential choices, it’s time to talk to them. Here are some questions you can ask to help you make an informed decision:
- Do you lend for owner-occupied properties? If you’re hoping to use a hard money loan to buy your own primary residence, this will be the first question you need to ask. Most hard money lenders won’t, but a few will.
- How is the loan repaid? Are you expected to make interest-only payments during the term? No payments? Will the full balance be due at the end in one balloon payment? Knowing how the loan will be repaid — and being able to meet those payments — is the most important factor of all.
- What is the interest rate of the loan? Not all lenders publicly advertise the interest rate of their hard money loans on their website. If not, ask them. This will help you choose the cheapest loan that will work for you, while avoiding the potential for hundreds or thousands of dollars in interest payments.
- What are the fees on the loan? Again, not all lenders publicly advertise all of the fees. Make sure to get a full list from each lender you’re considering.
- What is your experience in hard money lending? You probably don’t want to be someone’s first go-around in hard money lending, especially if you are new at it yourself. Good, experienced hard money lenders can be more than just a source of quick cash. They can be an asset that can help you navigate any speed bumps in the process.
- What is your real estate broker license ID? Hard money lenders must be licensed by the state to give out these loans. Which is to say: You can’t get one from Joe Hardmoneybags down the street. Look them up through your state’s real estate bureau to make sure they’re properly licensed before you trust them.
Beware of loan sharks
It’s rare, but it’s possible you might come across a loan shark while you’re wading around in the sea of hard money lenders. These loan sharks can make your life a living nightmare as interest charges pile up in between threatening phone calls and even physical assault. Spotting these loan sharks early and avoiding them will help ensure your real estate venture is as successful as possible.
First, look at the interest rates of the loan. The classic sign of a loan shark is that this predator won’t disclose the interest rate, or it’ll be above your state’s usury limit. Usury just refers to an illegally high interest rate, and loan sharks are betting that you won’t put in the work to find out what those limits are. But, don’t fret: You can find your state’s usury limits here.
Also make sure that your hard money lender is licensed. That doesn’t prevent him/her from being a loan shark, but it will weed out lenders operating illegally. Check with your state’s real estate bureau to see they are properly licensed, and if you’ll be taking out a loan for your own residence, check the Nationwide Multistate Licensing System and Registry.
Loan sharks know that you want your cash quickly and easily if you’re in the market for a hard money loan. That’s why another hallmark of loan sharks is that they offer little or no paperwork. This isn’t the time for “pinky promises.” Make sure that you have a signed contract before you accept the money.
Finally, the best way to guard against loan sharks is to always have your loan contract looked over by a real estate attorney. This will not only protect you from illegal hard money lenders, it will also tell you if the terms of your loan are fair or not. This may cost you some cash, but it’s a small price to pay for your long-term security.
Part IV: Alternatives to Hard Money Loans
Home equity loan
A home equity loan is a loan taken out against the amount of equity you have in your home (i.e., the difference between what your home is worth and what you still owe on it). Because of this, you already need to own real estate — either another investment property, or your own home. You can use this money for a down payment on a second property. Or, if you have enough equity, you may be able to buy the second property outright with the money from your home equity loan.
Home equity line of credit (HELOC)
A HELOC is similar to a home equity loan except that rather than receiving all of the money at once, you have access to a line of credit where you can withdraw money as you need it. As with home equity loans, this will only be available if you already have equity built up in other real estate. This is also a good choice for those looking for a down payment or to outright buy a second property.
A cash-out refinance works like a regular mortgage refinance. However, rather than refinancing for the remaining amount of the mortgage, you can elect to take out a larger loan so that the difference will be paid to you in cash. It’s like resetting your mortgage clock, with that extra equity being re-lent back out to you. Again, you need equity built up in already-owned properties to use this type of financing option, and most people will use it to fund a down payment or the entire purchase of a second property.
Business line of credit
Rather than having a specific loan for a specific property, a business line of credit can allow you to withdraw money whenever you need it to make a real estate purchase. These investor tools are available from banks and other institutions and typically require a lot of up-front work to set up. You need to be able to prove to the institution that you have a good credit score, are responsible with money, and already have a track record as a competent real estate investor.
Some banks offer bridge loans that are very similar to a hard money bridge loan. They’re designed to give you cash in between the buying of one property and the selling of another. When given out by banks, they typically still have high credit requirements, however they’ll probably charge better interest rates than you’re apt to find with a hard money lender.
If you have certain affiliations with the military, you might be eligible for a VA (Veteran’s Administration) loan to buy your own house (but not investment property). These loans are highly advantageous because they require no down payment and, unlike other mortgages, they don’t require you to pay PMI (Private Mortgage Insurance) if you put less than 20 percent down.
