What is a Hard Money Loan?

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Hard Money Loan Definition

A hard money loan refers to a short-term loan on a property where property plays the role of collateral. This type of loan is usually acquired through private lenders since institutional lenders cannot issue hard money loans due to strict regulations they have to adhere to. Hard money loans are considered short-term even though they can be issued for a long term. A hard money loan can be issued for 25 years to estimate hard money loan payments. On the other hand, a lender expects the borrower to pay it off within a few years because hard money loan rates are much higher than mortgage rates. Because of the high hard money loan rates, the borrower is expected to pay it off in full or refinance this loan to a conforming loan as soon as they can.

Hard money loan lenders usually do not look at a borrower’s creditworthiness nor do they analyze the ability of the borrower to pay off the loan. Instead, hard money loan lenders look at the collateral value and see whether they can cover the outstanding debt with the collateral in case the borrower defaults on their loan. Because of that, the approval time for hard money loans is shorter than for mortgages. On the other hand, since hard money loan lenders want to ensure that they can cover the debt outstanding with the collateral, they are usually willing to provide loans at a lower loan-to-value (LTV) ratio than mortgages usually require. It is important to note that since most hard money loan lenders are not institutional lenders, it might be possible to negotiate hard money loan terms with them.

Maximum LTV for Different Loan Types

How Does a Hard Money Loan Work?

Hard money loan terms are negotiated between a borrower and a lender. A hard money loan lender is usually an individual or a private lender because a bank or an institutional lender cannot offer hard money loans. The terms of the loan are negotiated based on the value of the collateral rather than the creditworthiness of a borrower. Usually, banks that offer conventional loans look at the credit history and income of a borrower to determine their creditworthiness. If a borrower’s creditworthiness is not good enough, then the bank is likely to reject the loan request. Hard money loan lenders usually do not look at the borrower’s creditworthiness. Instead, they simply analyze the value of collateral pledged to see whether they can cover the outstanding principal in the event of default by the borrower.

Hard money loan rates are usually much higher than the mortgage rates offered by banks. To compare, in October 2022, the average 30-year fixed mortgage rate was around 7.00%, while the rate of hard money loans ranged between 10% and 20%. Hard money loans for real estate are usually used as bridge loans, for house flipping, for BRRRR strategies, or for other commercial purposes. You can use a bridge loan calculator to estimate the cost of your bridge loan. People who purchase old and inhabitable properties in the hopes to fix them and sell them at a higher price are house flippers. They do not usually need to pay off the loan for multiple years because as soon as the construction is finished, they sell the property at a profit and cover the debt outstanding on the loan. In this case, the following calculations can be performed to estimate how much a loan would cost them.

Hard Money Loan Example

Suppose a house flipper is planning to get a property to renovate and sell. They are planning to get a hard money loan for real estate purchases, but they would also have to contribute their own money for the down payment and renovation expenses. The following table summarizes the financial information about the deal.

Hard money loans for real estate are mostly offered to finance investment properties because hard money loan lenders must adhere to certain regulations when it comes to financing owner-occupied properties. Since private lenders are looking for a high return, they are not willing to issue loans for owner-occupied properties due to strict government regulations. Hard money loans are usually used to purchase land for construction, finance a rental property, or as a construction loan.

How to Get a Hard Money Loan?

There are multiple factors hard money loan lenders may consider before issuing a loan. The biggest factor affecting the chances of approval is the property value and the LTV ratio, but other factors may affect the decision as well. The following list provides the most common factors that may affect the outcome of applying for hard money commercial loans.

• Credit Score

  Even though hard money loan lenders do not fully analyze the creditworthiness of a borrower, they still are looking for a minimum credit score of at least 600 to 620 points to approve a borrower for a loan.

• Loan-to-Value Ratio

  Different lenders may have different LTV ratio requirements. LTV ratio usually ranges between 50% and 70% for private mortgage lenders. It is unlikely that a borrower can get a hard money loan with an LTV ratio of over 70%.

• Exit Strategy

  Private lenders understand that their interest rate is much higher compared to conventional loans. This means that a potential borrower may want to refinance their loan or pay it back earlier. The lenders usually require the borrowers to present an exit strategy or a strategy on how the loan will be repaid. A clear exit strategy may greatly improve the chances of getting a hard money loan.

• Market Conditions

  This factor is not something a borrower can control. Private lenders usually look at whether they can cover the debt outstanding using collateral, and the price of collateral changes over time. If a lender has reasons to believe that the value of the collateral will go down, they will be less likely to approve a loan.

Pros and Cons of a Hard Money Loan

A hard money loan is a fast way to get a mortgage on a property, but this type of loan does not work for everyone because of the cost that comes with it. Before getting a hard money loan, a borrower should consider all advantages and disadvantages that come with the loan and see whether it is the optimal loan type to take.

Hard Money Loans Advantages and Disadvantages Chart

Pros:

• Fast Approval Process

  One of the main advantages of a hard money loan is that the lenders usually do not look into the ability of a borrower to pay off their loan. Because of that, the approval process is much faster than for conventional loans. In some cases, a fast approval process may be a necessary part of a successful closing. For example, if an investor is looking to buy a foreclosed home, the timing may be detrimental to the successful closing of the deal.

• Opportunities to Negotiate

  Hard money loans are mostly issued privately. Since a lender is private, they may have greater flexibility in issuing a loan than institutional investors do. Because of that, a borrower may be able to negotiate certain terms such as a repayment schedule or an interest rate.

• Easier to Get Approved

  Hard money loan lenders usually make their decision based on the LTV ratio of the loan and the quality of collateral. Borrowers with poor credit history who are not able to get a conventional loan may be luckier getting a hard money loan because hard money loan lenders are more likely to issue a loan to a person with good collateral rather than a good credit history.

Cons:

• High Interest Rate

  Hard money loans are much more expensive than conventional loans. Even though hard money loans are collateralized with a low LTV ratio, it is still considered risky. Some hard money loans carry an interest rate that is higher than subprime loans. For example, for October 2022, the average conventional loan interest rate was around 7.00% while the average hard money loan rate was getting close to 15.00%.

• Low Loan-to-Value Ratio

  Hard money loan lenders focus on the collateral value rather than the creditworthiness of an individual. The lenders are willing to issue loans with a low loan-to-value ratio to ensure that they can cover the debt outstanding with the hypothecated collateral. Because of that, a hard money loan usually has a smaller LTV ratio than the LTV ratio of a conventional loan. Usually, the LTV of a conventional loan is around 80%, but the LTV of a hard money loan ranges from 50% to 70%. This means that a buyer needs a higher down payment for a property they are planning to purchase.

• Short Terms

  Even if a person chooses to buy a property with a hard money loan, they will likely not be able to finance the house over 15 years with this loan. Hard money loans are usually short-term loans, and the lender may decline the request if the term of the loan is too long.

• Regulatory Difficulties

  It might be difficult to get a hard money loan for certain houses. For example, owner-occupied properties tend to have an enhanced regulatory oversight when it comes to financing. These difficulties with regulators may make the lender decline the request for such loans.