Hard money loans are asset-based loans in which the only collateral is the property in which the borrower is investing.
Common Hard Money Loan Characteristics
These private mortgage loans are considered extremely risky for the real estate investor. They are available only through private hard money lenders, rather than through banks or other financial institutions.
The Interest rates charged on these loans are extremely high, ranging from 12% to 20%.
Hard money loans are almost always short-term loans with a term period of one to three years. At the end of that time, the borrower must either sell the property to pay back the debt, pay the debt from his or her own assets, or refinance the loan with a traditional mortgage.
The amount of hard money you may be able to borrow is limited by the LTV ( loan to value ratio). A borrower buying money against a $100,000 piece of property, for instance, could typically expect to receive no more than 70% of the value of the property, or in this case, $70,000.
Unlike conventional residential loans, hard money lenders almost never finance beyond an LTV of 80%. As a measure of safety, a private lender generally insists that the buyer has a high amount of equity in the property to make it more difficult for the borrower to simply walk away from the mortgage later on.
Who Uses Hard Money Mortgage Loans?
Hard Money real estate loans have several disadvantages for the average borrower including crippling interest rates, short terms, strict guidelines that benefit the lender. So why would anyone choose to pursue a hard-money loan?
For most borrowers, these are loans of last resort. A borrower might, for instance, seek out this kind of loan to stave off foreclosure, or to survive during a quick sale of the property with an underwater mortgage. Some borrowers turn to these types of loans as bridge loans — loans required when they need to buy a second piece of property without having sold the first one.
These loans are also very popular among real estate investors who flip property. These are people who buy a distressed property, restore it, and then sell it at a profit. Hard-money loans are convenient for them because the approval time is significantly less than for a traditional loan and because they expect to finish restoring the home and sell it long before the loan term is over.
Why are Traditional Bank Loans Being Replaced by Hard Money Lending?
Unlike traditional mortgage loans, which take into account a borrower’s financial situation and ability to repay the mortgage, hard money lending is based strictly on the collateral of the property a borrower is purchasing.
Hard money loans have several drawbacks. They are short-term loans, lasting a few years at most. They also carry staggering interest rates, between 12% and 20% per year. Finally, most hard money lenders will only finance between 60% and 70% of the fair market value of the home, leaving the borrower to come up a down payment of 30% to 40% of the cost of the home.
In spite of these drawbacks, hard money lending is being used quite frequently today by real estate investors due to several factors.
Banks Are More Reluctant to Approve Traditional Mortgage Loans
During the housing bubble, almost anyone could get approved for some type of mortgage. Today, even people with good, but not great, credit scores and decent incomes are being turned away by banks. If those people wish to become homeowners, they may have no choice but to seek out hard money lenders and use the time when the hard money loan is in effect to boost their credit scores and financial profiles as much as possible.
Hard Money Lenders Approve Loans Faster
A traditional mortgage loan requires a credit check and a thorough investigation of a borrower’s income and assets. It can take weeks for a bank to make a decision about approving a loan. Hard money loans, on the other hand, are typically approved within a few days. Generally, all the borrower needs to do is submit a simple application and perhaps wait for the results of a home inspection to determine fair market value. This simplicity is fueling the rapid increase in the volume of loans originated through hard money lending sources.
More People Are Trying to Find Non-Traditional Ways to Make Money
The sluggish economy has affected not only the housing market but employment as well. Many companies are laying off workers, or encouraging/forcing workers to take early retirement. Many people, unable to find steady employment, have gone into business for themselves doing things like flipping houses. People who buy houses to refurbish them and then sell them quickly at a profit almost always use hard money loans for their financing.
In addition to an increase in people self-employed flipping houses, there are also more entrepreneurs who are willing to take the relatively high risk of issuing a hard money loan because, if the borrower does not default, the lender can make a great deal of money very quickly.
These are some of the main reasons why we are seeing more hard money loans today than we have in the past. It is a safe guess that, as the economy stabilizes, there will be less need for hard money loans and we will again see fewer of them.