What Is a Hard Money Loan? And Is It a Good Idea?

Are you looking to build long-term wealth and develop another source of income? For many, real estate investing is a popular option. In fact, a recent survey by BiggerPockets found that 28.1 Americans are residential real estate investors.

If you want to join the club but can’t qualify for traditional financing or need to close a deal quickly, there’s another option out there for funding: hard money loans. A hard money loan is an alternative to regular mortgages that you can use to buy and renovate investment properties, but it comes with some drawbacks.

Let’s take a look what a hard money loan is, how a hard money loan works, how to get a loan like this and whether it's a good idea for your financial and real estate goals.

What is a hard money loan?

Whether you need funding to flip a home for profit or need to demolish a home completely, there are times when a mortgage from a traditional lender may not be an option. When you need money quickly, a hard money loan can be a useful alternative.

With a traditional mortgage — often referred to as a soft money loan — banks or credit unions look at your credit and income to determine your eligibility for a loan. Their underwriting process involves looking at those factors to decide whether you can afford the loan payments.

By contrast, a hard money loan is an asset-based loan issued by a private company or private investor. The lender issues you funding based primarily on the value of the collateral rather than on your credit history or income. The application process will typically involve an assessment of the property’s value and potential. That way, if you can’t afford your payments, the hard money lender will simply move ahead with selling the property to recoup its investment.

Hard money lenders typically charge higher interest rates than you’d have on a traditional loan, but they also fund their loans more quickly and usually require less documentation. Hard money loans are also usually short-term loans with much shorter repayment terms than regular mortgages. Instead of having 15 to 30 years to repay the loan, you’ll typically have just one to five years.

How does a hard money loan work?

Hard money loans work quite differently than traditional loans so it’s important to understand their terms and what transactions they can be used for.

Types of real estate hard money can fund

Hard money loans are typically intended for investment properties. The type of loans available when it comes to hard money includes:

• Fix-and-flip loans: If you’re a flipper who’s planning on buying a home, making renovations, and reselling it quickly for profit, fix-and-flip loans allow you to get the money you need for the purchase price and repairs.
• Acquisition loan: If you find an investment property but don’t have the cash to buy it yourself, you can use a hard money acquisition loan to purchase it.
• Bridge loan: Bridge loans allow you to leverage other real estate you currently own to create the cash you need to purchase additional properties.
• Construction loans: If you need to demolish a property or develop land, you can use a construction hard money loan to fund your project.

In most states, hard money loans cannot be used to purchase a primary residence, so they’re not a viable alternative to a traditional mortgage for a regular homebuyer. State laws have different requirements for owner-occupied residence lenders than they do for hard money lenders, and most hard money lenders are not in compliance with these rules.

How much money you can get with a hard money loan

Because hard money loans are asset-based, hard money lenders are concerned only with the property’s value. When you apply for a hard money loan, the lender will look at the house’s loan-to-value ratio. The lender will calculate the LTV by dividing the total loan amount by the value of the property.

The maximum acceptable LTV for a hard money loan is typically 65% to 75%. That’s how much of the property’s cost the lender will be willing to cover. For example, on a $200,000 home, the maximum a hard money lender would be willing to lend you is $150,000.

To purchase the property, you’ll have to come up with a down payment large enough to cover the remainder of the purchase price. In our example, you’d have to come up with the remaining $50,000 on your own to purchase the property.

Interest rates, points, and other hard money loan terms

You can qualify for a hard money loan more quickly than with a traditional mortgage lender, and the deal can close in a matter of days. However, you’ll pay a premium for that convenience.

Hard money loans tend to have higher interest rates than traditional mortgages. As of January 2020, the average interest rate on a 30-year fixed-rate mortgage was 3.62%. By contrast, interest rates on hard money loans start at 6.25% but can go much higher based on your location and the home’s LTV.

There are other costs to keep in mind, too. Hard money lenders often charge points on your loan, sometimes referred to as origination fees. The points cover the administrative costs of the loan. In general, one point is usually equal to a percentage point of the loan.

Points are typically 2% to 3% of the loan amount. For example, three points on a $200,000 loan would be 3%, or $6,000. You may have to pay more points if your loan has a higher LTV or if there are multiple brokers involved in the transaction.

Although some lenders charge only points and no other fees, others have additional costs such as underwriting fees. Lenders charge an underwriting fee to process your application and review your documentation to ensure you meet their lending requirements. You can expect to pay anywhere from $500 to $2,500 in underwriting fees.

