What are Hard Money Loans and How Do They Work?
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Hard money loans can be a quick solution for financing or refinancing a real estate purchase when you can’t qualify for traditional financing or don’t have time for a lengthy mortgage application process. Despite the name, hard money can be easy to get — if you can make a big down payment and stomach higher interest rates and fees, that is.
If you have a need for mortgage speed, a hard money lender may be the answer, as long you understand the terms of the loan and know what to look for in the fine print.
In this guide to hard money loans, we’ll cover:
- What is a hard money loan?
- When should you use hard money loans?
- Are hard money loans a good idea?
- Where can I get a hard money loan?
- Final thoughts about hard money loans
What is a hard money loan?
Hard money loans are typically short-term loans used to purchase or refinance real estate for investment purposes. You may be able to purchase a primary residence using hard money, but due to regulatory changes, lenders prefer to make these high-cost loans on investment properties.
Hard money loans are most commonly given out by a local private investor or a group of investors who understands the real estate market and are looking for a high rate of return on their money. A high return for the lender means you’ll pay a higher rate for the loan, but you also won’t have to jump through as many hoops to get it.
In fact, for the most part, hard money lenders only look at the property, and they may not even request any income or credit information. They often conduct their own inspection of the home to make sure it’s something they’d be OK owning if the borrower defaulted on the loan.
Because hard money lenders don’t have to follow the same rules to verify that you can repay a hard money loan, you should pay extra attention to the terms. Make sure you aren’t agreeing to a loan that you can’t afford to pay back.
The “hard” in hard money has to do with the terms of the loan: Higher interest rates and fees may make the loan more difficult to repay and tough on your profit margin if you’re buying a property for a quick fix-and-flip. You’ll need a big down payment — in many cases 30% or more. Rates can easily rise into the double-digits and points (fees you pay to the lender) may range from 2% to 10%, depending on the size of your loan.
One of the other unpleasant features of hard money loans is that you’ll probably have to agree to pay a prepayment penalty or interest guarantee if you pay off the loan early. Institutional banks are most likely to charge a prepayment penalty, while private investors will call it an interest guarantee — either way, it means you’ll pay a percentage of your loan amount in a lump sum if you pay the loan off before a set time period.
When should you use hard money loans?
Hard money loans should be a last resort, as in the instance you don’t have the cash to purchase an investment property or aren’t able to meet the minimum requirements for standard investment property mortgage loans. Here are some of the most common reasons you might need a hard money loan:
- You’re buying a property that needs major repairs. House flipping investors can make good profits by finding distressed properties that were neglected due to foreclosure or poorly maintained by previous owners. In some cases, it may make more sense to completely demolish the existing home and build a new one.Buyers that need mortgages often are competing with all-cash buyers for these types of properties, and although a renovation loan might allow you to do the work, the time it takes to get approved may knock you out of the running if the seller wants cash quickly. A hard money loan can be funded quickly, giving you the competitive edge you may need to get your offer accepted.
- You’ve recently had credit problems. Sometimes life happens — a business fails, or major medical bills get out of hand to the point where a bankruptcy is the only way out. Hard money lenders are likely to lend money in those cases, even if your debt was just discharged recently.Unlike traditional lenders, hard money lenders don’t require a waiting period after major credit events, such as bankruptcy or foreclosure, before issuing a loan. If you have judgments or federal or state tax liens, you may simply have to provide paperwork to the lender to confirm the debt can’t be recorded against the home you are buying.
- You’re trying to compete against cash offers. If you’re trying to buy properties that are sold at foreclosure or property tax auctions, very often you need to have cash within a certain number of days to even compete against other offers. If you don’t have enough money on hand to shell out for the entire bidding price, a hard money loan is a fast cash alternative to any traditional type of loan. Again, because the loan is made based on the property, you won’t go through a lengthy underwriting process like you might with a traditional loan.
- You have a short-term need for the money. A hard money loan can satisfy short-term financial needs, such as providing cash to buy a house to fix up and flip, or acting as a bridge loan if you want to tap the equity in a current home to buy another one. Hard money lenders can be creative, with some providing financing on multiple properties if you don’t have enough equity in one property to cover what you need.Be careful though: Every property secured by a hard money loan gives the lender the right to foreclose if your investment plans don’t work out.
Are hard money loans a good idea?
Hard money loans may provide an easy path to fast cash to buy real estate. However, they also come with much higher costs, down payment requirements and terms that could increase your risk of default. Before you go down the hard money path, let’s review some of the advantages and disadvantages of financing a property with hard money.
- Collateral-based lending only. Collateral is the property that secures the loan. In simpler terms, it means the lender places the most weight on the property when determining if and how much to lend, rather than on an analysis of your income, assets or credit payment history.In most cases, hard money lenders review the condition of the property and assess how long it might take to sell in the event of foreclosure, or what it would take to renovate and rent it. If the property is acceptable, the lender will usually send you a terms sheet disclosing closing costs, the interest rate and any prepayment penalty.
