If you’re new to commercial real estate investing, you may have heard of the term ‘hard money loan’ but don’t fully understand it. Don’t worry—you’re not alone and we’re here to help. We will discuss all the basics you need to know about this type of loan and how it can be useful for commercial property investors who need fast access to cash.
What is a hard money loan?
Hard Money Loan Definition – A “hard” money loan is called such because it is backed by a tangible property—a “hard” asset that quickly produces enough income to pay off the loan. It’s an alternative way to get funding without using conventional mortgage lenders like banks or government-regulated financial institutions. Instead, the funds come from private money lenders.
These private hard money lenders do exactly what banks do—they lend money. The key differences lie in the loan structure, approval process, and loan purpose.
How much can you get from a hard money loan?
Hard money loans usually cover only 60% to 70% of the after-repair value of the property’s current market value, depending on the lender.
This is easier to understand if we do a sample computation.
For example, let’s say that you want to buy a property that’s currently on the market for $800,000, and its after-repair value is estimated at $1,000,000. Given all these numbers, a hard-money loan will likely cover $600,000 to $700,000. You have to come up with the remaining $100,000.
Hard money loans are sometimes called “rehab loans” because they include the property cost + renovation cost. Lenders will ask for rehab cost estimates from the contractor who will be hired to do the renovation. In many cases, only expenses that have a direct positive impact on increasing the property’s value will be approved. Luxury renovations like a disproportionately elaborate swimming pool, for example, may not qualify.
What are the hard money loan requirements?
Interest rates are quite high—anywhere from 9% to 15%, and sometimes even beyond that. Loan origination fees range from 1% to 3%.
Hard money financing is generally short-term, lasting only 12 to 36 months (but in some cases up to five years). It’s not a good idea to keep this type of loan for a long time, anyway, because of the high-interest rates.
Do note that hard money financiers take on more risk than traditional lenders. This is why loan origination fees and interest rates are higher—to compensate them for the increased possibility of default.
How are the funds released?
Funds from a hard money loan are distributed in predetermined “draws” as required by the contractor. The first draw covers the acquisition cost of the property. Subsequent disbursements are made based on the renovation schedule. In most cases, a large draw is made to purchase materials, and then several smaller subsequent draws are made over several weeks for labor.
How do you qualify for a hard money loan?
It’s generally easier to get a hard money loan to get a traditional mortgage. Here’s why:
Most traditional loans require proof that you can repay them. Banks look at your income, credit scores, and other metrics that measure how risky you are to lend money. Only when you have established a solid history of responsible borrowing and a good debt to income ratio can your application get approved.
The traditional loan approval process can also be painfully slow even if you show great credit scores and a reliable income. Any negative element in your credit report—including errors that are not your doing—can make the process even longer and lessen your chances of approval.
Hard money lenders don’t look at factors. They lend based on the value of the collateral securing the loan—the property you want to buy using their money. They are not as strict as banks in assessing your ability to pay because if you default on the loan, they will simply take the property and sell it to make their money back. In a hard money loan, the value of the property is more important than the borrower’s financial position.
What are hard money loans best used for?
- Hard money loans are popularly used by property investors seeking short-term funding for investment deals that need to be closed quickly. It can be a good option if you don’t want to pass on a great opportunity but don’t have enough liquidity to fund it fully.
- Hard money financing can also be useful for financing “fix-and-flip” deals when you are fairly sure that you can get your money back quickly and pay off the loan.
- Rental property investors who take the “buy-and-hold” approach also often use this type of financing to acquire and fix a property, and then eventually use a traditional lender to refinance the debt and pay back the hard money lender. It can be handy as a “bridge loan” to fund a certain property investment while you try to secure longer-term financing.
- House flippers who are unable to borrow money from banks also use hard money loans. In some cases, banks refuse to lend to them because of their low credit scores or because the deal doesn’t meet traditional guidelines.
Does a hard money loan make sense?
You may be wondering: If hard money is so expensive, why are so many commercial real estate investors funding their projects with it? And is it even logical to use it?
The answer depends on your project, your financial position, and your goals. In some cases, yes—it can be a sound financing tool. Hard money can be the best choice for certain borrowers who, for some reason or another, cannot obtain traditional funding fast enough to take advantage of a great opportunity. Here are just some of the reasons why:
1. It’s faster.
Hard money financing is closed quicker than traditional loans because lenders are mostly looking at the collateral, not at your financial position as a borrower. They don’t have to spend too much time looking at your bank statements and verifying your income.
Once you’ve established a relationship with a hard money lender, the process will generally move even quicker. This is why this type of financing is great if you want to close deals right away before others can get to them. It’s a fast way to get money for a hot market when deals often get multiple offers.
2. It’s more flexible.
Compared to traditional loan agreements, hard money agreements are more flexible because lenders don’t have a standardized underwriting procedure. Each deal is evaluated individually. This potentially gives you leeway to tweak factors such as repayment schedules, depending on the situation. When you apply for a hard money loan, you will likely deal with investors who are willing to negotiate—not large financial institutions with strict policies to follow.
3. It’s easier to get approval.
Do you have negative items on your credit report, such as a foreclosure? Do you have bad credit? Do you lack loan documentation?
