Hard Money Loan Example and Overview
A hard money loan is a type of loan that is secured by real property.. These loans are primarily used in real estate transactions, with hard money lenders being real estate investors that are generally individuals, companies, or hard money lending funds.
Hard money loans are primarily used for real estate investing transactions and are money from an individual, company, a lending fund, and not a bank.
A hard money loan, unlike a traditional mortgage, is usually taken out for a short time. It’s a way to raise money quickly but at a higher cost and lower LTV ratio.
Because hard money loans rely on collateral rather than the financial position of the applicant, the funding time frame is shorter than a conventional loan.
Terms of hard money loans, such as loan amount and closing costs, can often be negotiated between the lender and the borrower. These loans typically use property as primary collateral and typically require a personal guarantee.
Default by the borrower can still result in a profitable transaction for the lender through collecting the collateral.
How Hard Money Loans Work
Hard money loans have terms based mainly on the value of the property being used as collateral, and less so on the creditworthiness of the borrower. Since traditional lenders, such as banks, do not make hard money loans, hard money lenders are often private individuals, companies, or hard money lending funds that see value in this type of potentially risky venture.
Hard money loans may be sought by property flippers who plan to renovate and resell a real estate rental property that is used as collateral for the financing—often within one year, if not sooner. The higher cost of a hard money loan is offset by the fact that the borrower intends to pay off the loan relatively quickly—most hard money loans are for one to three years—and some of the other advantages they offer.
Hard money lending can be viewed as an investment as well as the provision of a service. There are many who have used this as a business model and actively practice it.
Special Considerations for Hard Money Loans
The closing costs of a hard money loan to the borrower is typically higher than financing available through banks or government lending programs, reflecting the higher risk that the lender is taking by offering the financing. However, the increased expense is a tradeoff for faster access to capital, a less stringent approval process, and potential flexibility in the repayment schedule - things you just don’t get from private money mortgage lenders.
Hard money loans may be used in house flipping, turnaround situations, short-term financing, and by borrowers with poor credit but substantial equity in their property.
Pros and Cons of a Hard Money Loan
There are pros and cons to hard money loans related to the approval process, loan to value (LTV) ratios, and interest rates.
One advantage to a hard money loan is the approval process, which tends to be much quicker than applying for a mortgage or other traditional loan through a bank. The private investors who back the hard money loan can make decisions faster because the lender is focused on collateral rather than an applicant's financial position.
Lenders spend less time combing through a loan application verifying income and reviewing financial documents, for example. If the borrower has an existing relationship with the lender, the process will be even smoother.
Since the property itself is used as the only protection against default, hard money loans usually have lower LTV ratios than traditional loans: around 50% to 70%, versus 80% for regular mortgages.
Also, the interest rates tend to be high. For hard money loans, the rates can be even higher than those of subprime loans. As of 2020, the average interest rate for a hard money loan is 11.25% with rates varying from 7.5% to 15% for the United States in 2020.
Another drawback is that hard loan lenders might elect to not provide financing for an owner-occupied residence because of regulatory oversight and compliance rules.
Example of a hard money loan.
An experienced house flipper (developer) finds a house that needs refurbishment for sale for $100,000.00. It will require $25,000.00 worth of upgrades and the Lender, through 3rd party appraisals has determined that the property has an after repair value (ARV) of $155,000.00. The developer secures a 9 month loan for $105,000.00 from a hard money lender. This loan has a loan to ARV of 68%. The loan would have an interest rate around 12% and the developer would pay 2 to 3% in upfront fees (points) to the lender. The lender advances $76,200.00 at the time of close, so the developer has $23,800.00 equity in the project. As the developer achieves certain construction milestones, the lender confirms the work was performed, and releases the additional monies to finance the remaining construction. Larger projects will have multiple milestones and payment advances for the renovations. The developer needs to complete the house within the 9 month timeframe and secure traditional financing. If they cannot achieve that within the timeframe, the lender may agree to a 3 or 6 month extension and the developer will continue to pay interest plus additional points to the lender.
Investor Pros / Cons
· Higher rate of return on investment, typically 10% +
· Short term loan, usually 12 months or less.
· 1st position lien on the property
· Higher risk loan
· Investment is not liquid
· If a borrower defaults, property must be sold to recoup investment, sometimes at a loss.