Hard Money Loans: What To Watch Out For
Molly Grace5-minute read
January 03, 2022
If the phrase “hard money loan” makes you think of quick and easy business deals that end in “cold, hard cash,” you’re not too far off the mark. However, just because this type of loan offers fast financing doesn’t mean it’s a good, safe option for everyone.
What are hard money loans and are they something to be wary of? Let’s take a look.
What Is A Hard Money Loan?
A hard money loan is a short-term, non-conforming loan that does not come from traditional lenders, but rather individuals or private companies that accept property or an asset as collateral. Borrowers may turn to hard money loans after a loan or mortgage application is denied, or to avoid the lengthy process of getting approved for a loan through traditional means.
Like a traditional mortgage, a hard money loan is a secured loan, guaranteed by the property it is being used to purchase. The “hard” part of “hard money” refers to the tangible asset being used to back the value of the loan. When a person defaults on a secured loan, the lender can take over ownership of the asset to recoup its losses.
Unlike traditional mortgages or other types of secured loans, hard money loans come with a fast and typically less stringent approval process, making them ideal if you need to make the purchase happen fairly quickly.
With a mortgage, it often takes more than a month, from application to close, to purchase a property. With hard money loans, it’s possible to close in just a few days.
Hard Money Lenders: What To Know About Working With Them
How Does A Hard Money Loan Work?
Let’s take a look at how hard money loans work compared to more traditional forms of financing.
Though not a formally defined category, in this context “traditional” refers to loans that are taken out through a process most people are familiar with: you apply for a loan, the lender checks your credit and ensures you have the ability to repay them and, if they determine that your finances meet their standards, you’re approved for the loan.
There are many different types of loans that fall under this umbrella, including mortgage loans, auto loans, personal loans or home equity loans. Though it’s usually possible to get these types of loans from private lenders that don’t have the same requirements that traditional lenders do, these private loans can be more expensive and less advantageous for borrowers because the risk is much higher.
Traditional lenders will take a thorough look at your entire financial situation, including your income, the amount of debt you currently owe to other lenders, your credit history, your other assets (including cash reserves) and the size of your down payment.
These lenders go through this sometimes lengthy process to minimize the amount of risk they take on when they lend money to an individual. By ensuring their borrowers are creditworthy, lenders can offer better rates and overall more affordable financing.
Hard Money Loan
With hard money loans, the lender approves a borrower based on the value of the property being purchased.
The lender may do a quick check of your credit or finances, but in general, the process will be much less rigorous than it is with a traditional loan. This allows the process to happen more quickly, so borrowers can get their money in a matter of days as opposed to weeks or even months.
The downside of this process is that the lender takes on significantly more risk, which translates to a more expensive loan for the borrower. Hard money loans typically come with high interest rates, and lenders might require larger-than-average down payments (though this isn’t always the case).
Hard money loans also tend to have short repayment periods – often just a few years. Compare this to traditional mortgages, which commonly come with 15- or 30-year terms.
What Are Hard Money Loans Used For?
Here are some common reasons individuals seek out hard money loans.
Flipping A House
Real estate investors who make money by purchasing low-cost properties in need of fixing up, making value-boosting repairs and renovations and then flipping the homes for profit may utilize hard money loans.
Because these projects typically happen fairly quickly, professional flippers often prefer faster forms of financing. Additionally, because house flippers generally try to sell the home within a short period of time – typically less than a year – they don’t need a lengthy loan term like you’d get with a traditional mortgage.
Purchasing Investment Property
Individuals who want to invest in rental property but don’t qualify for traditional financing might seek out a hard money loan to pay for their investment.
This method can be useful for those who either can’t get approved for a traditional loan due to their credit history or those who need more money than what a traditional lender will let them borrow.
Purchasing Commercial Property
Similarly, a business owner might use a hard money loan to fund the purchase of commercial real estate if they’re unable to secure traditional financing. Hard money loans can be useful for entrepreneurs purchasing a unique property that doesn’t qualify for conventional financing or those who find traditional commercial loan limits to be insufficient for their needs.
Hard Money Loan Rates: What To Expect
As we’ve said, hard money loans are expensive. Just how expensive are they? Let’s compare interest rates on these loans to more traditional loan types.
In September 2021, the average rate on a conventional 30-year fixed-rate mortgage was 3.01%, according to Freddie Mac. By contrast, hard money loans can have interest rates that are much higher, often 8 – 15%.
Hard money loans can also be more expensive depending on the preferred loan-to-value (LTV) ratio of the lender. If a lender will only finance 70 – 80% (or less) of the property’s value, you’ll likely have to bring a sizeable down payment to the closing table. If you don’t have the cash available to do this, you might have a hard time finding a hard money lender who will work with you.
Pros And Cons Of Hard Money Loans
As we’ve discussed, some of the pros of using a hard money loan include:
- Faster approval process
- Approval based on property, not credit history
- More flexible
Some of the drawbacks of hard money loans include:
- High interest rates
- Often require large down payments
- Shorter terms give you less time to repay
- Riskier than traditional financing
- May need to have proven track record of successful house flips
The Bottom Line: Hard Money Can Be Riskier
Hard money loans can be a useful tool for those in need of financing through less traditional routes. However, they come with high rates and a significant amount of risk if your investment isn’t as successful as you’d hoped. In general, these types of loans are best left to the pros.
If you’re looking for alternative financing because your mortgage application has been denied, it’s a much safer bet to look into other options, such as working on rebuilding your credit or applying for a mortgage program that accepts those with less-than-stellar credit histories, such as the FHA loan program.
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