So you may have asked yourself, what is a hard money loan? Some homeowners are familiar with hard money consumer bridge loans, aka “bridge money” in the context of purchasing a home while waiting for their departing residence to sell. But in essence, most if not all hard money loans can be viewed as a “bridge” from one financial situation to another. Hard money loans are a great solution for temporary funding needs. These days hard money loans have become not only increasingly more commonplace, but a powerful tool for real estate investors. It is essential to know when hard money is right for your scenario, because in the right circumstances it is an indispensable tool for every real estate investor, providing a quick and versatile way to acquire real property.
A. What is Hard Money?
Hard money lenders are typically private investors or investor groups, pools of funds, life insurance companies, and even pension and retirement funds. Hard money loans
are an alternative to traditional bank lending that allows flexibility and expediency. Hard money lenders and hard money loans are not required to conform to the same guidelines as traditional financing, such as the standardized Fannie Mae and Freddie Mac underwriting guidelines for loans to be repackaged and sold on Wall Street. Put simply, a hard money loan is a loan that is secured by a “hard” asset – i.e., real property. Because hard money lenders secure their loans with real property as collateral, they are most concerned with a borrower’s equity in the property (or down payment for a purchase). The maximum amount a hard money lender is willing to extend – or leverage – is based on a percentage of the property’s value. Hard money lenders are most concerned about the Loan-to-Value (“LTV”), that is, the loan amount divided by the value of the property.
B. Why Use Hard Money?
Every well-equipped borrower’s toolbox should have a reputable hard money funding source. Although banks are usually able to offer lower rates, banks do not offer hard money loans
, their loan programs don’t allow for the same flexibility hard money lenders can afford. In addition, traditional lenders have loan committees and a more involved underwriting process, and it is not unusual for both of these to delay the loan process. Hard money loans bridge borrowers from one type of financing to another. Because of this, there are 2 main reasons to use hard money loans: 1) Speed; 2) and Temporary Financing Solutions. 1) Speed: Same-as-Cash Purchasing Power
One of the main reasons to use hard money loans is their speed. Hard money loans can be closed much quicker than traditional loans, offer in 1-2 weeks, sometimes quicker. Some of the best hard money lenders are able to make their underwriting decisions and issue a term sheet on the first phone call, and some are even able to fund loans in 24 hours! For those needing a quick close with minimal documentation, hard money loans are a great fit. 2) Temporary Financing Needs
Hard money loans are simpler and quicker than traditional loans
, and there are two main categories of temporary financing situations in which hard money loans make sense: (1) Property needs to be stabilized; and/or (2) Borrower’s financials need to be stabilized.
(a) Value-Add / Property Stabilization / Fix-n-Flips / Construction
Hard money loans are particularly well-suited for situations in the financed property needs to undergo some kind of renovation. This can range from cosmetic upgrades to full gut rehabs and rebuilds. The issue for borrowers in these situations is that traditional lenders base their funding decisions on the current value of a property.
Hard money lenders, on the other hand, are willing to base their funding decisions (at least in part) on the future value after renovated value (“ARV”) of the property. Hard money lenders are willing to lend on the riskier, future expected revenue of a property, because they mitigate their risk with a lower LTV and charge higher rates.
Fix-n-flips are a classic situation in which a hard money loan makes financial sense. In these situations, the loan is based on the after-renovated value. Once the property is finished being rehabbed, and realizes its full income-producing capacity (“stabilized”), the hard money loan can be paid off in 1 of 2 ways: sell the property, or refinance with a traditional lender now that the as-is value supports the loan.
(b) Borrower Financials Currently Less Than Perfect
Hard money lenders are far less concerned with credit issues such as foreclosures, bankruptcies, late mortgage payments, etc., and have less stringent underwriting guidelines.
There are times when a borrower is simply unable to provide documental traditional lenders require, whether due to the nature of their business, or the fact that tax returns may not be an accurate reflection of the current financial situation.
Hard money lenders are willing to look past such credit issues where there is enough equity in the property, or a borrower has enough access to capital to make payments on the debt.
Hard money lenders typically do not want tax returns or employment/income info. If there is significant equity remaining in the property after the hard money loan is accounted for, some hard money lenders will refinance a property with nothing more than a Driver’s License, Preliminary Title Report, and a visual inspection of the property (a “drive-by appraisal”).
C. What Does A Hard Money Loan Look Like? 1) Types of Hard Money Loans
(a) Fix-n-Flips, Commercial Value Adds, and Construction Loans
Fix and flips, value adds, and other distressed properties, as well as construction loans, can be difficult to finance using traditional lenders such as banks because these types of properties are inherently risky. This is a prime example of where hard money loans can be used.
Construction projects are by nature short-term, and usually, these types of hard money loans are for terms of 18-36 months. Hard money construction loans are used to cover the cost of labor and materials for the development project, and sometimes also the land acquisition.
