A hard money loan is a loan from a private lender backed by a tangible asset like real estate. These loans usually have shorter terms and higher rates than traditional mortgages.
Definition of a Hard Money Loan
A hard money loan is a loan from a private or non-traditional lender. The asset being purchased is used as the collateral for the loan, reducing risk for both the borrower and lender.
- Alternate definition: A loan that bridges the gap between an investment purchase and long-term financing.
- Alternate name: short-term bridge loan
Hard money loans are used for quick turnarounds between the purchase and sale of a property. They can also be used for quick home financing until the buyer secures a traditional loan.
These loans are generally used in the real estate industry. Some investors buy homes in need of repairs, fix them up, and then sell them for a profit. This is known as flipping and can be hard to get financing for.
Other real estate investors might use hard money loans for commercial or rental properties if they can't find conventional financing.
How Does a Hard Money Loan Work?
A hard money loan is a way for you to borrow money for real estate without using traditional mortgage lenders. Instead, the funds come from individuals or investors who lend money based primarily on the property you’re using as collateral.
Traditional mortgage loans require proof that you can comfortably repay the debt. Lenders often review your credit scores and any income available to evaluate your creditworthiness. If you have plenty of income, savings, or can get another collateralized loan you might not need to worry.
However, the process becomes more challenging if you have a low credit score, an income source that is difficult to verify to your lender’s satisfaction, or a high debt-to-income ratio.
Hard money lenders are primarily concerned with the value of the collateral securing the loan. They are less concerned with your credit scores and income than traditional residential mortgage lenders.
If anything goes wrong and you can’t repay the loan, hard money lenders expect to get their money back by taking the collateral and selling it.
Hard money loans are generally short-term loans, lasting from one to three years. You use them as a quick way to get money for a purchase. However, you wouldn't want to keep one of these loans for an extended period because interest rates for hard money are typically relatively high. For instance, the average interest rate for hard money loans in 2020 was 11.25%.
Do I Need a Hard Money Loan?
Hard money may be appropriate if you can't get traditional funding for your real estate purchase. Because traditional lenders focus on the value of your collateral, hard money can potentially close quicker than other loans.
The hard money lender isn't likely to spend as much time as traditional lenders examining your application (although they still want to make sure you'll repay them). For example, they may not spend as much time verifying your income sources or reviewing your bank statement.
Once you've established a relationship with a lender, additional funding processes can move quickly, giving you the ability to close deals that others can’t. That’s helpful in hot markets when properties get multiple offers.
If you can qualify for other forms of financing, you might come out ahead with traditional loans. For example, FHA loans allow you to borrow with less-than-perfect credit, have low down payment requirements, and may have lower rates than a hard money loan.
Hard money agreements might be more flexible than traditional loan agreements. For example, depending on your situation, you might be able to tweak things like the repayment schedule or other more strict features a traditional lender will not negotiate.
The most important factor for hard money lenders is the collateral that secures the loan. Since the property acts as a guarantee, it becomes easier to get approved for an investment property.
You also might be borrowing money from someone willing to work with you directly—not a global institution with strict policies.
Is a Hard Money Loan Worth It?
A hard money loan is not perfect. While it seems simple—an asset secures the loan, so all parties are safe—hard money has its drawbacks, too.
A primary drawback of hard money might be the extra costs you incur. This is an expensive method of borrowing. Interest rates are relatively high, and you may need to pay closing costs or other fees to get funding.
Foreclosure or other negative items in your credit report are less important for a hard money loan approval process.
A short time frame can also be risky. For example, if things don’t go according to your plans, such as a material delay or structural surprises while renovating a home, you may face a cash flow squeeze or pay more interest than you expected.
Finally, the way lenders value your property may drain your resources more than you expect. For instance, if your lender required a 30% down payment when you'd expected one for 20%, you might have a shortage of capital for labor and materials.
What It Means for Individual Investors
While approval can be quick and easy, most hard money lenders keep loan-to-value ratios (LTV ratios, or the ratio of the loan value to the value of the home) relatively low. The maximum LTV ratio tends to fall between 65% and 75%, so you'll need assets to qualify for hard money.
With conservative ratios, lenders know they can sell your property relatively quickly and have a reasonable chance of getting their money back.
Hard money loans make the most sense for short-term loans. Fix-and-flip investors are an excellent example of hard money users: They own a property just long enough to improve it, increase the property value, and sell it as soon as they can.
Hard money borrowers might hope to sell a property and repay the loan within a year or so. It may be possible to use hard money to purchase a property that you want to live in. You could, but you’d want to refinance as soon as you can get a loan with lower rates and a longer loan term.
How to Get a Hard Money Loan
To find a hard money loan, you’ll need to contact institutions specializing in this type of transaction. Quick internet searches for hard money lenders can generally reveal several lenders in your area.
Local real estate agents and real estate investor groups are a good source for names. Reach out to several lenders, discuss your needs, and develop a relationship so that you can fund projects quickly and easily when you need to.
It helps to shop around since hard money loans are less regulated. You might be able to find lower rates or be able to negotiate different terms with different lenders.
- Hard money loans are loans given out by private lenders for investment purposes.
- The rates for these loans are generally higher, and the terms are much shorter than traditional loans.
- The asset you're taking the loan out for becomes the collateral for the loan, so the lender's risk is reduced.