What is a Hard Money Loan?

A hard money loan is kind of like a bet...

If you take out a hard money loan, you’re usually betting that you’ll be able to fix up a property well enough that you’ll pay back the loan and make a profit once you flip the house and sell it. If you don’t earn as much as you thought you would, you may end up losing money even after you sell the house.

A hard money loan is a type of loan that is often used by borrowers with poor credit histories or home flippers looking to quickly buy a house, fix it up, and sell it for a profit. Getting approved for a hard money loan comes with less strict requirements and moves much faster than that of a traditional mortgage. This makes it well-suited for short-term, time-sensitive real estate purchases.

Hard money loans are similar to mortgages in that they’re secured with collateral in the form of real property. That means that if the borrower doesn’t pay back their loan on time, the lender can likely sell the house to try to recover their money — But the similarities end there.

Traditional lenders (like banks and other financial institutions) evaluate loan applicants based on their financial stability and creditworthiness. They look at factors like their credit score, credit history, income, and debt-to-income ratio.

Hard money lenders, on the other hand, don’t generally care about an applicant’s creditworthiness or income, although they do factor it in slightly.

Hard money lenders provide fast, short-term loans to real estate investors and borrowers with poor credit histories.

These lenders mainly care about two things: the value of the property used as collateral and the borrower’s track record in real estate investing. Theoretically, a loan applicant could have millions of dollars in debt, no income, and a credit score of zero, and still be approved for a hard money loan. In other words, hard money loans are secured with equity, not creditworthiness.

This type of financing is typically only given for commercial investment properties as there’s a lot of red tape for hard money loans for residential properties due to the Dodd-Frank Act. However, while hard money loans are usually used by real estate investors, they are sometimes used as a sort of “last resort” loan by regular borrowers who can’t get approved for a traditional loan.

For example, if a borrower’s credit score was wrecked by a divorce, or a self-employed homebuyer’s tax returns don’t reflect their true income thanks to their many write-offs, hard money loans may be the only way for them to secure a loan.

Hard money loans typically have higher interest rates, which is why they’re preferred for short-term real estate investments, not for mortgages. Higher interest rates aren’t as significant of a problem for a period of a year as they are for a period of 15 or 30 years (typical mortgage terms). Sometimes, hard money loans are referred to as bridge loans because they bridge a short-term gap in cash flow or capital.

As of 2019, interest rates on hard money loans ranged from 7.5% to 15%. For comparison, the interest rate on a traditional mortgage ranges from 3.13% to 7.84%.

To get a hard money loan, interested borrowers need to bypass traditional lenders and go straight to private money. Hard money loans almost always come from private investors who are not bound to the same strict regulations that banks and other lending institutions are.

Consequently, these lenders are able to shorten the lengthy underwriting process and grant loans within just a couple days. They can also offer loans to borrowers who aren’t qualified for a traditional loan.

Instead of assessing loan applicants on creditworthiness, hard money lenders focus on whether or not a piece of real property will serve as sufficient collateral. These types of loans are riskier for lenders, so they usually come with significantly higher interest rates. However, hard money loans are usually short-term loans, lasting just a few weeks to a few years, so the higher interest rates won’t be as detrimental to a borrower as the same rate on a traditional 30-year mortgage would be.

To take out a hard money loan, borrowers typically need to pay a down payment of 20% to 30% of the property’s value upfront, sometimes more. However, some lenders let seasoned investors with a successful track record take out loans with no down payment. But be careful of any hard money lenders that specifically advertise no-down-payment loans — These lenders are often predatory.

Many hard money lenders also charge a loan origination fee (an upfront fee to process the loan) of 1% to 10% of the loan’s total amount.

Lenders then determine the amount they’re willing to lend to the borrower based on the property’s loan-to-value (LTV) ratio — That’s the value of the loan divided by the value of the property.

Usually, hard money lenders offer loan-to-value ratios of 50% to 70%. So, if you want to purchase a property for $100,000, you can typically expect a hard money loan for no more than $50,000 to $70,000.

Sometimes, lenders base the loan amount on the after-repair value (ARV) — That’s the estimated value of the property after a home flipper has fixed it up. Some hard money lenders will even finance the cost of repairs.

Once a borrower has a loan, they need to make monthly payments toward the principal and interest. When the property is finally paid off, the loan is over. If a borrower pays off the full amount of the loan earlier than the set term, they may face a penalty, depending on the terms of the loan.

Hard money loans have the following advantages:

• Fast approval process: Borrowers can be approved for hard money loans much faster than traditional loans, often within a couple days.
• Based on assets, not credit: Borrowers with poor credit histories can get approved for a hard money loan as long as they have sufficient collateral.

However, hard money loans have the following disadvantages:

• Low loan-to-value (LTV) ratios: Hard money loans typically finance a smaller portion of a property’s value than a conventional loan would. A hard money lender may offer a loan for 50% to 70% of a property’s purchase price, while a traditional lender usually offers a loan for 80% to 95% of the purchase price.
• High interest: Hard money loans come with high interest rates. Typical hard money loan interest rates are 7.5% to 15%, while traditional bank loans are 3.13% to 7.84%.

Hard money loans can be useful for real estate investors who really know what they’re doing. They can help home flippers secure a loan quickly and get into a market that’s moving fast, but they come with high interest rates and more conservative LTV ratios.

Generally, you’ll want to have successfully flipped homes before considering a hard money loan. If you’re not confident you can sell the house quickly for at least enough money to cover the loan (including its high interest charges and any other fees) and make a profit, this type of loan may bring more risk than it’s worth.

For regular borrowers, hard money loans are usually seen as a last resort to be considered only when all other options have been exhausted. Clearly, they are not a “good” idea, but may be a necessary one in some cases.

Unlike traditional lenders, hard money lenders assess loan applicants on their investing track record and the value of the property being used as collateral.

However, hard money lenders are often hesitant to offer loans to first-time investors and will take their credit histories into account. Overall, hard money loans are based more on assets than creditworthiness, but an ideal applicant will have both.