All of these don’t make much of a difference in the eyes of hard money lenders. Many of them won’t even check your credit.
What they are more concerned about is the value of the collateral. If you intend to use the money to buy an investment property, lenders will look at how profitable it is to gauge whether it can produce enough income to pay the loan. If you’re borrowing against a property you own, lenders will look at that property’s value—not your credit history.
That said, hard money lenders will likely ask you about the state of your finances. It is because they want to know if you have enough assets to qualify. Most hard money financiers keep loan-to-value ratios relatively low at 50% to 70%. This gives them the confidence to quickly sell the collateral should you default on the loan and get their money back.
What are the key differences between traditional loans and hard money loans?
Let’s summarize what we have discussed so far:
- Hard money loan terms are much shorter—often as short at 12 to 36 months—whereas traditional loans can be amortized for 10 to 30 years.
- The interest rate for hard money loans is 4% to 10% higher compared to traditional loans.
- Traditional loans are intended for owner-occupied properties, while hard money loans are best suited for short-term investors.
- Hard money loans are backed solely by the property collateral, whereas traditional loans are backed by both the borrower’s credit and the property.
Do think about these differences when you’re deciding on how to finance your real estate investment.
How can you increase your chances of getting approved for a hard money loan?
When you apply for a traditional bank mortgage, you have to satisfy underwriters’ standards by showing that you have the means to pay the monthly amortization. The bank will send an appraiser to ensure that the mortgage is not bigger than the property’s value. This whole underwriting process can take as long as 45 days.
A hard money loan application is assessed differently. The lender focuses on the deal. They will ask:
- Do the financials add up?
- Are you buying the property a good discount?
- Are the proposed renovations properly budgeted for?
- Has the after-repair value been accurately determined?
- How sure are you to sell the property on time, make a profit, and pay off the loan on schedule?
If you have these bases covered, you increase your chances of getting approved for a loan.
Do note that hard money lenders typically look for real estate and rehab experience, too. Provide proof that you are a successful real estate investor if you want to further improve your chances. Show that you know what you’re doing, and they will be more open to negotiating the interest rates.
How long does it take to get approval?
Because these loans are more flexible, they are much faster. You can expect to get approval and funding in as fast as seven days.
Are there any downsides to a hard money loan?
Hard money loans are not perfect, and like any other financing product, they have their drawbacks.
- Perhaps the most obvious is that these loans are expensive. The interest rates are considerably higher (typically double digits) compared to other types of financing. You may also have to pay additional fees, including loan origination fees. Most lenders also require builders risk insurance—and this is costlier than property and casualty insurance that is regularly required for traditional mortgages.
Other forms of financing may be cheaper, depending on your circumstances. If you have bad credit, you may still be able to get a low-interest FHA loan. If you can’t get approval because the property you want to buy requires serious repairs, try an FHA 203k loan—it might allow you to pay for rehab at lower costs.
All this said, hard money loans typically require a lower loan-to-value ratio. This means that you won’t need the usual 20% down payment required in traditional investor financing. It is one consideration to keep in mind.
- Hard money lenders will not always see the property in the same way you do. They may peg their value lower than you expect. It’s possible that the loan won’t be large enough to pay for the entire renovation, especially if you end up running into unanticipated expenses.
- You need a solid plan in place—and things have to go as scheduled—to succeed in leveraging this type of financing. The rehab has to get done on time. Any unforeseen issues can make this short-term loan strategy very expensive.
There’s a possibility that you will walk away with nothing if you don’t finish the repair work on time or can’t sell the property for a profit. The lender can seize the property if you default on the loan; after all, it is the collateral.
Is hard money lending legal?
The real estate investing industry has sadly been tarnished by predatory hard money lenders who exploit newbie investors. However, most hard money lenders are 100% legitimate businesses. They are seasoned investors who are actively looking to fund profitable real estate projects and get a good return on their money.
That said, it’s important to do some due diligence when choosing a lender to approach. Keep in mind that unlike traditional financial institutions, they are not subject to the strict requirements and regulations, so you have to be careful.
- Look for a lender with extensive experience in hard money loans.
- Check if their fees and interest rates are reasonable. Compare rates from different lenders, if possible, to ensure that the terms proposed to you are competitive.
- Check if they truly have enough funding for your project. The last thing you want is to work with a lender who can’t come up with the promised cash for a scheduled disbursement. This can be a very big problem, especially if it’s crucial for your project to be finished on time.
- Look for a lender with a good reputation. Check reviews about them. If you know other real estate investors, ask them for recommendations. They may also be able to give you advice on which lenders to avoid.
- A hard money loan can be just the financing you need to see a deal through, for as long as you work with a reputable lender. Proceed with caution, but don’t be scared. As long as you know exactly what you’re doing and have a solid plan for repaying the loan quickly, you can succeed in using this type of loan.
How do you find legitimate hard money lenders?
The best way to find suitable hard money financing for your project—whether you’re fairly new to real estate investing or have been doing this for a few years—is to work with a reliable full service commercial real estate investment advisory firm.
You can count on Capital investors Direct. Our head offices are in Rockville, Maryland, but we have representatives all over the US. We offer custom loan solutions, including hard money loans from $1,000,000 up to $5,000,000 for financing commercial properties—and we do that in as fast as 48 hours.