Hard money loans are an alternative to borrowing money from traditional banks and mortgage lenders. They are commonly used by professional real estate investors to source for funds for various real estate projects. This kind of investors are experienced in this sector, and they understand the workings and demands of these loans. However, before jumping into hard money borrowing and applying for a loan, new investors need to dedicate some time to understand the drawbacks and benefits of private money loans.
Top 3 Drawbacks Of Hard Money Loans
Certainly, hard money loans appear simple enough, and it has helped numerous real estate investors realize their investment goals but it has its own unique downside that you’ll need to be aware of beforehand:
1. Interest Rates Are Higher Than Banks And Other Traditional Lenders.
Interest rates are higher because the hard money lender is agreeing to bear a greater risk by approving your loan.
Typically, they won’t make a deep check of your credit score, income and other areas of your financial record as a bank would before giving loan approval. That is clearly precarious. Borrowers should expect interest rates of between 9 and 14 percent. They’ll also pay loan origination fees of several points which equal a percentage of the total loan amount to get funding.
The points should range from 2 to 4. Potential borrowers should get firsthand information and compare rates from different hard money lenders before making a decision.
2. The Loans Are For Short Term Use
Hard money loans are designed for short-term lending periods of from a few months to 2 years. With special arrangements, you may get loans of up to 3 to 5 years, but that is not the norm.
The longer the loan term, the higher the risk to the lender because interest rates may change by the end of the loan. If interest rates decrease, borrowers can refinance the loan to reflect the lower rates. If rates increase, borrowers can still maintain the loan at the original rates agreed at the beginning of the loan.
This translates to less money for the lender because he/she is forced to wait for the loan to end when they could have given out a fresh loan at the prevailing higher rates.
3. A Down Payment Or Equity Of Between 25 to 30 Percent Is Required
Down payments or equity requirements are always seen as a serious problem to borrowers. They view it as an unnecessary stumbling block created to prevent them from attaining their goals. But they need to look at things from the point of view of the lender.
Hard money lenders are literally “sticking out their necks” when they issue loans without thoroughly investigating your credit records and other shortcomings in your financial standing.
Hard money lenders have the ability to overlook various shortfalls and issues on a borrower’s record, but they must ensure that the borrower has enough equity (or down payment) in the property. The only way they can ensure you have a stake worth fighting for is to demand a down payment. Such measures will make the borrower commit to the project all the way.
Top 3 Benefits Of Hard Money Loans
1. Speedy Approval And Funding Process
The swift approval and funding process of hard money lending is hands down its number one benefit. It’s not rare to get approval the same day the loan application was raised.
To start the process, a hard money lender will look briefly into the following:
- Details of the proposed collateral property
- Down payment/equity available
- The would-be borrower’s experience in real estate investing
- Payment plan
- The borrower’s cash reserves for holding costs
Approval is almost automatic once everything checks out.
The actual funding also is quite fast, and the money can be accessible in as little as 3 to 5 days. This is perfect for real estate investors faced with a quick and competitive investment opportunity. For instance, hard money lending has rescued many investors that would have been frustrated out profitable real estate deals when the initial lender withdrew at the funding stage. This same funding process would take up to 30 days or more if you were to approach a bank.
2. The Requirements For Hard Money Loans Are Less
The requirements for obtaining a hard money loan are fewer than what you can expect from banks. Private lenders will want evidence of the following;
- Adequate down payment/equity
- Exit strategy
- Cash reserves for holding costs
- The borrower’s experience with real estate investing
A bank will stipulate many more requirements than the above, and there are so many factors that could make them deny a loan request. Such factors include foreclosures, recent short sales, loan modifications, poor credit history, and bankruptcies. Banks and other traditional lenders will not consider borrowers with 4 mortgages even in a situation where the borrower’s credit is exceptional, and they have an excellent record in every other criterion.
With evidence of down payment/equity of 25 to 30 percent of the collateral asset, borrowers with negative credit score can still get a loan from hard money lenders.
If the property the borrower intends to buy is an owner-occupied property, the borrower can get hard money funding to purchase a property and then repair whatever issues there are on their records or wait for the stipulated period of time to have issues removed from their records. Once that is sorted out, the borrower can choose to refinance with a lower cost conventional loan.
Another benefit of hard money lending, when compared to conventional lending is that conventional lenders hardly approve home loans to borrowers that have worked in their current job for less than 2 years or to borrowers that are self-employed. This is the case even when such a person is an excellent candidate for a loan and this happens because of how rigid bank financing conditions can be.
Thankfully, borrowers that find themselves in this situation can still obtain short-term hard money loans of between 1 to 3 years to buy the property. They can then refinance later into a lower cost conventional loan as soon as they attain the required 2 years at their current job.
3. They Are Ideal For Projects That Conventional Lenders Will Not Consider
There are certain risky but profitable real estate projects banks would not be willing to finance. One of such is the fix and flip.
A fix and flip loan will allow the investor buy a property with short-term funding, quickly make whatever repairs and rehabilitation are required and then sell it off for a profit. All this can take about a year to complete. This is fine for hard money lenders but banks, on the other hand prefer longer term loans with small, regular interest payments.
By nature, banks will only fund projects with as little risk as possible. They will never consider loans that deviate from their lending criteria and this is partly due to the many laws and regulations that guide their operations. If the property has issues like bad wiring, structural problems, or drainage issues banks will not touch it.
To a hard money lender, the above property is an opportunity for profit. They will provide the funds to the borrower to buy the asset and make the needed repairs. The borrower can then choose to sell or refinance with a bank loan.