Real estate investors and those considering entering the market would do well to understand hard money loans, which are chiefly used in real estate transactions but are not offered by banks. With that said, here is an explanation of what hard money loans are, how they work, who they benefit, and more.
This loan type, which is secured by property, is mainly used in real estate transactions. Hard money loans are widely considered short-term bridge loans or loans of last resort and are generally issued by private individuals or companies rather than traditional banks.
The terms of these risky ventures largely hinge on the value of the property put forth as loan collateral. That differs from bank loans, which are primarily based on the borrower’s creditworthiness. Hard money lenders can usually lend up to between 65% and 75% of the property’s existing value, and loan terms are generally between three and 18 months.
Generally, hard money loans have higher interest rates than conventional mortgages, reflecting the relatively heightened risk the lender takes in providing the financing. Rates can even top those of subprime loans. Recent rates on hard money loans averaged between 10 percent and 18 percent, rendering such loans significantly pricier than traditional mortgages, which currently run between four percent and 5 percent.
Working out the interest on a hard money loan calls for taking the loan amount and multiplying it by the proffered interest rate. This means that, if the offer is a $100,000 loan that carries an 8.5 percent interest rate, the overall interest paid would amount to $8,000. Likewise, if the offer is a $300,000 loan with a seven percent interest rate, the overall interest paid would be $21,000.
While hard money borrowers generally are not required to submit the voluminous paperwork that traditional banks usually require, they will have to turn in some documentation that may include:
Such documentation will vary and depend on the lender, as well as any prior relationship with the lender.
Hard loan borrowers generally tend to be short-term investors and “flippers” — those who purchase a property, hold onto it for what is usually under a year, renovate it, and then sell it for a higher price. As such, they are generally more apt to accept the higher rates in exchange for expediency, which is the hallmark of such loans.
It is not unusual for borrowers to have funds in hand in around 10 business days. Contrast that with traditional loans, for which the wait time runs between 30-50 days. Borrowers usually plan to repay the loan right away, thus mitigating the higher rate’s impact and making the loan less expensive.
In addition to turnaround scenarios, hard money loans are also used in short-term financing. They also are common among borrowers who have poor credit but a great deal of equity in their real estate. Because they can be garnered so quickly, such loans can be used to forestall foreclosure.
In addition to quicker access to capital, borrowers can expect less stringent qualification requirements and potential repayment flexibility, although they may be required to submit a higher down payment.
In general, hard money loans may be a better fit for particularly affluent investors who need property funding fast. They are often used to cover a one-time project or expense.
With all the risk involved, it is natural to wonder why an investor or company would ever lend such a loan.
One common reason is that the collateralized property may ultimately be worth the loan amount, if not more, particularly following any renovations. A related reason is that the lender simply believes the property is a worthwhile investment.
To illustrate, a borrower sought to buy a fixer-upper for $100,000, with renovation costs estimated at $30,000. The anticipation was that the rehabbed house could be sold for $180,000. Thus, the hard money lender lent 70 percent of the property’s projected value after renovation.
In another example, the hard money loan was for $250,000 with a 7% interest rate and a six-month project turnaround time.
Net profit = $410,000 – $354,354.65 (repair and flip expenses) = $55,645.35
Loan amount = ($260,000 + $52,500)*0.8
Loan amount = $250,000
Monthly repayment = $250,000*0.07/12
Monthly repayment = $1,458.33
Total interest paid = $1,458.33 over six months
Total interest paid = $8,750
Down payment = Purchase price + Renovation budget – Loan amount
Down payment = $260,000 + $52,500 – $250,000
Down payment = $62,500
The overall renovation and flip expenses are the sum of all anticipated costs associated with the property fix. Here, costs included the loan amount, down payment, property taxes, total interest paid, and state recording and transfer tax. Other expenses included an origination fee, closing costs, title insurance, a realtor fee, property insurance, and overall holding costs.
Ultimately, the total renovation and flip cost came to $354,354.65.
There is no perfect loan product, and that goes for hard money loans. However, there are benefits for the borrower.
As for the advantages, the loan approval process tends to happen quicker than it would for a traditional bank loan. Hard money lenders – typically private investors – can decide on applications faster since the lender’s focus is the collateral instead of the borrower’s credit and finances.
Compared to bank loans, hard loan lenders tend to spend less time going through an application reviewing financial documents and verifying earnings or other income, for instance.
As for the investors, they are not as worried about repayment since they have the borrower’s collateral, which may be worth more than the loan.
There are potential drawbacks to hard loans, including what are usually higher loan-to-value (LTV) ratios than conventional loans. The LTV ratio is an evaluation of lending risk that banks and other lenders study before green-lighting a mortgage. Usually, loans that show high LTV ratios are deemed higher risk, which often results in a higher interest rate. For most lenders, 80 percent is the threshold for a favorable loan-to-value ratio.
Further, loans with a high LTV might call for the borrower to buy private mortgage insurance (PMI) to offset lender risk.
Other potential drawbacks include interest rates that tend to be high, as well as the possibility that lenders may not wish to offer financing for a residence that is occupied by the owner, due to compliance rules and regulatory oversight.
While no investment is risk-free, real estate remains a popular investment, its benefits including possible steady secondary income streams, leverage, cash flow, and tax favorability.
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Despite their shortcomings, there are definite benefits to hard money loans for investors, developers, and those known as property “flippers.” Loan terms are generally short and can be arranged much more swiftly than a loan through a traditional bank.
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