There may come a time in your life when you really need or want some money and traditional lenders have turned you down. Maybe you’ve even thought about getting a quick loan from one of those local payday loan stores? Well, if you have real estate, or are using the money to buy real estate, you may be able to get a hard money loan. The question is, should you take one? Here, we’ll discuss what a hard money loan is and in what circumstances you should consider using one.
What is a Hard Money Loan
A hard money loan is a loan that doesn’t come from a bank. They are typically issued by private lenders or from private companies. For example, when you drive around town and see all of the business signs that say something like ABC Capital, ABC Funding or ABC Financial Group; these could be hard money lenders. These types of loans are given to people that have real collateral, which in most cases means that you have actual real estate to collateralize the loan. In many cases, hard money loans are provided to help people buy real estate that they cannot get financing for from a bank.
Hard money loans carry a much higher interest rate than traditional mortgages and commercial property loans. They are also for much shorter durations. While a residential or commercial property loan is often for periods between 15 and 30 years, most hard money loans are for a period of a few months up to a few years. Whereas traditional loans are given by banks based on income, debt ratios, and credit scores; these types of loans are usually based almost solely on the value of the underlying asset. A typical hard loan will be for as much as 60-70% of the value of the underlying asset, which is a much smaller percentage than traditional loans, which can reach as high as 90-100% of the property value.
Hard money lenders are willing to give loans without as strict of requirements as traditional lenders because the loans are more fully collateralized. That’s because the low loan to value (LTV) ratio means that they are more likely to get their money back if loan payments are not made. Also, these types of lenders are compensated with higher interest rates than traditional loans, which is also an incentive for these types of lenders.
When a Hard Money Loan Makes Sense
These types of loans can be very beneficial for both the lender and the individual getting the loan, but only in the right circumstances. One should never take out a hard money loan on existing property unless they have a detailed plan on how to pay the money back. As hard money loans have short durations, you must pay back all of the principal at once, so you won’t be able to spend the money from the loan on anything. Instead, you’ll have to find a way to refinance the loan into a traditional loan at some point. Here are some examples of how to use a hard money loan to your advantage.
Example 1. You are Buying a Property That Needs Improvements
If you are buying a home that needs a lot of improvements and is deemed unliveable for some reason, a traditional lender will probably not give you a loan. For example, I have a friend that bought a foreclosed home and the kitchen flooring was removed during a remodel. Because the flooring was removed the banks considered the home unliveable and would not give a traditional loan for the house. Unfortunately, you can’t touch the floor until you own the house, and you can’t own the house until you fix the floor. For reasons like this, you could get a hard money loan, then buy the house and fix the floor. After that, you should be able to qualify for a traditonal loan where you can refinance the property and then pay off the hard money. In this example, a hard money loan is a great asset.
Example 2. You Don’t Qualify for a Traditional Loan Because Your Debt Level
Another example would be for a real estate investor. Often times, investors are turned down for loans on second and third properties because they have too much debt overall and not enough income to show for it. In many cases, banks need to see years of positive cash flows from your property before they are willing to lend money to you. If you need money to buy your next investment property and can’t get a loan for this reason, you could consider getting a hard money loan. The idea would be that you get the loan, buy the property, and then improve the cash flow on the property during the course of the hard loan so that when the hard loan comes due, you can refinance into a traditional long term loan. In cases like this, when you have multiple properties it often makes sense to refinance existing properties that have proven cash flows and then use that equity to help pay off the hard money lender.
In conclusion, you can see that hard money loans can make sense, but you must be very careful not to get stuck in a hard loan with no way to refinance and pay off the hard lender. These loans are basically bridge loans that need to be paid off in a short time. Never even consider a hard loan for personal spending or any other reason than using it for investment purposes. Hard loans should only be used in circumstances in which you are almost certain that you will be able to pay back the loan in the specified period. You must have a clear and detailed plan as to how you are going to use the loan to get your property in good enough shape to finance it with a traditional loan.