Some hard money lenders also charge prepayment penalties, as they make their money off the interest charges you pay them. That means if you pay off the loan early, you may have to pay an extra fee, adding to the loan’s cost.

Who should use a hard money loan?

Using a hard money loan makes sense in the following situations:

• You have a quick closing and a regular bank can’t meet the deadline. A traditional financial institution can take weeks or even months to complete the approval process. By contrast, a hard money loan can close within a few days. If a great investment becomes available and you need to seal the deal quickly, a hard money loan can be a smart option.
• You lack the necessary credit score for a traditional mortgage. Many traditional lenders have strict credit requirements. If your credit score isn’t up to their standards, you may struggle to qualify for a loan. Although a hard money lender may do a credit check, they will also look at the asset in question when determining your eligibility for a loan. This means you’re more likely to be offered financing than if you applied for a traditional mortgage with a questionable or thin credit history.
• You need short-term financing. If you need money quickly for renovations to flip a house for profit, a hard money loan can give you the money you need without the hassle and paperwork of a traditional mortgage.
• You plan on using the BRRRR method. BRRRR method stands for buy, rehab, rent, refinance, and repeat. It’s a strategy investors use to buy investments such as rental properties without using a lot of their own assets, and hard money can be useful in these scenarios.

Although hard money loans can be useful for real estate investors, they should be used with caution — especially if you’re a beginner to real estate investing. Hard money lenders require you to put down significant amounts of money as down payment and have much higher interest rates and fees than traditional mortgages. With shorter repayment terms, your monthly payments will be far more expensive than with a regular mortgage.

Finally, if you default on your loan payments with a hard money lender, the consequences can be severe. Some loans are personally guaranteed so it can damage your credit. And because the loan is secured by the property in question, the lender can take possession and foreclose on the property because it serves as collateral.

How to find a hard money lender

Hard money lending rules can vary from state to state so it’s important to do your homework and find a licensed lender in your area.

To find a reputable lender, talk to trusted real estate agents or mortgage brokers. They may be able to refer you to lenders they’ve worked with in the past. Hard money lenders also often attend real estate investor meetings so that can be a good place to connect with lenders near you.

Before submitting a loan application with a hard money lender, check with your state’s department of real estate to ensure the lender has a valid real estate broker license. Ask the lender for references from previous clients and check for complaints with the Better Business Bureau.

Funding options if hard money isn’t for you

Although hard money loans can be valuable tools for real estate investors, they’re not for everyone. If you decide against taking out a hard money loan, consider these other financing options:

Private money lenders

One alternative is to borrow money directly from a private individual. A private lender can be a friend, relative, or a local business person willing to lend you the money you need to purchase a property. You borrow the money from them, and work with them to come up with loan terms, including interest rate, monthly payment, and loan length.

Working with a private money lender can be a good idea if you’ve struggled to get approved with other lenders and need money quickly. However, make sure you get everything in writing, and you should expect to pay a higher interest rate than you would with other types of funding.

Home equity loans

If you own another property, such as a primary residence, and have built up equity, you could use that to finance your investment with a home equity loan. Equity is the value of the property minus what you still owe on the mortgage.

Like hard money loans, home equity loans are secured debt, which means your property serves as collateral. However, the underwriting for home equity loans also takes your credit history and income into account so they tend to have lower interest rates and longer repayment periods.

You can typically get the money you need as a lump sum to finance your real estate investment, and have up to 30 years to repay the loan, which makes it a more affordable option than a hard money loan.

Personal loans

If you need a smaller amount — $100,000 or less — you can apply for a personal loan. Unlike hard money loans, personal loans are unsecured and based on your credit. You can even easily apply for a personal loan online. If approved, you can get the loan amount disbursed to your bank account in as little as one business day, and gives you the money you need quickly.

Personal loans typically have repayment terms ranging from two to seven years, and interest rates can be as low as 3.49%, but can be as high as 35.99%. If you don’t have good credit, or have too much debt on your credit report, you may not be eligible for a personal loan.

Bottom line

If you plan on investing in real estate but can’t qualify for a traditional bank loan or need financing quickly, a hard money loan can be a useful solution. However, be aware that hard money loans are more expensive than mortgages and have shorter repayment terms. Make sure you fully understand the terms of the loan, and shop around and compare rates from different lenders to ensure you find the right loan for your needs.