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Not everyone can qualify for a traditional loan. Banks and credit unions look to verify a recipient via a background and credit check. Once this has been processed, they will then evaluate the loan request, recipient, and decide whether they are worthy. In other words, banks and credit unions look for someone trustworthy to lend their money to and this trustworthiness is mutually exclusive to creditworthiness.
Unfortunately, due to a host of reasons, bad credit or other circumstances can render someone unfit—in the eyes of these institutions—for a mortgage, loan, credit card, etc. Thus, they must look elsewhere.
On the flipside, there are investors, developers, and house-flippers that simply don’t like the traditional loan process. To them it is an arduous, complicated, and often-times rigged endeavor that leaves them owing a trust-fund worth of interest and with their credit maxed out.
Thus, what do these people do when they either can’t apply for a traditional loan or don’t want to?
Enter the hard money loan (HML).
What is a Hard Money Loan?
A hard money loan is (typically) a sum of money lent to an individual or business by a third-party investor(s). Rather than backing the loan via use of the recipient’s credit, the loan leans against physical assets. For example, rather than checking the individual’s credit score, the lender will grant the loan against the value of their home. Although real estate is the most common backing of hard money loans, other physical assets have been known to work as well.
When discussing borrowing hard money, it is important to note that they are typically issued to property developers While hard money loans certainly exist elsewhere, and are processed for a variety reasons, they are most commonly tied to real estate and flipping houses.
Some of the common types of HMLs go as follows:
This hard money loan allows a real estate developer to move on their green-lit project.
Bridge loans allow someone to snatch up a property quickly. These borrowers usually have the intention of selling or refinancing the home. Additionally, a bridge loan can allow someone to purchase a new property before they are able to cash out on their anchor home. In simpler words: a bridge loans allows the borrower to pay for a down payment although they do not have funds yet. This type of loan can also be issued to someone that does not qualify for a mortgage.
This type of hard money loan provides a borrower with the resources to purchase a property quickly, rehabilitate it, and then sell it. This sale will cover the cost of the property, loan, and provide additional profit.
Outside of the realm of real estate, this loan is tailored towards the borrower that does not qualify for a traditional loan. They will need to borrow against a physical asset, such as a property they own. Owner-occupied loans are almost always lent to homeowners.
Alternatively, private investors or firms will provide hard money loans on a case-by-case basis, which means the borrower may have the intention of using the money outside of real estate and may back the loan via different physical assets, such as a car.
How Does a Hard Money Loan Work?
Hard money loans have a bad reputation. We will delve further into this stigma later but generally, people think of HMLs as money handouts from the neighborhood mob that comes with, well, a serious price. If you fail to pay, they own you. Might even break your legs if you’re unlucky.
In the financial world, this notion is laughable. Hard money loans are simply an alternative method, one executed outside of traditional methods, that can provide investors, individuals, and real estate developers with capital.
The typical way a hard money loan works is as follows:
First, an individual or business will desire a hard money loan. This can be a result of their inability to obtain a traditional loan or simply their preference. They contact a hard money lender, explain their situation and amount coveted. The hard money lender will then evaluate their assets and investment opportunity and, if they deem the individual or business eligible, set a lending value based on the total value (always less) of the assets owned or to-be-purchased.
Fees & Interest
Upon settling on a price, the hard money lender will then apply fees and set an interest rate. As a rule of thumb, interest and fees will always be higher when it comes to a hard money loan. The risk does not come without reward—as we will explain later. Generally, the break down goes as follows:
- 2-5% processing fee, often required upfront before the loan is issued
- 12-21% annual interest
Say, for instance, you have been approved to take out a $100,000 hard money loan. In the best-case scenario of our above estimates, you will have to pay $2000 before receiving the loan and will accumulate $12,000 in interest per year. These numbers are relatively standard across the industry, but they do vary dependent on the value of assets, case, and lender.
Although hard money loans vary, the most typical must be paid within 6-12 months. These loans are processed quickly and their greatest advantage is their processing speed. At a cursory glance, the above processing fees and interest would not be worth it if not for how quickly these loans are issued.
Granted, not every borrower’s circumstance is the same, and hard money loans can range from 6 months to five years. Usually this is not the case.
A hard money loan can take anywhere from three days to a month to process. The average time, however, is one week. Therefore, borrowers who have come across an expiring but potentially lucrative real estate opportunity prefer hard money loans; while they may have higher fees and interest, dealing with less paperwork and downtime means they can seize the opportunity before them.