(b) 1-4 Unit Residential Purchase and Cash Out Hard Money Loans
Hard money loans are commonly used to purchase 1-4 united residential properties quickly because their speed often provides same-as-cash purchasing power.
In addition, many investors utilize the equity in their property by “cashing out,” or placing a lien on property in exchange for cash proceeds.
(c) Commercial Hard Money Loans
Hard money loans are also used for multi-family apartments, commercial, industrial, retail, raw law, and many other property types. 2) Typical Hard Money Loan Terms
Hard money loans have terms of between 12-36 months but can be longer on a case-by-case basis. They are most often structured with interest-only payments, such that the loan balance is never paid down during the life of the loan, but rather includes a balloon note for the entire loan balance at the end of the loan term.
Rates and fees charged by hard money lenders are almost always higher than traditional loans. For example, rates are generally between 7% and 12% but vary widely based on property type and use, location, and LTV.
Fees charged on hard money loans will generally include 2-4 origination points. Origination points are a percentage of a given loan amount. 1 origination points equals 1%, and for a $500,000 loan 1 origination point equals $5,000. Like traditional loans, hard money loans will also include processing, underwriting, and legal fees, along with all third-party costs such as title, escrow, appraisal, etc.
(d) Loan-to-Value (LTV)
Because the lending decision is based primarily on the asset, the LTV (Loan to Value) is one of the most important ways hard money lenders secure loan repayment. For a purchase, borrowers typically need a minimum of 20% down, and for a refinance they generally must retain at least 20-25% equity in the property.
(e) Property Valuation
Once a term sheet is issued, the next step is property valuation. Value is generally determined through a broker price opinion (BPO) or an independent appraisal. Sometimes if the LTV is low enough, around 50-60% or less, a hard money lender will do a “drive by” appraisal, to confirm the property is substantially sound and in good repair consistent with the lenders internal valuation system.
(f) Exit Strategy
Because most hard money loans consist of interest-only payments in which the principal balance is not paid down during the life of the loan, there is a significant repayment at the end of the term. But this is never cause for concern because savvy investors and the best hard money lenders require a clear exit strategy before funding a hard money loan.
Takeout loans are the permanent financing secured to replace the current bridge loan. This is one of the main ways the balloon payment at the end of a bridge loan is paid.
Another main way to exit a hard money loan is to sell the property. This is often a fix n flipper’s strategy—purchase and rehab a distressed property with financed funds, then sell the renovated property at a profit. A flipper could, however, choose instead to hold the renovated property as a rental, in which case a permanent takeout loan would need to be secured. Once the property is turn-key ready with renters lined up, a traditional lender will be more willing to finance the property.
D. Hard Money Myths Debunked 1) 100% Financing—The Holy Grail
FALSE! No hard money lender will provide 100% financing. In fact, many hard money lenders will require a higher down payment than traditional lending sources. Otherwise, there would be no equity available to mitigate the risks associated with default. 2) Hard Money Loans Are Designed to Fail
FALSE! Hard money lenders are looking for a return on their money. In the event of default, they lose out on interest, the ability to place the money elsewhere, and time and effort to foreclose, all of which delay return on investment. Hard money lenders do not want to foreclose.
E. Finding the Best Hard Money Lenders
Many hard money lenders do not have a retail channel, meaning they will only funds loans procured through a broker. The best brokers spend many hours scouring thousands of loan programs to find the best rate and terms for their clients. Mortgages are largely fungible, and borrowers tend to be rate sensitive, so it is in the broker’s best interest to find the lowest rate and most favorable terms available in order to close the deal. Also, watch out for excessive upfront fees. Reputable brokers do not charge their fees unless and until the loan is funded (although in some instances a lender will require an application fee/deposit). Except for situations in which you are paying for a credit check, appraisal, or placing the funds into a separate performance escrow with a trusted escrow company, high upfront fees and costs can be a potential red flag.
F. Advantages and Disadvantages of Hard Money Loans 1) Pros of Hard Money Loans
2) Cons of Hard Money Loans
- Speed – Streamlined Process – Faster than traditional loans
- Flexible temporary financing solutions
- Viable option to finance rehab and value add projects
- Less focused on credit history
- Minimal documentation and asset verification
- Interest-Only Payments available
- Larger down payment may be required
- Generally, more expensive than traditional loans
- Balloon payment requires good take out strategy (this is not a con for savvy investors!)
G. Hard Money Not A Good Fit? – How To Avoid Hard Money
For borrowers that fall outside traditional underwriting guidelines but are looking for long-term loans with more attractive rates than hard money loans, a great option is no tax return investment property loans
. These loans do not require tax returns, income/employment, or debt-to-income ratio calculations. These are a great option for properties that have positive cash flow. They provide the flexibility and lessened documentation of hard money loans, but with rates closer to traditional financing.
H. The Bottom Line
Hard money loans are a powerful tool for real estate investors. They are quick and flexible, providing same-as-cash purchasing power. Hard money loans are also the most viable option for financing renovations or other value add projects. If you would like to discuss your hard money options, please give us a call today.