How do hard money loans work?
A hard money loan is a short-term loan secured by real estate, not credit. Unlike mortgages, which take a long time to underwrite, hard money loans can be secured quickly — making them a great choice if you’re in need of fast cash. The underwriting standards are typically less strict too because they’re issued through private lenders, not banks or credit unions.
That’s also why most hard money lenders specifically target real estate investors, who want to make quick offers on bargain properties. Some lenders won’t even work with traditional homebuyers, so if you’re looking for a mortgage alternative for an owner-occupied property, this may not be your best bet.
For a hard money loan, “the lender is at liberty to decide the circumstances under which they’re willing to make that loan,” said Tendayi Kapfidze, the chief economist at LendingTree, which owns MagnifyMoney. Each lender establishes its own requirements for credit scores, debt-to-income (DTI) ratios and loan-to-value (LTV) ratios and often, these standards are looser than what traditional mortgage lenders may require.
“Typically, the buyer puts up significant collateral, so if things go astray, the lender can recoup their outlay,” Kapfidze said.
For most types of hard money loans, that collateral is the same: your house. If borrowers default on their loan, the hard money lender will take and sell the home. That makes these loans riskier than standard mortgages.
Unlike traditional mortgages, lenders expect repayment much more quickly. Expect your hard money loan to last between 12 months and five years — but considering the high interest rates, you’ll probably want to pay off your debt as quickly as possible, anyway.
“The biggest difference with hard money loans is the interest rate,” Kapfidze said. “If you’re getting a mortgage backed by Fannie Mae, Freddie Mac or government interest rates, there’s a lower interest rate because of the perceived guarantee. There’s less risk for the lender.”
While the exact interest rate will vary by lender, borrowers may pay up to 15% annual percentage rate (APR), or more.
Hard money loans can help buyers a number of ways. Common loan types include, but are not limited to, the following:
- Bridge loans, which help buyers “bridge the gap” between the current property they own and the property they hope to buy. A hard money provides short-term financing to help with the down payment and moving cost, which is typically repaid after closing.
- Fix-and-flip loans, which help potential buyers purchase distressed properties intended for renovation and reselling.
- Owner-occupied loans, which help consumers with poor or no credit buy a home.
Benefits of hard money loans
With high interest rates, short payment terms and your house on the line, you might be wondering why anyone would want a hard money loan. But there are a number of circumstances well-suited for these unique loans.
“If you’re not able to access a traditional loan, then maybe there’s an opportunity here,” Kapfidze said. For consumers who have difficulty obtaining traditional loans or for projects that don’t conform with traditional lenders’ requirements, a hard money loan may be necessary.
The benefits of a hard money loan are:
- Speed. Buyers in need of funds fast may choose a hard money loan. Because the underwriting guidelines for hard money lenders are often less strict, and require less documentation, the loan can close quickly.
- Lenient requirements. Have a low credit score? A tax lien on your house? Are you a foreign national struggling to establish U.S. credit? Underwriting standards for hard money lenders are significantly more lenient than traditional lenders.
- Flexibility. Many hard money lenders provide funds from their own reserves, allowing them flexibility with the loan’s terms — especially in terms of the repayment timeline. Whether you want to repay the loan in six months or seek a longer-term period, lenders aren’t restricted to pre-established term sheets.
- Leverage in the real estate market. For flippers hunting down bargain properties, finding fast funding is essential. Quick financing lets them snap up the perfect home for rehab before other buyers do.
Pitfalls of hard money loans
While hard money loans are ideal for a number of circumstances, these borrowed funds can be risky.
“If you’re unable to pay back the loan and you have your property as collateral, your lender has a claim on that property,” Kapfidze said. And while that may also be true with traditional mortgages, the high interest rate and quick payment schedule common among hard money loans might make your monthly payment sky-high.
Some of the major pitfalls of hard money loans include:
- Higher interest rates. Even if you pay off your loan in full, you’ll end up paying a lot more interest than you would with a standard mortgage. For example, a $50,000 loan with a 15% interest rate and a five-year repayment plan will cost you more than $21,000 over the life of the loan.
- Shorter terms. Repaying a large loan in five years or fewer means higher monthly payments. Understand how the true costs of your loan fit into your household or business budget before proceeding.
- Little oversight. Unlike traditional mortgage lenders, hard money lenders experience little government oversight. Borrowers must take care to avoid unethical lenders looking to exploit desperate buyers.
When to consider a hard money lender
Still not sure if a hard money lender is right for you? Here are some circumstances where this loan might be a good fit.