Hard Money Loans and Property Acquisition
While the aforementioned process is an oversimplification of the hard money loan, it does serve as a viable overview. Most hard money loans will follow those exact steps, regardless of the borrower or circumstance. But we should take a look at the most common reason for hard money loans; flipping properties.
How Do I Prepare?
If you are currently interested in obtaining a hard money loan in order to acquire a property, then you will need the following items before contacting them:
- The Purchase Price
- Exit Strategy
- Costs of Construction
- ARV (After Repair Value)
- Scope of Work
These are the base items you are going to need. If you stroll into a third-party lender’s office and say, ‘I want x loan because I want to buy a house’ they are nearly always going to want to vet the property you are referring to. You need to have the items handy—even if just for credibility purposes. They are going to take a borrower more seriously when they waltz in meaning business.
In addition to the above items, and to speed up the process, you will also want to include the below. Remember, this not a bank or financial institution; they are going to want to mitigate any risks by analyzing your investment history and other comparable properties.
- A Breakdown of all Construction Costs
- Property Feature Analysis
- Comparable Properties That Support ARV (provide addresses)
- ARV Breakdown
- Potential Profit Margins
- Evidence of Experience
- Credit History Access
How the Lender Regards Your Flip-It Request
Take an Arizona hard money lender, for instance. They will estimate the size of a given loan dependent on a percentage of the property’s After Repair Value, an appraiser’s (usually independent) ARV, in-house ARV, a percentage of the given purchase price, percentage of the as-it-stands value, percentage of total coasts, or a combination of multiple of these eliminates.
With that being said and as we have stated before, each hard money lender is going to have a different process and this will vary both by the case in question and the third-party which lends the money. We can, however, make a few overt generalizations.
For residential flip-it requests, usually a hard money lender is going to size a loan to about 80%~ of the purchase price or 60-70%~ of the after repair value. In which case, here’s a breakdown:
You are looking to buy a home that, for sake of an easy example, costs $100,000. The repairs and renovations are going to cost you around $50,000 and you expect to sell the home for around $200,000~ after all is said and done. If you had the money, then your profit would be somewhere in the realm of $50,000~ .
In which case you are probably going to see a hard money loan quote come in around $140,000~. This price is a combination of the above elements and, will still require some initial capital to sustain (by use of the example, you will need another $10k for the renovations and you will still have to pay for the loan fees and interest).
In addition to the total amount, some lenders may reserve a portion of the loan. This is commonly known as a ‘holdback’ and it is used for future advances. Often, it is given incrementally at certain milestones per se (like different stages of the home’s rehab) and can be used to pull equity out of the property before the sale is finalized. However, this holdback amount is not exempt from interest or fees. A hard money loan typically charges interest on the total amount issued (HML + holdback) from the date the funds are transferred.
How Can I Use a Hard Money Loan?
Saying that you can use a hard money loan in any which way isn’t necessarily true. While their applications can, theoretically, be endless, usually the way in which you are going to use the loan is dependent on the contract signed between you and the lender. For instance, if you are taking out a loan to buy a house as agreed upon by you and the lender, then blowing all the money on vacation will (most times) negate your contract.
With that being said, there are a few key reasons people take out hard money loans rather than traditional ones—even those that qualify for both.
Developers often prefer hard money loans because they can borrow larger amounts, back them with physical assets (which they own), and the processing time is much quicker. The reliability and efficiency of the hard money loan process is enough to justify the higher interest and fees. This is particularly true when an opportunity with a short expiration date surfaces.
Those who own tangible assets but have bad credit may not be able to qualify for a traditional bank loan. They can spend all their time proving income, net-worth, and providing proof of their assets, but if they have bad credit (most times) the bank will not deem them eligible. Thus, they turn to a third-party lender looking for a hard money loan. The alternative process then grants them eligibility because the loan is backed by that which they own and their credit has no role in it.
This dynamic is often what gives hard money loans their infamous reputation—the financially distressed. At times, a borrower that has a loan in default they need to refinance will come to a hard money lender as a last-ditch effort to rectify the situation. Unscrupulous lenders can, in these instances, draft shady and ruthless hard money loan contracts that the distressed borrower is forced to sign—due solely to their own difficult circumstances.
However, in ethical and more common cases, if the borrower knows they are going to come into a sum of money but, due to current circumstances, cannot stay afloat, a hard money loan can be the perfect bridge to guide them over their troubles.
