What is a Hard Money Loan?
A hard money loan is a short-term loan, which uses a real estate property as collateral. Lenders for this type of loan generally consist of private investors or private investment funds, as opposed to more conventional lenders such as banks or insurance companies.
Hard money lenders have a different approach when it comes to assessing a borrower’s eligibility for financing:
– Unlike banks and insurers, private lenders are not concerned with a borrower’s credit scoring or credit history; they rely on the value of the property that is put up as collateral, to both decide how much they are willing to lend (using a loan-to-value or LTV formula) and to secure their investment against possible losses.
– Hard money lenders tend to specialize in an asset type they finance. For instance, if the lender has focused on providing capital for office buildings and a borrower comes along and applies for a mortgage for an industrial property, chances are they will be turned down.
– Private lenders are less reluctant to provide a loan for a property that is not in mint condition. Hence, they can be the ideal option for individuals or companies looking to buy and renovate a property before selling it at a much higher price. They are also helpful for startup businesses that don’t yet have a credit history and cannot afford ideally located high-value properties.
What are pros and cons of hard money loans?
Because of the factors listed above, hard money loans have a series of risks, which borrowers should keep in mind when deciding what sort of financing they need.
– Shorter terms: typically, we are looking at 12 to 36 months. Because the process of securing these loans is quicker than in the case of conventional lenders, they are sometimes used as bridge loans. That is, the borrower takes out a loan from a private lender while waiting for the bank to approve a long-term loan. The second loan is then used to pay off the hard money loan.
– Higher interest rates: to compensate for the higher risks they take on, hard money lenders charge much higher interest rates. Whereas interest rates charged by traditional lenders generally stay below 10%, hard money loans range from 10-15%, sometimes going even as high as 20%. Throughout the term of the loan, the borrower only pays the interest, delivering the full amount in one lump payment (called a balloon payment) on the due date.
– High origination fees: this is a fee the lender will ask for to cover costs related to processing the loan. If, for example, a bank’s origination fee is 1%, a private lender can go as high as 4% to 5%. Because it is calculated as a certain percentage of the loan, and since the amount lent can be up to 65-75% of the property’s value, this can add up to significant cost to the borrower.
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