Navigating the world of financing in the real estate market can be a daunting task, especially for real estate investors. But thanks to hard money lenders, you can get credit for your next property or project without dealing with a bank.
With flexible terms and quick funding times, hard money loan programs have a lot going for them.
This article will explain more about how hard money lenders work – including their benefits and drawbacks. Ultimately, these loans can provide essential capital when traditional financing options aren't available, becoming a reliable source for creative financing.
Hard Money Lenders 101
What Is a Hard Money Loan?
A hard money loan is a short-term loan from a private lender. It is non-conforming, meaning it does not meet the mortgage guidelines Fannie Mae and Freddie Mac set forth. Let's first look at the process for traditional loans, and then compare it to hard money loans.
For a traditional mortgage loan, you must go to a bank, and you must show proof of income, savings and a review of your credit score to qualify for the loan. Depending on your credit history and the current real estate market, you may pay origination points to help lower the interest rate. Approval or denial of the loan occurs within 30 days.
The loan you get could be a fixed-rate loan (the most popular being 15 or 30-year terms). You could also choose an adjustable-rate loan, which would see the interest rate change at specific intervals, but the loan term would be for 30 years.
A hard money loan carries a less stringent approval process. Hard money lenders typically start with a credit or finance check, but this is a small part of the process. This information is compiled with the rest of your application but is one of many things considered for approval. In other words, you can still qualify for private lending even with poor credit.
Some lenders require proof of past successful flip loans. You obviously will only have this information if it's not your first flip loan.
Finally, you may have to provide information about the property or your plans. That's because hard money lenders offer loans based heavily on the property's resale value rather than the borrower's ability to repay the hard money loan.
You may get lucky enough to be approved in just minutes, but it could take several days.
After you have chosen a loan offer and agreed upon the terms, your lender will provide a proof of funds letter so you can immediately start with your real estate investment purchase, construction, or renovation.
The biggest advantage of a hard money loan is you can get the funds quickly, usually in a few days. Compare this with a traditional mortgage which can take a month or longer for approval.
Of course, there are drawbacks, the major one being the interest rate. Since there is more risk for the hard money lender, they charge an interest rate much higher than the going rate for a 15 or 30-year mortgage.
How Do Hard Money Loans Work?
Unlike traditional loan approval, getting approved from a hard money lender is less dependent on the borrower's ability to pay it back and more on the property's value.
Because of this, loan amounts are based on the project rather than what you offer as collateral.
The loan term is typically one year or less and is an interest-only loan with a large balloon payment at the end.
Where To Find a Hard Money Lender
Investors looking for a short-term loan from private lenders can contact real estate agents, title agents, closing attorneys, and other investors for leads.
Additionally, an online search will also yield results for your local area.
The last thing you need to consider is using a local or national lender. Some investors prefer local hard money lending because the lender better understands the area and is more likely to approve your request.
However, others prefer national lenders, which have deeper pockets. Ultimately, you must decide which route to take for your investment property, as both have perks and drawbacks. Reach out to one of their customer service representatives to get more information.
Why Real Estate Investors Use Hard Money Loans
So why would someone choose to take out a hard money loan instead of a conventional loan?
There are a handful of reasons, including needing the cash quickly to purchase a property.
Unlike those who invest in Real Estate Investment Trusts (REITs), others want to own property. As an investor, you won't hold onto properties for 20 or more years, so you need a lending option that is flexible enough to accommodate short-term commitments.
Because these loans are quick to get and have a short payback period, they work as short-term bridge loans until the property eventually lands in the hands of the long-term owner or you obtain traditional financing.
Owning investment property is an excellent way to make money if you make wise choices and the market cooperates. Here are a few ways investors can use a hard money loan to improve their portfolio.
Flipping a Property
Hard money loans are perfect for house flippers because the goal is to sell the property within a few months. Therefore, they do not need a low-interest rate since they only need the money for the immediate term to purchase the property or cover rehab costs.
Even though the rate on the money they borrow is higher, they account for this in their plans, so they can still turn a profit.
Buying Investment Property
Since approval only takes a few days, if an investor zeroes in on a property, they can offer and close within days, not months. That agility gives them an edge over other investors.
Once they own the property, they can apply for a traditional mortgage with a better interest rate if they plan to keep it long-term.
Building a Real Estate Empire
It is challenging to qualify for additional rental property loans with a traditional lender because you want to borrow more than the bank is comfortable with.
A private hard money lender could be a sound alternative in the short term.
Buying Commercial Real Estate
A commercial bridge loan is a way of getting fast cash before a more traditional loan comes through. When you need a significant amount of money quickly, like purchasing a commercial property, a hard money loan can fill the gap.
Hard money lenders will even offer to finance real estate development. While this is not the most common use of a hard money loan, it is a way for people with limited credit history to build a home or start real estate investing.
Another use could be to cover the costs of upgrading a rental property you plan to sell. In this case, the property has become dated over time and needs a refresh to sell for top dollar.
The added benefit here is the repair value could make the home more valuable, meaning you sell it for more money.
Advantages and Disadvantages of a Private Money Lender
Of course, working with hard money lenders has pros and cons. So whether you are borrowing for a rental property or some other real estate investment, consider the details of a private money loan carefully before diving in.
- Fewer rules and regulations, i.e., no red tape
- May offer a new business opportunity
- Usually doesn't review a borrower's credit history
- Fast funding
- Higher interest rates
- May require a more significant down payment
- Less time to repay the loan
- Sometimes require proof of successful home flips
Alternatives to Hard Money Loans
If working with a hard money lender isn't a step you're ready to take, and a traditional lender isn't an option, there are some in-between options for you to consider.
In this case, a private lender is a friend, family member, or other investor looking to earn a return on their investment. You would have to set up a legal agreement outlining the terms and conditions of the loan agreement and the payback period.
While rare, it is a great alternative to consider.
Home Equity Line of Credit
A HELOC can give you the cash you need to improve your home or use it as a down payment on a rental property. There are requirements for these loans, but they are usually less stringent than home mortgage loans.
Additionally, investors who own multiple investment properties could take out a home equity loan from each property and pool the equity to use as a down payment or rehab a property.
Fannie Mae Homestyle® Loan
Still government-backed, these loans are for home renovations, not new constructions.
The loan allows the borrower to wrap the rehab costs into the mortgage, so they have one monthly payment each month.
If you're dealing with bad credit or are an investor looking to build a rental portfolio, using hard money lenders is a smart option.
While hard money loans carry high-interest rates, these loans can help you gain access to fast cash.
You will only use them for some purchases you make, but you never know when you might stumble upon the perfect property to buy. And if it's a great deal, it's only a matter of time before another investor finds it.
You can put yourself in the driver's seat toward ownership by closing quickly.
This article was produced by Wealth of Geeks.
Jon is the founder of MoneySmartGuides, which helps people dig out of debt and start building wealth so they can achieve their dreams. He has over 15 years of experience in the financial services industry and 20 years of investing in the stock market. He has both his undergraduate and graduate degrees in Finance and is FINRA Series 65 licensed, and has a Certificate in Financial Planning.