One of the many things America is famous for is its diverse financing industry. There's a loan available for just about any purpose – at least if you can qualify, and the purpose of the loan is within traditional guidelines. But if you fall outside the lines on either, a hard money loan may fill in the gap. If you're self-employed, have impaired credit, or want to undertake a risky property investment, a hard money loan should be on your radar.

What Is a Hard Money Loan?

A hard money loan is a short-term loan that uses the value of real property owned by the borrower as its collateral. They're used primarily with unconventional real estate transactions, like house flipping.

Hard money loans are provided directly by hard money lenders. A hard money lender is typically a private source, not a bank like with a traditional loan.

There's also a lack of standardization among hard loan lenders. Since hard money lenders are most commonly individuals or non-bank institutions, each will set its own loan requirements. Real estate investors who may qualify for a hard money loan with one lender may be declined by another.

If you're interested in a hard money loan, understand they're not like traditional loans. Expect to make a larger down payment on a property than you will with a conventional mortgage, for a loan that will last only from a few months to a few years. You should also be fully prepared to pay a higher interest rate and closing costs than you would with traditional financing.

Why Is it Called a Hard Money Loan?

Hard money loans have earned the title "hard money" as a result of being a last resort loan source. Real estate investors will turn to hard money lenders after exhausting traditional financing sources. Many lenders in the space have a stringent approval process that can make qualification difficult even for seasoned investors.

Another reason for the term may have to do with the higher interest rates and closing costs they carry. Hard money loans also require a larger down payment than conventional financing sources.

Finally, finding the right lender to work with is yet another factor contributing toward making these loans hard.

What Are Examples of Hard Money Loans?

Hard money loans are a type of financing you might need if you're looking to do a short-term real estate deal, like the fix-and-flip of a single-family property. That's the kind of deal that won't be available through traditional loans.

Another example is if you are self-employed. The approval process can be difficult on a traditional mortgage, even if you have an outstanding credit history. It's often difficult for the self-employed to fully document income with a traditional lender. That lender may be looking for income tax returns that don't adequately reflect the self-employed borrower's true cash flow or financial position.

In another example, a hard money loan may be a good choice for someone with less than perfect credit.

Hard money lenders won't necessarily ignore income and credit considerations, but on the whole hard-money-loans process is largely based on the experience of the real estate investor, the strength of the investment property, and a larger down payment, much more so than the borrower's credit worthiness, or verifiable income.

As an example, let's say you're a self-employed real estate investor shopping for hard money loans for the purpose of obtaining short-term financing to complete a fix-and-flip project. The lender may require you to put down anywhere between 20% and 40% of the value of the property, and also charge you a higher interest rate than what you will pay on a traditional mortgage.

If hard money loans are your only option, and there's enough profit potential in your fix-and-flip deal, the loan will be worth taking.

Hard Money Loans vs Other Loans

Investors don't necessarily need to turn to hard money lenders to finance real estate deals or other financing needs. There are other financing alternatives that can be used, and each comes with its own advantages and disadvantages.

Personal Loans

For many investors, the primary alternative will be personal loans. These are unsecured loans offered by banks and credit unions, and increasingly by online learning platforms. Since they are unsecured, they generally require a strong income and good or excellent credit. But if you qualify, you can borrow as much as $50,000 or even $100,000 without pledging any collateral. What's more, since the loans can be taken for any purpose, they can be used for commercial real estate projects.

As flexible as personal loans are, they can be even more expensive than hard money loans, depending on your income and credit profile.Typical loan terms range between three years and five years, with interest rates between 5.99% and 35.99%, based largely on your credit score. Closing costs can also be steep, as personal loan lenders charge between 1% and 8% of the loan amount in points. That can be as much as $4,000 on a $50,000 loan, and it will be subtracted from the loan amount upfront.

Other Loan Types

Other loan types for real estate investors will primarily be home equity type financing arrangements. These consist primarily of home equity loans and home equity lines of credit (HELOCs), which are available through traditional financial institutions, like banks and credit unions.

