What is a hard money loan and how does it work?
The hesitance of traditional lenders such as banks to lend to individuals and small businesses has led to the rise of private lending as an alternative. As banks stick to their strict lending regulations, private lending has been experiencing exponential growth since the 2010s. In 2016, non-bank lenders accounted for 53% of mortgages in America.
Private lending options such as hard money loans offer more unique benefits than traditional loans. They are a more flexible and quick way to access cash. This comes in handy for a small business that needs emergency funds to sustain cash flow and pay bills.
Hard money loans have a long history stretching back to the late 1950s. The market for hard money loans grew due to people seeking extra cash with lenders using real estate as collateral.
For a business owner or individual considering hard money loans to finance real estate investing, it’s crucial to have a good idea of how this financing option works and the approval process.
What Are Hard Money Loans?
Hard money loans are asset-based loans or bridge loans. They are common in real estate transactions where investors use the property as collateral to get the loan. They are usually sourced from private lending institutions or individual investors rather than banks.
Hard money loans are mostly used in fixing and flipping property used as collateral to be sold for profit, which usually takes between 6 months to a year. It can also be helpful in securing commercial or rental property when the bank is not an option.
How Do They Work?
A hard money loan is generally a form of short-term financing lasting between a year to three years. Unlike traditional mortgage lenders, private lenders issue a loan based on property value and not the credit scores and income of the borrower. An investor with a credit score of as low as 600 can qualify for a loan.
While hard money lenders will not lay down strict approval requirements, most will ask for a down payment which is typical in real estate transactions. The down payment acts as security in case the borrower defaults. If the borrower fails to pay back the loan, the lenders will either sell the property at an auction or renovate and sell it to make a profit.
The main concern for the lender is the value of the property, since they are exposing themselves to a big risk such as foreclosure. They have to make sure the property can be sold to get back their investment.
Lenders rely on what is termed as the loan-to-value ratio (LTV) to calculate the amount of capital to lend as a loan. The formula is the total loan amount divided by the value of property used as collateral. A borrower can access a loan that is 65% to 75% of the property value. Traditional banks have a higher LTV of 80%.
Borrowers should expect common costs associated with hard money loans, including an origination fee, application fee, processing fee, underwriting fee, broker fee, funding fee, and doc prep fee. Typically, as a short-term loan, it charges higher interest rates (10%-15%) than traditional loans, but is still preferred in the real estate industry.
Qualifications of Hard Money Loans
Hard money loans are popular among real estate investors because the approval process is straightforward, unlike with banks. However, the process may differ from lender to lender.
Since private lenders don’t have set down requirements, borrowers can negotiate favorable terms. What lenders generally look for include:
1. Down Payment
Lenders are mainly concerned about the amount of equity or down payment on the property, which acts as collateral. They usually require 25% to 30% for residential properties and 30% to 40% for commercial properties.
2. Borrower’s Finances
The lender will also determine if the borrower has enough cash reserves to pay the monthly loan and interest payments. Some lenders may ask for three months of bank statements to evaluate the borrower’s income. The more cash reserves an investor has, the greater the chances to qualify and obtain lower interest rates.
3. Investor’s Experience in Real Estate
A lender will highly favor a borrower who has years of experience of flipping properties rather than a borrower looking into the first property. A novice borrower will increase the chances of qualifying for a loan if they can provide details about the property and their exit strategy. However, they may be subject to higher interest and fees than an experienced investor. To lower the costs of the loan, the investor can offer a higher down payment like that of 35% to 40%. In the case the property is being occupied by the borrower real estate experience isn’t as much of a factor.
Why Hard Money Loans Can Be Better Than Traditional Bank Financing
As highlighted earlier, hard money loans tend to be attractive to property flippers and borrowers who can’t qualify for traditional loans. Here are three pros of hard money loans.
Hard money loans have a quick turnaround, meaning they have a shorter approval process than traditional loans. Since the lenders are mostly looking at property value, cash can be available in a matter of days or weeks. However, hard money loans for consumer purposes take longer to process as they are subject to TILA-RESPA Integrated Disclosures.
With hard money lenders, a borrower can negotiate repayment terms and loan periods. Borrowers are not required to follow the same lengthy and stringent underwriting process as traditional lenders.
Poor credit history will not prevent an investor from accessing the loan. In general, lenders look at a few factors such as equity in the property, amount of cash reserves, and the investor’s experience in real estate and their exit plan.
Hard money loans offer a much better alternative for real estate investors due to their lenient and flexible nature. Despite the high interest rates hard money lenders charge and the lower LTV ratio, it’s available to borrowers who can’t access conventional lending. Working with the right private hard money lender will allow for a smooth and transparent process.
Need help finding a hard money lender?
Benworth Capital is a trusted and top lender for hard money loans. We offer residential, commercial, and second mortgages, which can take as little as 24 hours to be approved. We aim to help our clients not to lose great investment opportunities due to a shortage of capital. Please contact us today to help you secure your hard money loan.
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