FHA (Federal Housing Authority) loans are designed to make homeownership more affordable to more Americans. You can qualify for an FHA loan for your primary residence with a credit score of as little as 500 and a down payment of as little as 3.5%. However, these mortgages often come with an up-front and/or monthly mortgage insurance, which can make the loan more expensive over the long term.
PART V: FAQs
Do loans for someone’s primary residence have a balloon payment?
No. Loans made to consumers (i.e., not businesses) are subject to additional regulations under the Dodd-Frank Act. One of these regulations bans lenders from charging balloon payments. In these cases, most lenders will write a typical 30-year mortgage with equal monthly payments going toward interest and principal, rather than the typical interest-only payments followed by a large balloon payment. Keep in mind, you’ll still be paying super-high interest rates on this loan for those 30 years if you don’t refinance the loan.
Why do hard money loans have such high interest rates?
Hard money loans are riskier to make simply because the loan isn’t guaranteed to be paid back with income. If you default on the loan, the lender will get the property, sure, but that comes with its own costs and hassles, as the lender has to go through the legal process of acquiring and selling it.
Secondly, hard money lenders charge high rates simply because they can. People are willing to pay these high interest rates for the advantages these loans offer (ease of approval, quick financing).
How do I pay off the large balloon payment at the end of the loan?
Hard money lenders don’t expect you to be able to accumulate the cash to pay off the loan when it comes due through rental fees or other steady income alone. They expect you to have a plan to pay it off.
Some lenders offer the option to extend the loan (at a price, of course). But generally, you’ll either need to sell the property or refinance the loan with a more traditional mortgage. That’s why it’s important to know your exit options before you take out the loan. Know which refinancing programs you’re going to apply for and what their requirements are (if you’re going that route), or have a backup plan in case you can’t sell the property before the note comes due.
What if I’m unable to make the final balloon payment?
Try to talk to your lender and explain the situation. Keep in mind, though, you did agree to pay the loan back. If you’re unable to do so when it’s due, the lender has every legal right to foreclose on the property.
What do I do if I think I am a victim of predatory hard money lending?
You can file a complaint with the Consumer Financial Protection Bureau, who will help you work to resolve the conflict with the company. You can also file a complaint through your state’s consumer protection agency.
Additionally, if you think the lending terms are illegal, you can bring your case to a real estate lawyer. He or she will be able to assess whether any true fishy business is going on, and potentially help you take your case to court.
What kinds of real estate can I use hard money loans to buy?
You can find hard money lenders willing to lend on all types of property, including single- and multifamily residences, commercial property and land. You can get a hard money loan for a ready-to-sell property, or, more commonly, get a rehab loan that allows you to quickly fix up the property and sell it for a profit even after factoring the high cost of the loan into the equation.
Hard money loans are not often made available to people for their primary residence, however it is possible to find such lenders.
Do I need to have a property picked out before I apply for a loan?
Yes. Hard money lenders generally base their lending decision on the property you’d like to buy. Alternatively, some lenders will give you a hard money loan using property you already own as collateral.
Can I take out a hard money loan for the purchase price and repair and remodeling costs?
It’s common to take out hard money loans to fix a property up and sell it. The labor and materials for a fix-and-flip cost money, too, and there are a few different ways hard money lenders handle this.
Some companies will lend you a percentage of the after-repair value (ARV) of the property, meaning that you can get the funds to start fixing the property right away. Other hard money lenders will allow you to finance the property and repair costs separately. Each time you need to withdraw some money for repair costs, you submit some paperwork with an estimate of the cost and receive the cash in the form of a construction draw.
Are hard money loans only available to LLCs or other formal business structures?
Many hard money lenders will only give out loans to formal business structures such as an LLC, rather than to an individual. However, there are always exceptions — it’ll just be harder to find a lender. Besides, if you’re serious about real estate investing, it’s always a good idea to form a formal business entity separate from yourself.
What inspections do hard money lenders require?
Most hard money lenders base the size of the loan on how much the property you want to buy is worth, so it’s important for them to get an accurate, independent appraisal. Depending on the lender, you may also need a home inspection and a survey done before you’ll be approved for a loan.
Do I need to show the hard money lender how I plan to pay off the loan?
Generally, hard money lenders will require you to have a plan in place to pay off the loan when it comes due before they’ll give you the loan. Even if they don’t, you should have a plan, not to mention a backup plan.
Who is in charge of regulating hard money loans?
Hard money loans for business purposes are regulated on a state-by-state basis through each state’s real estate bureau. That means there are no overarching federal regulations guiding the industry.
Disclaimer: This article may contain links to MagnifyMoney, which is a subsidiary of LendingTree.