Home equity loans and HELOCs are taken against the borrower's primary residence. A lender will generally allow a borrower to access between 85% and 90% of the value of his or her home, less any existing mortgage indebtedness.

The advantages of this arrangement are many. Interest rates are much lower than those from a hard money lender, and closing costs are minimal. Loan terms can range from 5 to 30 years, and often come with an interest-only period for the first few years, resulting in low monthly payments. In addition, the funds can be used for just about any purpose.

The disadvantages are just as numerous. First, you'll be pledging your primary residence as collateral for a loan on an investment project. That will put your home at risk if the investment goes bad. Second, the amount you'll be able to borrow will depend on the equity you have in your home. If you don't have much equity, this won't be a reliable source of funding.

Third, traditional lenders place heavy emphasis on the borrower's creditworthiness. Most will require at least a good credit score, but the highest loan amounts and lowest interest rates will be available to those with excellent credit scores.

Disadvantages aside, tapping home equity is often a preferred source of investment real estate financing if you have abundant equity, a high income, and excellent credit.

As an example, let's say your home is worth $400,000, and you owe $200,000 on an existing first mortgage. If a bank is willing to loan you 85% of the value of your home, it may provide a home equity loan or HELOC of up to $140,000.

That's calculated by multiplying the property value of $400,000 by 85%, which results in allowable equity of $340,000. By subtracting the $200,000 existing first mortgage, the bank will lend you up to $140,000.

Real Estate Crowdfunding

An increasingly popular source of real property financing is real estate crowdfunding. This is a financing alternative that's come up on the internet in just the past 10 years. Real estate crowdfunding is offered on dozens of web platforms, and brings investors (those seeking only to invest their money in a real estate deal) together with real estate principals ("sponsors"). Sponsors offer their property deals on a real estate crowdfunding platform, which is then vetted by the people who run the platform.

If the sponsor and the proposed deal clear the vetting process, the investment will be offered on the platform, giving investors an opportunity to contribute toward funding the project. With most real estate crowdfunding platforms, multiple investors will participate in a single property deal.

While real estate crowdfunding platforms can be an alternative to hard money loans, there are some caveats.

As the primary investor in the real estate deal you are sponsoring, you may not be able to get direct financing for your project. While some real estate crowdfunding platforms do offer financing to deal sponsors, the majority favor equity investors. These are often more sought after by private investors because equity offers greater profit potential than the interest on short-term loans.

If you do accept an equity arrangement with a real estate crowdfunding platform, you will be sharing the profits on the deal with those private investors.

Another potential obstacle is the vetting process. Some real estate crowdfunding platforms put both sponsors and their deals through an extensive due diligence process. They'll look at the property itself, its location, and the specifics of the deal, as well as your qualifications as the sponsor. Some platforms accept fewer than 5% of the deals presented, which means acceptance is hardly guaranteed.

Loan Sources to Avoid

There are some sources you shouldn't borrow money from, even if it's to make a "can't miss” real estate deal. There are bad loan types like car title loans, pawn shop loans, or payday loans that are best avoided. These types of loans are hardly viable alternatives to a hard money loan.

Typically available through private lenders, they carry very high interest rates, low loan amounts, and notoriously short loan terms.

For example, payday loans have an average annual interest charge of 391%. And they're only good until your next paycheck. If that's only two weeks away, that's when the loan will need to be repaid. What's more, you'll pay through upfront fees. For example, the lender may advance you 85% of your next paycheck, then take 100% on payday. And of course, you can borrow no more than the amount of your next paycheck (less the fees). That will be far too little to finance a serious real estate deal.

Car title loans and pawn shop loans typically have similar provisions, though they can offer longer terms and higher loan amounts. Still, they're short-term in nature – usually not more than one or two years, and will lend you much less than the value of the asset you're putting up for collateral. Since these loans are provided by private lenders, terms can vary significantly from one lender to another. You should also be aware that if you can't make your payments, the lender will take your property.

How Does a Hard Money Loan Work?

A hard money loan provides money for short-term expenses similar to a bridge loan. A hard money lender provides the loan as long as the borrower is willing to pledge a piece of real property as collateral against any default.