- You can’t find traditional financing — especially for an investment property. Many hard money loans are designed for real estate investors, not your average buyer looking to purchase an owner-occupied property. In fact, many hard money lenders won’t even lend to consumers. But if you’re looking to renovate an investment property and don’t meet traditional lenders’ requirements, a hard money loan may help you proceed.
- You need money fast. These loans send funds more rapidly than a traditional lender. If the local real estate market is hot and you need cash quickly, a hard money loan may entice the sellers to choose you.
- Your credit score is low. Your property serves as collateral for a hard money loan — not your creditworthiness. Buyers with extremely poor credit may not meet the requirements for a traditional loan, making a hard money loan their only choice.
Where to find reputable hard money lenders
A Google search will turn up hundreds of eager hard money lenders, but finding out which ones are reputable and which are not can be difficult. Talk to real estate investors in your area to learn about the best lenders nearby.
Ask any potential lender the following questions:
- Do you only work with investors? If you’re hoping to use these funds for an owner-occupied property, a hard money lender that works exclusively with real estate investors won’t be a good fit.
- What is the interest rate? If you don’t see interest rates outlined on the lender’s website, ask directly. You don’t want to be surprised by a high interest rate.
- How will I repay the loan? Hard money lenders handle repayment in different ways. Some ask for interest-only payments, and some request full repayment at the loan’s end. Others work much like traditional mortgage lenders, with regular monthly payments throughout. Find out what each lender expects so you can be sure the repayment fits within your budget.
- What fees will I pay? Get a thorough accounting of any fees you might pay, as well as any points you’ll be expected to pay. A “point” is an upfront fee, calculated as a certain percentage of the total loan that lets you lower your interest rate.
- What happens if I pay the loan off early — or late? Some lenders don’t let you pay a loan’s balance early. And some charge additional fees if you pay any installments late. Know what your lender expects ahead of time.
Risks to look out for
Not everyone who labels themself a “hard money lender” is worth working with. Loan sharks may masquerade as a reputable lender — but their real goal is causing you slow financial pain before stealing your house from under you.
First, check your lender’s license. The Nationwide Multistate Licensing System offers information about licensing requirements for all 50 states, and allows you to search by lender to ensure its validity. Asking for your lender’s license number can help you weed out potential loan sharks, but it’s no guarantee.
Next, look at the interest rate: Each state has regulations limiting how high lenders can set this number. But loan sharks may not shy away from usury — the legal term for charging illegal interest rates. Knowing your state’s legal interest rate limits will help you avoid predatory loans. And pay attention to adjustable rates, too. Sure, the initial rate may be attractive, but soon it may rise dramatically.
Compare your payments amount to the interest. A common feature of subprime loans is a regular payment that doesn’t even cover the accruing interest. Over time, the amount due continues to grow. If regular payments won’t pay off your loan, you’re probably dealing with a shark.
Asking a real estate lawyer to look over your hard money loan contract is the best way to know you’re not being fleeced. And yes, you do need a contract. Don’t accept any money until both you and the lender have signed.
Alternatives to hard money loans
Just because you have poor credit doesn’t mean a hard money loan is your only option. If you’re looking to purchase a house, there are a number of federally regulated mortgage programs that offer lower interest rates and better terms. Consider looking for a loan through the Veterans Administration available for veterans or the Federal Housing Administration, which can help make owning a home affordable.
Other options include:
- Home equity loans. These loans offer your home’s equity — or the difference between your home’s worth and how much you owe — in cash. Expect an interest rate of 4.5% to 6%, although underwriting standards will be stricter than those of a hard money lender. Home equity loans can help you afford a down payment or the kitchen renovation of your dreams.
- Home equity line of credit (HELOC). A home equity line of credit works much like a home equity loan, except not all the money is provided up front. Think of it like a credit card: You can take out funds as needed and pay down your balance over time. Keep in mind these loans often have a variable interest rate, which goes up and down in tandem with the nationwide prime rate.
- Cash-out refinancing. Much like a home equity loan, a cash-out refinance gives you funds equal to your equity — but it also replaces your current mortgage. That means you may end up paying a higher interest rate, depending on the current prime mortgage market.
- Business line of credit. Plan on making it big as a real estate investor? A business line of credit gives you easy access to quick cash when necessary, helping you purchase affordable properties quickly.
If you need cash fast and don’t have the credit for traditional loans, a hard money loan may suit you, especially if you’re purchasing investment properties. But pay careful attention to the loan’s interest rates and repayment terms. Loan sharks may masquerade as hard money lenders, and signing the contract for one of their loans can leave you underwater. Before taking out a hard money loan, make sure there’s no other, traditional loan that suits your situation.
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