Hard Money Loan Pitfalls
Before You Use a Hard Money Loan
A hard money loan is not always the best choice. While it seems simple - the asset secures the loan so everybody’s safe - hard money is only one option. It is expensive, so things have to work according to plan for profits to materialize. A hard money loan is different than loans you may have used in the past. Lenders use more conservative methods to value property than you may expect.
Hard Money Loan Costs
Hard money loans are expensive. They are designed to be temporary, and the interest rate on a hard money loan gives you an incentive to move on as quickly as possible.
First, interest rates are generally higher on a hard money loan. You should not be surprised to pay more than 10% APR, and you can easily pay several times that. A hard money loan should be used to help with a temporary need, not as something you’ll keep around forever.
You may not even have the choice to keep a hard money loan going for long. Most loans require you to repay in full within one to five years, so you have to plan ahead. These loans are often used for house flipping projects as opposed to the purchase of a home you'll live in.
In addition to higher interest rates, you’ll often pay more points to get a hard money loan. Five points or more would be reasonable, but you’d need a good reason to pay that much on other loans. Again, a hard money loan is a shorter-term loan, so you’ll amortize those points over a shorter period of time. They drive up your borrowing costs.
Credit for a Hard Money Loan
You may not need good credit or any credit to qualify for a hard money loan. However, many lenders will pull your credit and look for red flags. Yes, they can sell the asset and get their money back, but they’d rather not do that. If you have bad credit, you may not qualify for a hard money loan - even if it’s a safe bet for the lender.
Low Loan to Value Ratios
With these loans, an asset, such as the property you're buying, serves as collateral to secure the loan. You'll need to sign documents allowing your lender to place a lien on the property.
Loan to value ratios are generally more conservative with a hard money loan. Despite claims about 'little or no money down', you’ll need assets to qualify for a hard money loan. It may be possible to pledge different types of assets to qualify - such as personal assets or other properties - but you need sufficient equity in those assets.
As a general rule of thumb, expect loan to value ratios between 50% and 70%. Lenders want extra assurance that they’ll get their money back by selling assets.