Hard Money Loan Risks and Benefits for Real Estate Investors

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What Is a Hard Money Loan. PhotoAlto/Frederic Cirou/Getty Images

You have searched long and hard to find the perfect investment property. The problem is that because the property is in such a bad condition, no bank is willing to give you a mortgage on it. Enter the hard money loan. Learn what a hard money loan is and the benefits and risks for a property investor.

What Is a Hard Money Loan?

Like any other loan, a hard money loan is a sum of money that is borrowed from a lender.

The exact terms of the loan will vary based on the contract between borrower and lender. 

The borrower receives the money, while the lender receives monthly interest on the loan until it is paid back in full. The lender will also often charge the borrower an up-front, one-time fee in order to process the loan.

A hard money loan is backed by the physical asset, which is the property being purchased. More traditional loans are based on the borrower’s credit score.

Where Do You Get a Hard Money Loan?

Hard money loans can be obtained from individual investors or an investor group.

Who Needs a Hard Money Loan?

Hard money loans are commonly used in real estate investing. Traditional lenders, such as banks and other financial institutions, are not comfortable lending on risky investments. They are more interested in lending on stable investments where they feel there is a greater likelihood of having the loan paid back.

Therefore, if an investor wants to purchase a distressed property, they have limited options when it comes to finding financing. Real estate investors who want to do a gut rehab or a quick property flip commonly use hard money loans.

Other real estate investors, who may be purchasing income properties, may use a hard money loan initially until they can stabilize the property.

Once the property is stable, these investors will secure a more traditional mortgage at a lower interest rate and pay off the higher interest hard money loan.

Hard money loans are also used by individuals who are unable to get a mortgage from a bank due to a poor credit score. They may have poor credit, but still have enough equity in their property to have the hard money lender interested in making a loan. This scenario can be seen when an owner is facing foreclosure on a property. 

Benefits of a Hard Money Loan

Here are 4 reasons a real estate investor may obtain a hard money loan:

1. Quick Process: Since you are working with one individual lender, or a small group of lenders, there are fewer hoops to jump through. Hard money lenders are not interested in your credit score or how much debt you have. 

Since the property is the asset that is backing the loan, they are only interested in how much value they see in the property. Depending on your lender, you could have your loan in a few days or a few weeks. It could take one to three months to secure a more traditional mortgage.

2. Can Borrow More: With a traditional mortgage, you have to put down a minimum of 5 percent of the purchase price.

Banks prefer for you to put down 20 percent of the purchase price, which will often give you better terms on the loan. If you put down less than 20 percent, you will often have to purchase mortgage insurance, which will increase your monthly mortgage payment.

With a hard money loan, the lender may be willing to lend you 100 percent of the purchase price. Without a down payment, you would only be responsible for paying the origination fee and the monthly interest until you pay the loan off in full. 

3. Establish Relationship: Just as you can establish a relationship with a bank or other lending institution, you can establish a relationship with your hard money lender. If you have shown a history of honoring the terms of the contract and paying your loan back on time, or even early, the lender will likely want to work with you in the future.

Because of your proven track record, the lender may be willing to loan a greater percentage of the purchase price, reduce the origination fee or reduce the amount of time it would take to receive the loan.

4. Good When Starting Out: Hard money loans are not right for every investor, or for every investment, but they can be a great starting point. When you are just starting out, these loans allow you to purchase property with very little money of your own. Once you have established yourself a bit as an investor, you may be able to secure a line of credit from a bank instead of using a hard money loan, which will have a much lower interest rate. 

Risks of a Hard Money Loan

While there are benefits to obtaining a hard money loan, here are 4 risks you must also consider:

1. High Interest Rate: One big downside of a hard money loan is that they often come with very high interest rates. It is not uncommon to see interest rates between 10 percent and 20 percent on these types of loans. The lenders know they have the upper hand because you have very few options for securing a loan.

Since they are also taking a risk by loaning so much money, they want to make sure you have an incentive to pay it back quickly.

2. High Origination Fee: An origination fee is a fee the lender will charge to process the loan. It is a percentage of the loan.

Again, since this is a riskier investment, the hard money lender is trying to protect themselves. It is not uncommon for the lender to charge as much as five times the amount of a normal lender. For example, if a typical bank charges one percent of the total loan as an origination fee, a hard money lender could charge five percent of the total loan.

3. Not Long Term: While it is common to have a 15-year mortgage or a 30-year mortgage, this is not the case with hard money loans. While every contract is different, these loans will often have to be paid back within a few months or a few years. If the loan is not paid back within the first few months or year, the already high interest rate could increase.
    
4. Losing the Property: Since the physical property is the guarantor of the loan, not you personally, if you cannot pay off the loan, you will lose the property.