When Does a Hard Money Loan Make Sense?
In a traditional real estate loan, approval is typically contingent upon the personal repayment capacity of the individual(s) involved in the loan. To determine eligibility, a lender may review the borrower’s personal tax returns, W-2 income statements, and individual credit score as inputs in the loan approval decision. While this sort of analysis works for many traditional loan requests, there are certain types of loans where it may not be required. One of these types is known as a “hard money loan.”
In this article, we will review what a Hard Money Loan is, the pros and cons of obtaining one, and the situations where it may be a suitable alternative to a traditional mortgage loan. At Diversified Lending Solutions, we offer hard money loans to qualified borrowers. To learn more about our current lending programs, click here.
Let’s start with a definition.
What is a Hard Money Loan?
A Hard Money Loan is any loan that is obtained from a non-traditional or private lender. The word “hard” in the title refers to the fact that the value of the asset securing the loan – the “collateral” – has a greater bearing on the loan approval decision than the individual creditworthiness of the borrower(s).
The features of a hard money loan vary from one deal to another based on need, but they typically include the following:
- Loan Amount: Hard money loans can be as small as $75k for small residential investment properties, and $10 million or more for larger commercial properties.
- Term: Hard money loans also tend to have a relatively short term, usually in the 12-24 month range.
- Cost: Given the increased risk, hard money lenders typically charge a relatively high origination fee and it can be expected that hard money loans will have higher interest rates than a conventional loan.
- Collateral: The collateral used to secure the loan is a real estate investment property. If the borrower were to default on the loan, the lender would foreclose on the property and sell it to repay the loan balance.
- Loan to Value: Whereas a traditional bank may cap the loan to value (LTV) ratio around 80%, hard money loans are usually lower. The exact amount varies by lender, but it is likely closer to 60% or 65% LTV.
- Approval Process: Whereas a traditional loan may take 30 days or more to be approved, a hard money loan is much faster. In some cases, it could be approved in 1-2 days and funded shortly thereafter.
- Repayment: The monthly payments for a hard money loan will likely be interest only whereas a traditional mortgage usually requires principal and interest. However, this also means that the hard money loan may have a large balloon payment at the end of the loan term while a loan from a traditional lender could be fully amortizing.
Remember, these are just generalizations. The actual deal may differ from the parameters described above based on the needs of the borrower.
What Are The Pros and Cons Of Obtaining a Hard Money Loan?
Like anything, there are pros and cons to obtaining a hard money loan. Both are tied to the features described above.
The major benefit of a hard money loan is speed. They are approved and closed quickly, which provides borrowers with the capacity and certainty they need to get deals closed. Other benefits include:
- Approval Criteria: As a generalization, the approval criteria for a hard money loan are less stringent because the focus is on the collateral, not the individual borrower(s) income, credit history, and tax returns.
- Convenience: Because the lender is not looking at documents like tax returns, financial statements, and pay stubs, hard money loans are more convenient to apply for. The required documentation is less than a traditional loan, which makes it much easier on the borrower.
- Flexibility: Hard money loan proceeds can be used for a variety of costs including purchase and renovations. In addition, the structure of the loan can be tailored to the borrower’s needs.
But, these benefits should be balanced against the potential downsides to obtaining a hard money loan.
The major downside to a hard money loan is the cost. They are more expensive than a traditional loan in two ways. First, the interest rate is likely to be higher. In addition, the upfront fees including origination and closing costs are also likely to be higher than a traditional bank loan. Other potential downsides include:
- Term: Hard money facilities are short term loans. If the property or project is not complete by the time the term is up, extension/refinance options can be very expensive.
- Down Payment: During the underwriting phase, hard money lenders may cap the loan to value ratio at a relatively low level like 60% or 70%. This means that the borrower must make a sizable down payment on the property, which may limit their working capital for other uses (like improvements). Some hard money lenders will fund up to 100% of acquisition and construction costs, so long as the loan amount does not exceed 65-70% of the property’s ARV (“After Repair Value”). To learn more about DLS’ 100% Financing Program for residential fix and flip properties, Click Here.
- Foreclosure: Like a traditional loan, a hard money lender has the ability to foreclose on the property if a borrower Because hard money loans are particularly common with property rehab projects, it can be especially risky if a lender foreclosed on the property mid-project. Because they have to complete the renovations, this scenario presents additional risk for the lender, which is why hard money loan interest rates and fees are higher than traditional loans.
Given this set of pros and cons, the next most logical question for borrowers is, when does it make sense to obtain a hard money loan versus traditional financing?
When Does a Hard Money Loan Make Sense?
A hard money loan does not make sense for all borrowing scenarios, but there are two in particular where the benefits can outweigh the costs.
First, when traditional financing is not an option for whatever reason, a hard money loan can be a suitable alternative. For example, if a project involves a riskier property type like a hotel or restaurant, a hard money loan could be a useful “bridge loan” to purchase the property, rehab it, and lease it up to stabilization so that it can qualify for a traditional, permanent loan.
Or, a more common use case is a residential fix and flip transaction. In this case, real estate investors can use a hard money loan to purchase a home and fix it up. Once complete, the home is sold and the loan is repaid. If there is enough profit in the sales price, the higher interest rates charged can be justified and all parties can make money in the transaction.
Regardless of the use case, the more important point for real estate investors is this, it is critically important to understand the entire cost of a hard money loan (fees plus interest rate), the time frame involved, and the purchase price/value of the property that it will be used for. With this information, it is possible to compare the cost to a traditional loan to understand the most beneficial scenario.
Summary & Conclusion
A hard money loan is a type of loan that is obtained from a private lender, private investor, or other non-traditional financing company. While the specific terms can vary by deal, hard money loans are characterized by their short term, generous approval criteria, and high interest rates.
In real estate investing, there are pros and cons to obtaining a hard money loan to finance a project. On the pro side, these short term financing facilities offer quick approval, minimal paperwork, and a high degree of flexibility in what the funds can be used for. On the downside, hard money loans have high costs, low loan to value ratios, short terms, and the potential for foreclosure in the middle of a project in the event of default.
Even though they are more expensive, hard money loans are particularly useful in two scenarios. First, they can be used to finance a project that involves a traditionally high risk property type like a hotel or restaurant. Or, and this is more common, they are used by house flippers to finance the purchase and renovation of a property before a quick sale. If the potential profit in the transaction is sufficient, the higher costs can be justified.