If you are considering venturing into real estate investment and researching the industry, you will likely come across the term “hard money loan.”
For a starter, a hard money loan is not hard to get, except that you will need to fulfill specific requirements.
Understanding the nitty gritty of hard money lending can reveal new opportunities for real estate investments, especially when conventional financing methods are inadequate.
What is a hard money loan?
A hard money loan is a type of short-term finance option that is secured by real property. It is usually used by investors primarily interested in purchasing a property to renovate or develop and then selling it for a profit.
Hard Money Lenders are individuals or private companies who accept property or an asset as collateral.
Although lenders may request your credit score, it is not a significant determinant of whether the loan will be approved. The property’s market value determines the amount an investor qualifies to borrow.
Unlike traditional loans provided by banks, the processing time for a hard money loan is usually shorter. This is why it is the preferred loan for investors in urgent need of finance or those whose applications have been denied.
Key characteristics of hard money loans
Hard money loans are characterized by the following:
High-interest rates
Generally, hard money loans have a higher interest rate than traditional loans offered by banks and mortgage companies.
The interest rates can range from 8 percent to 18 percent of the loan’s value. This makes hard money loans more expensive than regular mortgages. The average mortgage rate in the first quarter of 2024 was 6.69%.
This may be of less concern for flippers and short-term investors as they might pay the loan back within a short period, which can reduce the effect of the high interest, hence making the loan cheaper.
Short repayment terms
Hard money loans have short repayment terms. The stipulated repayment duration generally ranges from a few months to a few years, unlike conventional mortgages with a term of about 30 years.
The short-term makes it a perfect loan option for flippers or investors needing urgent cash to close a deal.
Loan-to-Value
For conventional loans, individuals need a good credit score to qualify. Lenders rely on it to assess the probability of the lender repaying the loan.
Hard money lenders, on the other hand, even though they might request applicants’ credit scores, are more concerned about the value of the property the borrower will be using as collateral.
This is known as loan-to-value (LTV). The amount approved for the borrower is often around 60 to 80 percent of the value of the property the lender will finance.
Collateral and down payment
To get approved for a hard money loan, you must be able to make a down payment of about 20 to 35 percent of the property’s value or its after-repair value (ARV).
The financed property will then serve as the collateral for the loan. If you default, the lender may seize the property.
Aside from LTV, lenders also assess their risk using Loan-To-Cost (LTC). LTC is used to examine how much of the project is expected to be financed by loan versus equity—the more equity, in this case, down payment, the lesser the loan risk for the lender.
If a lender has an LTC of 75 percent, the required down payment will be 20 percent. Depending on the lender, the LTC is calculated based on the borrower’s credit score, industry experience, and property valuation.
Who should use a hard money loan?
Hard money loans are used by real estate investors, developers, and flippers to purchase commercial or investment properties.
Aside from property flippers, the loan can be leveraged by investors handling acquisitions facing time constraints.
This short-term finance option can also be used by homeowners facing foreclosure who have substantial home equity.
How to qualify for a hard money loan
Although the credit rating is not a major determining factor in a lender’s decision for the approval of a hard money loan, they consider other factors, including:
Equity/Down payment
Most private lenders try to reduce their risk as much as possible when giving out loans. Investors with higher equity in a property stand a higher chance of getting their loan application approved.
This means investors can increase their chance of approval by providing down payments above the minimum required by the lender.
Cash reserve
Some lenders like to ensure the borrower has enough cash reserve to cover additional fees if the project exceeds budget.
Such additional funds can protect the project from short-term issues or unexpected expenses.
Experience in real estate
Borrowers with more real estate experience likely find it easier to get their loan request approved compared to newbies.
However, people with zero real estate experience can still get hard money loans, except that the lender will subject them to more scrutiny to ensure they can repay the loan.
Exit strategy
An exit strategy outlines how the borrower plans to repay the loan. For flippers, this entails selling the property after repair. Homeowners may get another loan to repay the hard money loan; likewise, investors with acquisitions face time constraints.
Mistakes to avoid when using hard money loans
While hard money loans are preferable for borrowers to fund real estate projects quickly, it is vital to approach them cautiously. Avoid these common mistakes made by borrowers to save yourself from financial setbacks:
Not doing due diligence
Many private lenders are offering hard money loans. Their requirements and mode of operation differ. Before settling for a lender, do your due diligence about the firm.
Proper due diligence can save you from unfavorable terms and hidden fees.
Overestimating property value
Lenders generally base the approved loan amount on the value of the property securing the loan. While overestimating the property’s value might qualify you for more loans, it can significantly increase the overall interest.
Overestimating can make it harder to repay the loan if the property’s value does not meet expectations.
Submitting wrong information to lenders
Desperate borrowers make the mistake of presenting lenders with information that may improve their chances of getting the loan application approved.
Meanwhile, lenders usually do their research and verify all submitted documents.
Some borrowers also fail to submit the documents needed to approve their loans. When applying for a hard money loan, ask the company to provide you with a list of documents you will need so you will be sure you are submitting the correct information to the lender.
Failing to read the terms and conditions
Although urgency makes many borrowers turn to hard money loans, reading and understanding the lender’s terms and conditions is essential before applying.
Rushing into a loan can lead to expensive errors and financial instability.
Applying with a poor credit score
Lenders do not prioritize credit rating when assessing a borrower’s qualification for a hard money loan.
However, having a good credit score can improve your chances, especially if you have little real estate experience.
Poorly planned exit strategy
Hard money loans need to be repaid and with interest. Plan your exit strategy before applying for the loan, whether selling the property or using other funds to repay the loan.
A well-planned exit strategy can save you from financial stress and potential foreclosure.
Michael Zhou is a Senior VP of Business Intelligence Development and has assisted the Fortune 1000 company with expertise in the web as a whole, including ground-zero marketing efforts that benefit both consumer and vendor. He is also a contributor on Esprittoday.