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What Is a Hard Money Loan?

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When you need funding fast but don't have the best credit, you can still get the financing you need — provided you take out the right loan. When it comes to real estate, traditional mortgages are not your only option. You can also turn to so-called "hard money loans."

How do hard money loans work? Is a hard money loan suitable for your situation? Today, we'll answer these questions, giving you the breakdown of hard money loans.

Hard Money Loans Explained

A hard money loan is a loan that uses real property or collateral to secure the loan's value rather than relying on a lender's creditworthiness or credit history (at least entirely).

The majority of hard money loans are used as a short-term solution until permanent financing can be obtained. They can be advantageous if you have contractual obligations that require a fast closing or have your funds tied up in other investments.

Hard money loans are commercial-use loans, meaning they can only be used for investment purposes. In real estate, that means the property must be a non-owner-occupied residential asset or a commercial asset.

How Do Hard Money Loans Work?

With traditional loan options, the lender, such as a bank or credit union, will look at your credit score and verify your income to determine whether you can repay the loan.

In contrast, with a hard money loan, you borrow money from a private lender or individual, and their decision to lend will focus on the quality of the asset.

The hard money lender’s decision to lend is not credit score driven and does not require income documentation to be submitted. Instead, the loan is backed by collateral.

Collateral can be anything from real estate and vehicles to business equipment or any other physical assets that the lender can repossess and sell to recoup their lost funds if you default on the loan. A real estate hard money lender will only accept real property as collateral.

For instance, if you default on a hard money loan and have your investment property as collateral, the lender has the right to possess the property if you default on the loan.

Since hard money loans are collateral based, also known as asset-based loans, they require minimal documentation and allow investors to close in a matter of days.

However, these loans come with more risk to the lender, and therefore require higher down payments and have higher interest rates than a traditional loan.

Hard money loans also come with more risk to the borrower and require them to have a solid exit strategy in place to ensure they have a way to payoff the loan when it matures.

Key Differences Between Hard Money Loans and "Traditional" Mortgages

In addition to the above breakdown, hard money loans and traditional mortgages have other differences that distinguish them in the minds of investors and lenders alike:

  • Hard money loans are funded faster. Many conventional loans may take one to two months to close, but hard money loans can be closed in a few days.
  • Hard money loans are short-term. Most hard money loans have short repayment periods, usually between 1-3 years. Traditional mortgages, in contrast, have 15 or 30-year repayment terms on average.
  • Hard money loans have high-interest rates. Most hard money loan interest rates are anywhere between 9% to 15%, which is significantly higher than the interest rate you can expect for a traditional mortgage.
  • Hard money loans are interest only. A hard money loan only requires your monthly payment to cover the interest, allowing you to keep your expenses low until longer-term financing is secured or the asset is sold.
  • Hard money loans require larger down payments. To take out a hard money loan, you usually need to make a down payment of between 35% and 50% of the current value of the property.

Regarding similarities, hard money and traditional mortgage loans usually have fees and closing costs between 2% and 5% of a property's listing price. Furthermore, these loans have prepayment penalties if you try to pay them off in a shorter time frame.

How Do You Get a Hard Money Loan?

As noted above, hard money loans are usually acquired from companies or individuals, not banks or credit unions.

To get a hard money loan:

  • Contact a hard money lender, such as an individual or company specializing in these types of loans
  • Upon receiving your loan application, the lender may check your finances or credit. This process is usually faster and less rigorous than the process of applying for a traditional mortgage, however
  • The lender will also need to underwrite the subject property that is being used as collateral for the loan. This will include ordering an appraisal.
  • You'll receive a term sheet that outlines the loan terms you have been approved for. Once the term sheet is signed, the loan will be sent to processing.
  • During loan processing, the lender will request documents and prepare the loan for final loan review and schedule the closing. This can take anywhere from a few days to 2 weeks, depending on how quickly you provide the lender with all the necessary documentation.

What Are the Advantages of Hard Money Loans?

Hard money loans have a lot of advantages and benefits.

Firstly, hard money lending comes with a much faster approval process than traditional mortgages. As a result, it can be a more sensible option for investors facing a short closing window.

If you are in a race to purchase a property with another rental investor, a hard money loan may let you get the money you need to make an offer to the current property owner ahead of your competitor.

In addition, hard money loans offer loan approval based on the property rather than credit history. If you are an entrepreneur with difficulty verifying all of your income or a foreign national with no credit history in the U.S., you can still qualify for financing with a hard money lender.

Hard money loans are frequently seen as more flexible than traditional mortgages, particularly in terms, conditions, and fees. This is due to the less strict underwriting process.

In essence, because individuals or corporations give hard money loans, they aren't subject to the same rules or restrictions as banks and credit unions. This means you can get unique, personally tailored hard money loans for your specific needs.

What Are the Cons of Hard Money Loans?

That said, hard money loans have some disadvantages to keep in mind before seeking them out.

For example, hard money loans usually require larger down payments. You'll need some capital upfront to qualify for a hard money loan and the physical property to serve as collateral. This can make hard money loans inaccessible for some investors or property owners.

In addition, hard money loans usually have higher interest rates than traditional mortgages. They are also interest-only loans which means your monthly payment only covers interest and the principal amount will be due at maturity as a lump sum.

On top of all that, hard money loans have shorter terms, meaning you have less time to repay the loan and will need to have an exit strategy in place to payoff the loan. Common exit strategies include:

  • Refinancing
  • Sale of the asset
  • Payout from other source

When To Use a Hard Money Loan

There are many situations where it may be advantageous to use a hard money loan.

For starters, real estate investors who like to house flip — that is, purchase a rundown home in need of a lot of work, do the work personally or with contractors to make it more valuable, then turn around and sell it for a higher price than they bought for – may find hard money loans to be ideal funding options.

House-flipping projects usually happen quickly. Because of this, professional house flippers usually like short-term, fast-paced financing solutions.

On top of that, house flippers usually try to sell homes within less than a year of purchasing them. Because of this, they don't need a long term and can avoid paying too much interest.

If you purchase investment properties, such as rental properties, you may also find hard money loans to be good choices. If you need more time to qualify for traditional financing, you can use a hard money loan in the short-term to purchase your first rental property, then refinance within a few years.

In some cases, you can also use a hard money loan to purchase vacant land. This is a good option for developers who are in the process of qualifying for a construction loan.

Note that, even in the above situations, the potential disadvantages of hard money loans still apply. You have to be sure you can repay a hard money loan before taking it out. Otherwise, you may find yourself in more difficult financial circumstances than before.

Contact Vaster Today

Ultimately, hard money loans are necessary financial tools you can – and possibly should – use in certain circumstances.

Getting creative with your financing options all starts with partnering with a real estate loan advisor you can trust to get the deal done.

With Vaster, you can take advantage of our knowledgeable loan officers to get the funding you need to finance any real estate deal quickly.

Contact us today to learn how we can help you secure your real estate deals ASAP.

Sources:

Hard Money Loan Definition | Investopedia

Hard Money Loan: Pros, Cons And Definition | Rocket Mortgage

How Do Hard Money Loans Work? | Experian

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