- No or low credit and income standards. Hard money loans don’t require much of any documentation of income or credit. You may still need to fill out some sort of application to indicate the type of work you do, and you should be ready to answer any follow-up questions that can arise during the process. For hard money loans offered through mortgage brokers, you’ll follow an online application process similar to applying for a regular mortgage loan. Most hard money lenders will require a credit report, mostly to see if you have any type of lien, such as a state or federal tax lien that could be attached to the home plan to finance. They may charge you a rate based on your credit score as well, but the terms are typically negotiable.
- No requirements to verify assets for down payment or costs or reserves. Hard money lenders aren’t likely to ask where the money is coming from for your down payment or closing costs. As long as you can produce funds for the down payment and any costs the investor might charge, your loan will be funded.This is very different from investor loans offered by conventional lenders. With traditional lenders, you would have to provide bank statements and proof that all of the funds for your investment property are coming from you. This flexibility is especially beneficial if you are purchasing a property with funds from a variety of different sources.
- Quick cash. Hard money lenders aren’t bound by the same mandatory waiting periods required by federal law on regular mortgage loans. If the investor likes the property, and you can come up with the money for the down payment and other costs, you’ll be funded often in a matter of days.
- Payment may be interest-only. To offset the pain of double-digit interest rates, hard money lenders often allow you to make interest-only payments during the repayment period. If you choose the interest-only option, you won’t be paying any principal down, and your loan balance will stay the same.This can be a good option if you only plan to have the loan for a short period of time. Just keep in mind that when you sell the home, the loan balance will be the same as taking out the loan if under the interest-only payment option.
- They typically require a large down payment. Investors will want some extra skin in the game from you in the form of a higher down payment. You’ll need to wrangle up at least 30% in most cases or more, depending on your credit situation and the type of property you are buying.
- Closing costs may be high. You may have heard of “points” — fees paid directly the lender — that allow you to buy a better rate on a traditional mortgage. Paying discount points with a traditional mortgage can help you buy a lower interest rate, resulting in a significantly lower monthly payment. With hard money loans, points are usually charged by the investor to cover the expense of having money tied up in your property.
- Interest guarantees or prepayment penalties may apply. As mentioned above, investors want to maximize their return on investment, and they may do so by requiring you pay whatever rate they’re charging for at least six to 12 months. Prepayment penalties or guarantee fees will need to be paid whether you sell the property or refinance it within the prepayment period, so you’ll need to figure it into your net profit if you think you’ll be selling the property before the period expires.
- Normally not for primary residences. Most hard money lenders prefer to make loans on properties that are true investment properties. If you’re thinking about buying a primary residence and need hard money, make sure your loan officer knows upfront, so you don’t waste time pursuing a hard money loan with an investor that only finances investment property.
- More difficult appraisal process. There also may be a cumbersome home appraisal process that requires not just one, but two appraisals to make sure the property sales price is supported by at least two independent sources. Because lenders take more risks on credit profiles, they may want an extra opinion on the home’s value before they agreeing to lend hard money on it.
Where can I get a hard money loan?
Shopping for a hard money loan isn’t like shopping for a traditional mortgage. Hard money lenders may work with local officers to help them find a home for loans that don’t fit into the conventional, FHA or VA approval box.
Talk to local real estate agents and loan officers
Chances are good that local real estate agents or a locally owned mortgage company has a contact that you can reach out to for a hard money loan quote. Don’t be discouraged if the answer is no — hard money investors are usually loaning money every six to 12 months, so a turndown may be more about timing than about any issue the investor has with the property you are buying.
Locally owned mortgage brokers and mortgage banks usually have a contact for hard money loans, or they may have “almost hard money loan” programs. “Almost hard money” loan programs may work more like traditional mortgage loans, with income, credit and appraisal requirements. While they may give you flexibility to be approved even if you just completed a bankruptcy last week, they may have more stringent income or asset requirements.
A loan officer with some experience with alternative lending may be a good resource to guide you in the right direction.
Shop around for the best hard money rate
Unfortunately, there is no online marketplace for hard money lenders. They tend to invest in very localized markets. You may find a national lender that provides hard money type terms, but the process will be more involved, and may end up being very similar to a traditional loan, defeating the reason most borrowers seek out a hard money loan.
You can get an idea of what lenders offer hard money loans in your state by clicking here.
Final thoughts about hard money loans
Be wary of any hard money lender that requires a nonrefundable earnest money deposit or a fee that you don’t pay through an escrow company or attorney working on your behalf. Make sure you understand the terms of the loan, and don’t be afraid to walk away from something that doesn’t sound right.