What is a Hard Money Loan?

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What You Should Know

  • A hard money loan is a short-term loan on a property that is issued from a private lender rather than a bank.
  • This type of loan has a fast approval process, but it has a much higher interest rate than conventional loans.
  • These loans are used for investment purposes to purchase land, rental property, or a house to fix and flip.
  • Private lenders look at the quality of collateral rather than the creditworthiness of a borrower.

Definition of a Hard Money Loan

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A hard money loan refers to a short-term loan on a property where property plays the role of collateral. Most of the time, banks do not offer this type of loan, so only individuals and certain companies may be able to issue a hard money loan. This type of loan is usually acquired through private mortgage lending since institutional lenders tend to avoid these loans. Hard money loans are considered short-term because they usually have a much higher interest rate than conventional loans, which means that a borrower has an incentive to refinance this loan to a conventional mortgage as soon as they have a chance to do so.

Pros and Cons of Hard Money Loans
ProsCons
Fast Approval ProcessA High Interest Rate
Opportunities to NegotiateLow Loan-to-Value Ratio
Easier to Get ApprovedShort Terms
Regulatory Difficulties

Since most of the lenders who issue hard money loans are not institutional lenders, it might be possible to negotiate the terms of the loan. Additionally, lenders of such loans usually do not analyze the ability of a borrower to pay off the loan as institutional lenders do. Instead, they look at the collateral value and see whether they can cover the debt outstanding with the collateral if the borrower defaults on their loan. Because of that, the approval time for hard money loans is much shorter than for conventional loans. On the other hand, since the 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 institutional lenders do.

There are various situations why an individual may choose to get a hard money loan instead of a conventional loan. Some of the most common cases for getting a hard money loan are:

  • Construction Loans
  • Fix and Flip Loans
  • Buyer Has a Poor Credit History
  • Short Time to Close a Deal

How Does Hard Money Loan Work?

A hard money loan is negotiated between a borrower and a lender who is usually an individual or a company but not a bank. The terms of the loan are negotiated based on the value of the collateral rather than the creditworthiness of a borrower. Usually, banks that issue conventional loans look at the credit history and income of a borrower to determine their creditworthiness. If their creditworthiness is not good enough, then the bank is likely to reject the loan. Private lenders like individuals and certain companies do not usually look at the creditworthiness of the individual. Instead, they simply analyze the value of collateral pledged to see whether they can cover the debt outstanding in the event of default by the borrower.

A hard money loan is not the best type of financing for most homebuyers because it usually carries a high interest rate. To compare, in 2021, an average rate for a 30-year fixed mortgage was 3.01%, while the rate of hard money loans ranged between 8% and 15%. Because of a high interest rate, a borrower who is looking to finance a house for 15 years may pay much more in interest using a hard money loan instead of a conventional loan. Instead, it is usually used by house flippers. 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, even though they pay a higher interest rate, they can use this loan as a faster and easier method to get approved for a loan.

Hard money loans are used mostly to finance investment properties. There are certain limitations as to what fees and interest rates a lender may set to finance an owner-occupied property. Since private lenders are looking for a high interest rate, they are not willing to issue loans for owner-occupied properties due to strict government regulations for owner-occupied properties. Because of that, this type of loan is usually used to purchase land for construction, a rental property, or for flipping purposes.

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.

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 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 the year 2020, an average conventional loan interest rate was equal to 3.72% while an average hard money loan interest rate was 11.25%.

  • 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.

Requirements for a Loan Approval

There are multiple factors a lender considers 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.

Credit Score

Even though private 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.

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