The Beginner’s Guide to Hard Money Loans
Experienced real estate investors use hard money loans (private money loans) repeatedly throughout their career, but new investors don’t always have a clear idea of exactly what they are and how they work. They may think hard money loans involve working with lenders who look like they have mafia connections, do business in dark alleys and charge exorbitant interest rates and points.
In the past, a few unscrupulous lenders gave the hard money lending industry a bad name when they funded extremely risky loans with real estate as collateral with the intention of foreclosing on the properties. Thankfully, these types of lenders no longer exist in the current hard money lending industry, but some stigma may remain for novice real estate investors who haven’t worked with a reputable hard money lender.
This guide will cover the fundamentals of hard money loans including when a hard money loan should be used, common loan to value (LTV) ratios and loan terms, what a borrower needs to obtain a hard money loan and how to find a local hard money lender.
What is a hard money loan?
A hard money loan is a short-term loan that uses real estate as collateral. The money for the loans come from private investors instead of traditional lenders like credit unions and banks. The length of the loans are generally around 1 year, but loan terms of 3 to 5 years are available in some situations. The borrower is typically required to make monthly payments while the loan is outstanding. Because hard money loans are short-term, they require a balloon payment that is due at the end of the loan term.
The loan amount the hard money lender is able to loan to the borrower is determined by the value of the property being used as collateral for the loan (multiple properties may be used as collateral for one loan). The property used as collateral could already be owned by the borrower or it could be a property the borrower is purchasing.
The value of the property being used as collateral for the loan as well as the borrower’s equity in the property are the primary concerns for the hard money lender. The credit of the borrower may be considered by the lender, but credit issues alone usually aren’t enough to prevent the borrower from receiving a hard money loan. Other issues on a borrower’s record such as recent foreclosures, bankruptcies, short sales or loan modifications can also be overlooked by hard money lenders. Borrowers who are unable to get a traditional loan from a bank or credit union may still be able to receive a hard money loan.
What types of real estate transactions should hard money be used for?
Hard money has traditionally been used by real estate investors for loans such as fix and flips, cash outs, refinancing, bridge loans, investment property loans, construction loans and land loans. These are situations in which banks are reluctant to lend or not able to provide financing at all. Other lesser known types of hard money loans include estate and inheritance loans.
There are also situations where a borrower looking to purchase a residence (not professional real estate investors) is not able to receive a loan from a traditional lending source. In many cases a hard money lender may be able to provide subprime mortgages to these individuals.
Hard money loans are not needed for every situation. When a borrower is looking to purchase their primary home and has good income history, credit and no problems on their record (short sale, foreclosure, bankruptcy, etc.) they should pursue a traditional bank in order to get the lowest financing costs available if they have time to go through the longer application and funding process.
Who should use hard money loans?
Hard money loans should be utilized by borrowers when financing from banks or credit unions is not possible or the borrowed funds must be received in a short amount of time. Traditional lenders generally take 30-45 days to fund while hard money lenders take 5-10 days.
Real estate investors use hard money loans for a variety of reasons. The primary reason is that hard money lenders are able to fund the loans quickly and fund requests that a bank would not even consider. Reliable hard money lenders can fund loans within a week in many cases. Bank loans can take up to 30-45 days to fund. Hard money lenders are able to approve a loan application same day in most situations. The approval process at a bank or credit union could end up taking weeks.
Real estate investors understand that being able to get loan requests funded within a week with hard money is a massive advantage versus having to wait up to a month and half with a bank loan. When a real estate investor is attempting to purchase an investment property and there are multiple competing offers, offering a quick close with hard money financing will help the investor’s offer stand out and get accepted.
A borrower may also choose to use a hard money loan for the purchase of a primary residence if they have been turned away by traditional lenders. Borrowers are often turned away by banks due to recent foreclosures, short sales, loan modifications or poor credit. Borrowers can also be turned away if they recently started a new job and don’t have adequate income history (usually 2 years). These are all issues that hard money lenders are able to look past and still provide financing if the borrower is otherwise financially strong and has sufficient equity in the property.
Because hard money loans are for short-term use only, a borrower who utilizes a hard money loan to purchase a primary residence would be expected to attempt to fix any issues on their record (or simply wait until enough time has passed) so they could qualify for a traditional bank loan and refinance out of the hard money loan in the future.
There are other specific situations which perfect for using hard money such as an inheritance or probate loan against an estate. This involves allowing heirs of an estate to borrow against property within an estate until the assets are distributed or allowing heirs to split ownership of a property that one heir wishes to maintain ownership of while another heir would rather have cash.
Hard money loans for various property types
Hard money loans are available for most all property types:
- Residential (single family or multifamily)
Many hard money lenders tend to specialize in a specific property type and this will come up early in the initial conversation between the borrower and lender. If the lender isn’t able to lend on a specific type of property requested by the borrower the lender may be able to refer the borrower to another lender who can fund the request.
