Cash flow is considered the life's blood of business, and real estate investing is a business that is heavily dependent on cash flow. Between the cost of properties themselves and renovations to enhance the value of those properties, it takes money to make money in real estate.
What can a real estate investor do when the business is a little short on liquidity? In certain situations, hard money loans may be an answer - as long as the borrower fully understands the costs and consequences.
What is a Hard Money Loan?
A hard money loan is a broad term that generally describes a relatively short-term loan made at a high-interest rate. In business, this can take the form of what is sometimes known as bridge financing, which can help a business close the gap between the date when money is needed to make an investment and the date when the long-term funding for that investment becomes available.
The reality of a hard money loan is that they are frequently the best financing option when a bank loan is not available, despite their high cost. In a real estate context, hard money loans are secured by properties, but not generally by a property being purchased with the loan. For example, an investor who owns several properties might use one as collateral to take out a hard money loan to purchase another property.
Property Types for Hard Money Loans
Various types of property can be used to obtain a hard money loan, including single family residences, multifamily residential property, or commercial property. Hard money lenders look at this type of lending as a form of investment, so they may specialize in lending for a certain kind of property. Remember, the lender is interested in the property being used as collateral, not necessarily the property you intend to use the money for. So, look for lenders whose specialty matches the type of property you have to offer as collateral.
The one type of property you may find that hard money lenders shy away from is owner-occupied residential property. That's because this raises additional regulatory hurdles for lenders. Also, hard money lenders want easy access to the collateral if the borrower defaults, and this can be complicated in owner-occupied situations.
How Can You Use a Hard Money Loan?
When you think of how to use a hard money loan, think about short-term cash flow needs. For example, suppose you own multiple properties and have a sale pending on one. An attractive purchase opportunity comes up at an auction or there is another distressed sale situation, but your wealth is tied up in the properties you already own. You could use a hard money loan to buy the new property, and then pay off the loan when the sale you already had pending closes.
Alternatively, you could use a hard money loan to renovate a property to make it more attractive for sale. As long as you are confident that the property will move quickly once you have fixed it up, a hard money loan could give you the cash necessary to make the improvements that will lead to a more profitable sale.
Benefits and Drawbacks of Hard Money Loans
The chief benefit of hard money loans is their flexibility. They are not dependent on conventional mortgage regulations and underwriting standards, so they can be available quickly and in situations where you would not qualify for a conventional mortgage.
Of course, there is no free lunch, so that flexibility comes at a price. If you seek a hard money loan, be prepared for the following:
- Putting up a hefty amount of security. Forget about a ten or twenty percent down payment that you might use for a conventional purchase mortgage. Hard money lenders expect a certain amount of trouble with their loans and want to make sure they can bank a substantial amount of security should you default.
- Paying a high-interest rate. Hard money loan rates will likely be well above conventional mortgage or even personal loan interest rates.
- Having a short repayment period. Timing is often the trickiest aspect of managing cash flow, and while a hard money loan might give you some temporary relief, it won't last for long. One way that hard money lenders hedge their risk is by lending for short periods of time. These are loans typically written for months, not years.
Who Should Consider a Hard Money Loan?
So, a hard money loan may give you access to financing you could not otherwise obtain, but it comes at a steep price. Under the circumstances, who should consider a hard money loan?
These loans may be best suited to real estate investors who are experienced enough to be confident in the following:
- That their deal flow will allow repayment of the loan. This comes back to the matter of timing. A real estate investor using a hard money loan should know the market well enough to be sure that sale proceeds or another source of cash will become available in time to pay off the loan.
- That the opportunity can overcome a high payback hurdle. This means that the potential gain being made available by the loan is large enough to represent a substantial premium over the high-interest rate charged on the loan.
Alternatives to a Hard Money Loan
Before you resort to a hard money loan, it is worth seeing if you could qualify for a more cost-effective alternative. Property owners may find they can use their accumulated equity to obtain one of the following types of financing:
- A home equity loan. This is a mortgage using the equity in a property as collateral. You don't necessarily have to use the borrowed amount for the property that has been used to secure the loan, so this could be one way of borrowing money against one property to invest in another. Interest rates on a home equity loan would likely be considerably lower than on a hard money loan.
- A home equity line of credit. This is a form of home equity loan which lets you access the money when you need it, so you only pay interest when you are actually using the money. That type of flexible access to capital might be ideal for property investors.
- Cash-out refinancing. There are a variety of reasons to refinance a home, such as lowering your mortgage rate or adjusting the repayment term to better fit your needs. If you also need to get your hands on some cash, you can kill two birds with one stone by cash-out refinancing. This entails borrowing more than you currently owe on a property, to convert some of your accumulated equity into available capital. As with a home equity loan, a refinanced mortgage is likely to be cheaper than a hard money loan.
A hard money loan is a tool that represents financial flexibility at a high cost. It may not be the right tool for every investor or every situation, but success in business often demands knowledge of the full range of tools at your disposal and their specific advantages and disadvantages.