Savvy real estate investors use other people’s money to get wealthy. This process of using ‘other people’s money’ is called leverage.
Hard money loans are one of the most common types of leverage used in real estate investing. You may be wondering ‘how do hard money loans work?’
Check out this overview of the pros and cons of using hard money loans.
How Do Hard Money Loans Work?
Hard money loans are an alternative to mortgage loans. They are used in real estate to help buyers who can’t or don’t want to qualify for conventional loans.
The source of hard money loans varies from individuals to investment funds. These loans are usually short term with the expectation that borrowers will repay the debt within five years.
Advantages of Hard Money Loans
There are many advantages to using a hard money loan over a conventional mortgage loan. Here are a few reasons to consider choosing a hard money lender for your next real estate purchase.
Bad Credit
Hard money lenders don’t require stellar credit scores to qualify for funding. In fact, some hard money lenders don’t pull your credit score at all.
They look at the after repair value (ARV) of the property to determine whether or not to approve the loan. Your creditworthiness won’t come into play if you find a property that will deliver profits for you and the hard money lender.
Collateral
With both a conventional mortgage loan and hard money loan, your home is used as collateral to secure the loan. The difference, however, is that with a hard money loan you aren’t using your personal property to secure the loan.
If you default, the investment property is taken away not the home you live in. This is a major perk as it makes the transaction less personal so you can stay focused on the numbers when choosing a property to invest in instead of how your personal finances will be impacted.
Speed
Mortgage lenders aren’t known for being quick. Going through underwriting on a conventional mortgage loan usually takes at least 30 days depending on the type of loan you pursue.
Real estate investors can’t afford to wait for months to secure a property. With competition high in desirable markets, investors can lose out on a good deal waiting too long to close on a mortgage.
They also tie up funds waiting for the lender to make a decision. It’s not uncommon for banks to ask borrowers not to make any other major purchases or keep a down payment untouched in a bank account until closing.
Hard money loans are issued much faster because the lender isn’t looking to go through every detail of your personal finances. The bulk of the lender’s attention will be focused on the property itself and its ability to bring financial returns.
The approval process is also more likely to be made by a much smaller team which means less red tape when issuing loans. Some hard money lenders are high net worth individuals who can provide immediate approval or denial of your loan request.
Loan Amount
Few lenders will loan less than $50 thousand dollars for an investor to purchase real estate. But hard money lenders are far more flexible than traditional lenders when it comes to loan terms.
For instance, there are hard money loans that cover 100 percent of the cost to buy and repair a home. This is unheard of in the conventional mortgage world.
Because hard money loans come from private lenders, you can also expect to speak to a decision-maker about your loan application. These decision-makers are more open to negotiating loan terms than mortgage lenders.
Expect the option to discuss interest rates and repayment terms when securing a hard money loan especially if your deal is attractive to the lender.
House Flipping
One of the most common hard money loan borrowers is house flippers. House flippers can’t always qualify for a conventional mortgage because banks won’t lend on risky repairs.
To a traditional mortgage lender, a major foundation or permitting issue makes the home too much trouble to use as collateral. As a result, borrowers will find that traditional lenders limit the number of repairs they are willing to overlook during the purchase process.
With house flipping, complete demolition might be necessary especially if safety concerns exist. Hard money lenders are used to these situations and will loan money to properties in bad condition if investors have a viable plan for flipping the property.
Many hard money lenders have experience in real estate investing and will be able to evaluate whether or not the house flip makes sense. House flippers can rest assured that if their application is denied, the property may not have been a good deal to begin with.
Disadvantages of Hard Money Loans
As the saying goes, there’s no such thing as a free lunch. Hard money loans don’t come without their fair share of disadvantages.
Here are some cons to consider before pursuing a hard money loan.
Interest Rates
One of the top things to consider when looking to profit in real estate is how much it costs to borrow money. You can’t earn a profit if all your earnings go toward debt service.
Hard money loans are known for having interest rates that are two or three times the amount of traditional mortgage loans. While this is of no consequence to seasoned investors, newbies should proceed with caution.
A house flip won’t take the same amount of time for a beginner as it would an experienced flipper. Unforeseen repairs could also prolong the process and cut into your profits.
Shorter Repayment Periods
Time is money when it comes to hard money loans. Your advantages in borrowing hard money only make sense when you can quickly flip the property for a profit.
This is because loan repayment periods are extremely short when you borrow hard money. The loan’s only purpose is to help you buy and repair a property.
Since you’re not living in the property, lenders expect the property to be sold as soon as repairs are complete. Consider partnering with a more experienced investor or taking your time applying for a loan if you aren’t sure how long repairs will take.
Should I Apply for a Hard Money Loan?
Hard money loans aren’t for the weak and the meek. They are a short term source of funding to help seasoned investors secure profitable deals.
How do hard money loans work if you have no money to invest? Even if you secure a 100 percent loan for your project, you will need funds to begin making loan payments.
It’s possible to form relationships with hard money lenders that get you access to better deals over time. For more information on real estate and personal finance, check our blog for updates.
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