A common example of a hard money loan is a car title loan. In this case, the value of the car serves as the basis for the loan amount instead of a credit score. For this reason, highly solvent individuals and alternative lenders (not banks) can make hard money loans to people with poor credit who are otherwise unable to secure a similar loan from a bank. With such loans, the collateral pledged is more important to the lender than the borrower's income or credit history.

For example, suppose Bob needs money to cover his monthly bills until he receives his next paycheck. Due to his poor credit history, his loan application is rejected by several traditional lenders. Though Bob doesn't have strong cash flow, he does have $110,000 of equity in his home, so he approaches an independent investor who agrees to give Bob a hard money loan of up to $50,000 in return for pledging his home as collateral.

In the case of a real estate investor, the property being purchased or renovated will be used as collateral for the loan.

Interest and Fees on Hard Money Loans

If you need to apply for a hard money loan, you should fully expect pricing to be higher than what you will pay on traditional loans. For example, hard money loan rates commonly range between 7% and 15%, but they can go as high as 20% depending on the lender. This is much higher than the 3.45% currently available on 30-year fixed-rate conventional mortgages for owner-occupied homes. This is to be expected, given that an investment purchase is higher risk than buying a primary residence.

Since the loan will typically come from a private lender, you can fully expect to pay more in closing costs than you will with a conventional loan. While traditional mortgages may require the payment of one point or less, hard money loans may require the payment of between 1% and 5% in points. Hard money lenders can also charge between several hundred dollars and several thousand dollars for additional fees, like underwriting and document preparation.

Why Does a Hard Money Loan Matter?

Hard money lenders assume high levels of risk and frequently charge high interest on hard money loans. It is important not to confuse hard money loans with home equity loans, which are made only by banks on the basis of home value combined with satisfactory credit.

But despite being quite different from traditional loans – and the favorable terms they provide – hard money loans fill an important need in real estate investing. For many investors, a hard money loan is the only source of financing for a project.

Hard money lenders will provide financing for unique individual real estate projects that can't be financed with a traditional loan. An excellent example is a fix-and-flip property. Since traditional lenders are primarily interested in making long-term real estate loans, they won't even consider providing a traditional loan for a project that's expected to be completed in one year or less.

Traditional lenders also don't like the risk associated with this type of real estate investing. Even though it can be highly profitable to the investor, it can be a serious risk to the lender if the deal goes bad. For example, if the investor hits hard times and abandons the project before it's completed, a bank won't be able to foreclose on the property without taking a big hit on the loan.

Enter the hard money loan. Hard money lenders are willing to take a chance on such a project. Most hard money loans will require that the lender is well-compensated for providing the financing. This can include high fees and a high average interest rate.

And even a hard money lender will take a close look at both the investor and the specific project. Both have to meet the hard money lender's requirements. That will include a large down payment, a business plan that makes sense, and an experienced investor.

If you and your project fit the qualifications, a hard money loan may be the only source of financing available to make your deal happen.

Are Hard Money Loans Worth It?

Unquestionably, hard money loans are expensive, and come with relatively short terms and a requirement for a significant amount of collateral. But for the borrower who is self-employed, has poor credit, or plans to invest in a non-traditional real estate deal, there may be few other loan options.

Real estate transactions are especially suitable for hard money loans. Fix-and-flip projects aren't eligible for traditional financing, leaving hard money lenders as the only alternative.

They are not for the average consumer. But for the person who has the proven ability to complete successful short-term real estate deals – but may have issues with credit or income verification – hard money loans may provide an important financing bridge to make a profitable deal happen.

Interested in real estate? Check out the best crowdfunding sites.

References:

https://www.stlouisfed.org/open-vault/2019/july/how-payday-loans-work

http://www.freddiemac.com/pmms/

https://www.longhorninvestments.com/hard-money-loans-costs-interest-rates/

https://www.bankrate.com/mortgages/hard-money-lenders/


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Rachel Siegel, CFA
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Rachel Siegel, CFA is one of the nation's leading experts at ensuring the accuracy of financial and economic text. Her prestigious background includes over 10 years creating professional financial certification exams and another 20 years of college-level teaching.

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