1st position and 2nd position hard money loans
All hard money lenders will be able to fund a loan request in 1st position. 1st position (also known as senior position) means it has priority over all other liens on the property if the borrower defaults. There are less lenders who are willing to fund a loan in 2nd position (junior position) because of the increased risk. 2nd position loans will have a higher interest rate.
Owner occupied hard money loans
The majority of hard money lenders are not willing to fund requests on owner occupied residential properties. This is due to the many restrictions, regulations and additional disclosures and documentation the government has recently mandated for this specific property type. Some hard money lenders are still able to consider lending on owner occupied property.
Loan to value (LTV) ratios
The loan to value, or LTV, is simply the loan amount divided by the value of the property. This ratio determines the amount the lender is able to loan on any given property. Hard money lenders typically are able to lend up to 75% of the current value for residential hard money loans. LTV’s for commercial hard money loans are often lower (~60-65%) since commercial properties are generally more difficult to value and take longer to sell than residential properties.
Lending based on the current value of the property is considered more conservative as some hard money lenders lend based on the after repair value (ARV). Lending on ARV is for fix and flip / rehab loans. The loan amount available to be loaned is a percentage of the estimated value of the property once the borrower has finished making the improvements to the property. Borrowing against a future value increases the risk associated with the project and decreases the amount of equity committed to the deal by the borrower. This increase in risk will result in higher lending costs for the borrower.
Some hard money lenders lend a high percentage of the ARV and finance rehab costs for the project. Borrowers who need this type of loan are often financially weaker than borrowers who use current value loans, and end up having to pay much more in lending costs. Some borrowers try to fix and flip properties with no funds at all but hard money lenders do not want to fund these types of requests.
Hard money loan interest rates and points
Hard money loan interest rates and points will be different for each hard money lender. There is no set standard and hard money lenders adjust their pricing in order to be competitive in their market. Different regions of the country can have drastically different hard money loan interest rates and points.
California hard money lenders typically have lower rates than most other parts of the country. This is because California has a large amount of companies who do hard money lending. Because there is greater competition, the interest rates and points are kept at lower levels than other parts of the country where there may only be a few different hard money lending options.
Because hard money loans are perceived as being riskier than traditional bank loans, the interest rates for hard money loans are higher than for traditional loans. Hard money interest rates typically range from 9-13% depending on the lender and perceived risk of the loan scenario. Points generally range from 2-5% of the total loan amount. Points and interest rates can fluctuate significantly depending on the request loan to value ratio.
What does a borrower need to receive a hard money loan?
Hard money lenders are predominantly interested in the value of the property being used as collateral as well as the amount of equity the borrower has invested in this property when considering whether or not to fund a hard money loan. The borrower’s credit is of some importance but not the most significant factor when analyzing a potential deal.
The borrower must also show that they have sufficient funds to make the monthly loan payments and for rehab costs if the loan is for a fix and flip project. The borrower will also be required to explain their exit strategy for the hard money loan, whether it will be selling the property, refinancing with long-term financing or raising cash from another source in order to pay off the loan.
First time hard money borrowers are often surprised about how few hard money loan requirements exist compared to the many regulations of conventional bank loans.
How to find hard money lenders
Most first-time hard money borrowers don’t know of any hard money lenders or know where to begin looking for them. There are many ways to find local, reputable hard money lenders. A simple place to start is searching Google for the city or area + “hard money lenders”. This will deliver a list of local companies who provide hard money lending services. This will serve as a starting point for collecting names of lenders to contact and consider.
Real estate investor club meetings are a good place to meet local hard money lenders. Many cities have real estate investor meetings on a monthly basis and representatives from hard money lending companies are usually in attendance in order to network with real estate investors who may be in need of their services. If there are no hard money lenders to be found at the meetings, speak with a real estate investor and ask if they have a hard money lender they would recommend. Any experienced real estate investor will have used a hard money loan at some point in their career.
Another source for hard money recommendations would be your personal real estate network including traditional mortgage brokers, real estate brokers or any other experienced real estate professional. If these contacts don’t have a trusted lender they will most likely be able to reach out to their contacts to find a recommended hard money lender.
Contacting hard money lenders and comparing quotes
After compiling a short list of at least a few hard money lenders, the process of contacting each lender begins. Borrowers who are new to hard money lending can benefit from reading this article that outlines 10 questions you must ask a hard money lender when applying for a hard money loan. After a brief conversation with the lender regarding the borrower’s loan request, the lender should be able to determine if they think they will be able to provide financing and give a rough quote. The quote should include the interest rate, points and any additional fees the lender will be charging for their services.
For more information on hard money loans, visit our Hard Money Lending Blog. Please contact North Coast Financial with any questions or to inquire about a hard money loan.