Pros and Cons to Obtaining Hard Money Loans
Differences Between Hard Money Loans and Purchase Money
To understand where hard-money loans came from, we can go back to the horse-and-buggy days. The most commonly used form of money among settlers in early America was gold coins. Native Americans, on the other hand, traded goods such as beads and pelts. If you borrowed money, you were expected to pay it back, and collateral was not always part of the bargain. Hard-money loans are typically uncollateralized. On the downside, if you didn't pay it back, you could be shot.
To settle the colonies, the United States government gave away plots of land in exchange for a settler's promise to live on the land, grow stuff such as corn or cotton, and raise livestock. To provide shelter, settlers chopped down a few trees and built their own log cabins. Today, we expect to either buy an existing home or we pay a builder to build a new home for us, and we rarely own a home free-and-clear.
For the most part, buying a home in the 21st Century involves some type of financing. There are generally three parts of the purchase price:
Hard Money Loans Versus Purchase Money Loans
A purchase money loan is money a home buyer borrows to buy a home. That home can be almost any type of structure, from a single-family residence, multiple units, a condominium, townhome, or stock cooperative to a modular or manufactured home.
Purchase money makes up part of the purchase price. The loan is secured by the property, meaning if the buyer stops making the payments, the lender may have the right to seize the home and sell that home to get its money back.
A hard money loan secured to real estate is a loan that is not purchase money. It is money loaned to a borrower, which is not always used to buy a home. You can get a hard money loan without owning a home at all -- without any security for that loan -- providing the lender feels you are a good credit risk. A credit card cash advance is a hard money loan. Or you can get a hard money loan that is secured to equity in the home but was not part of the original purchase price. Hard money lenders usually want the borrower and the security to qualify for a hard money loan.
Loan Sharks Are Hard Money Lenders
People who borrow money from loan sharks generally cannot get a loan from any other source. These borrowers might have bad credit, no assets or questionable occupations. Some borrowers are simply naive and fell on hard times.
If you have an asset that can be used as security for the loan, you might go to a pawn shop. If you have no item of value to trade for the money, a hard money lender such as a loan shark is the lender of choice. Loan sharks make their money by charging very high-interest rates, which are often against usury laws. Loan sharks might use threats of violence to encourage borrowers to repay the debt.
All loan sharks are hard money lenders but, fortunately, not all hard money lenders are loan sharks. It is not advisable to borrow money from a loan shark.
Types of Hard Money Loans
Most hard money lenders prefer collateral with securitization to make a loan. That collateral, such as a home, reverts to the hard money lender if the borrower defaults and the home eventually go to foreclosure. Real estate is an excellent vehicle to secure a hard money loan, providing the property in question has equity. One of the reasons for the mortgage meltdown in 2007 was the value of homes had fallen, which left many lenders holding the bag without any security.
Some buyers use hard-money loans as a routine to buy investment properties that need fixing up. They will save their cash and pay high points to take out a hard-money loan with a short repayment period. The problem with this approach is some buyers write their purchase offers as all cash, and they show cash accounts as proof of funds. If they obtain a loan, however, the transaction is NOT all cash.
Here are common types of hard money loans:
- Mortgage Refinancing is a Hard Money LoanA refinance pays off one or more loans secured to the property, which results in a new loan, generally with a bigger principal balance. A homeowner can refinance without receiving any of the proceeds by either rolling the costs of the new loan into the principal balance or paying the costs of the loan out of the borrower's pocket.
- In a cash-out refinance, the buyer takes out a new loan that is larger than the amount of the old loans plus the costs to obtain the money. The money above those two items is referred to as "cash to the borrower." It is the net proceeds of the refinance. Many cash-out refinances are subject to deficiency judgments.
- Equity Loans are Hard Money LoansHome equity loans fund fairly quickly and are subordinate to an existing first mortgage. In other words, an equity loan falls into second or third position. Borrowers cannot obtain a home equity loan in all 50 states.
- Bridge Loans are Hard Money LoansBridge loans are used by sellers who want to buy a new home before selling an existing home but need the cash from the existing home. You will see bridge loans used more often in seller's markets than in buyer's markets.
At the time of writing, Elizabeth Weintraub, CalBRE #00697006, is a Broker-Associate at Lyon Real Estate in Sacramento, California.