The overarching theme of a hard money loan is this: the borrower has a way of generating substantial profits quickly and these profits, in their finality, will still hold their value even after fees and interest accrue on the HML. They do not have the money upfront to fund the quick-profit project themselves and, due to the difficult and time-consuming bank loan process, turn to hard money lenders instead.
What Are the Hard Money Loan Requirements?
You may find yourself reading through this article and thinking, ‘okay, I understand, but how do I qualify for a hard money loan?’ While HMLs are certainly more lenient in their eligibility-process that does not mean that everyone will pass muster.
The primary factor hard money lenders look at when issuing a loan is the total profitability of the deal in which a borrower is bringing to the table. Banks, on the other hand, focus on the property as collateral and the borrower’s creditworthiness. Thus, while a hard money loan will still vet the borrower (yes, this can include a credit check) the importance is not necessarily on them, but on the project. Remember, most HMLs are issued to developers looking to flip a home, meaning most hard money lenders are well-versed in real estate and have their own analytical teams that will consider a given project and say yes or no.
The reason in which we stress this point is because, well, there are no objective requirements ubiquitous across the third-party lending industry. Each potential project is going to have its own gamut of circumstances and these, for better or for worse, are what will constitute whether or not you meet a hard money lender’s requirements. The industry is so diverse that certain hard money lenders will approve a given project while others will not.
The rule of thumb is there are three types of projects (all involving real estate) that appeal to the hard money lender.
- Fix and Flip
- Cash-out and Refinance
Commercial Hard Money Loans
The process of obtaining a commercial hard money lending is typically no different than an individual. With that being said, having company backing for a larger project, commercial real estate being the focus here, can greatly benefit the validity of the borrower. Hard money lenders will have an easier time approving a given project if the company, especially if it is held in high esteem, is liable.
This greater liability paired with commercial projects will, after the aforementioned components are verified, result in a much larger loan than an individual.
Where Do I Get A Hard Money Loan?
You can receive a hard money loan form a third-party hard money lender. Being that borrowers are continuously put-off by the traditional banking system, there are now more hard money lenders than ever. Still, seeking a hard money lender in hopes of finding the one with the lowest interest and fees is not necessarily the route to the most trustworthy, dexterous, or even ethical lender.
How Do I Find a Good Hard Money Lender?
Unfortunately, anyone with lending capital can consider themselves a hard money lender. The check sizes can range anywhere from a few thousand dollars to the millions. Thus, when it comes to finding a good hard money lender, the people are arguably more important than the deal. The goal here is to find a trustworthy establishment that upholds great values, a fantastic reputation, and their standard of work.
As with anything in the financial world, due diligence is key. Make sure to do you research and ensure that the hard money lender you are considering has a good track record. While hard money loans are certainly stigmatized, that is not to say the world is without unscrupulous and shady lenders. Here are some important questions to ask when you are looking to find a good hard money lender.
- Is the lender you are seeking an actual lender, or are they an extension of another?
- What is the source of their capital?
- How many loans have they processed in the last year?
- Credit scores, are they important? (often, lenders that don’t so much as bother with credit can be indicative of shadiness)
- How quickly do they process loans?
- After your loan is funded, is it sold or do they keep it in-house?
- Does the lender service the loan, or is it a third-party?
- What kind of documentation is involved? Are they reliant upon third-party appraisers?
- Is there an extension option on the loan in the case that your project goes on for longer than expected? If so, what sort of penalties or fees will accrue?
- If a quote is provided, is that real to the terms? Or will they do an ‘overhaul’ before you sign?
- The lender—are they well-versed in real estate? As in, do they flip homes themselves, or are they simply lenders?
- Has the lender ever foreclosed on a loan?
- Will they willingly provide references for borrowers they’ve worked with in the past?
These questions work as a fantastic starting point for at least peeling away the initial layers. The more answers you can obtain, the better your chances at understanding who your lender really is. Lastly, remember that these are not traditional institutions—meaning they are less regulated. The hard money loan business is typically relationship-based. Those that do well have long track records and varying clients. Those that want your money will promise the moon and eagerly await you to sign away.
A hard money loan can be a fantastic way to avoid traditional financial institutions and cash out on a quick loan—one that will help an investor seize an opportunity soon-to-expire. Despite their stigmatization, they are simply an alternate loan that comes with a different set of parameters. For developers, investors, and those who have the assets to support the loan but a bad credit score (often due to divorce), they can be a godsend.