What are Hard Money Loans?
How do you legally define it?
What are the essential elements you should know!
In this article, we will break down the notion of Hard Money Loans so you know all there is to know about it!
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Table of Contents
What Is A Hard Money Loan
A “hard money loan” is a type of loan that is generally used in real estate transactions and is taken out for a short period of time and secured by a real estate property.
Quite often, these types of loans are granted by individuals or companies as opposed to banks and financial institutions.
For example, when a person needs money for a short period of time, say a few months, and does not have a great credit score, some individuals or companies operating in such niche industries will offer financing at higher costs.
Since hard money loans are granted on the basis of the collateral the borrower is offering to secure the loan as opposed to the borrower’s credit history or financial capacity, the lender can earn a quick profit by lending on the short term.
Should the borrower default on the loan, the lender may still earn a profit by seizing the collateral real estate property.
A borrower seeking a hard money loan must expect to pay a higher rate of interest than traditional loans due to the fact that the lender is assuming a higher level of risk and is not considering the borrower’s credit to issue the loan but only the value of the real estate property.
Hard money loans are used for:
- Flipping a house or real estate property
- Purchasing an investment property
- Purchasing a commercial property
Hard Money Loan Definition
According to Investopedia, hard money loan is defined as:
A hard money loan is a type of loan that is secured by real property.
In essence, hard money loan has the following characteristics:
- It’s guaranteed by a real estate property
- It has a short term (a few months to a few years)
- It has a higher rate of interest than traditional loans
- The lender does not strongly consider the borrower’s financial position
- Banks and financial institutions do not offer such loans
How Does It Work
There are many reasons why borrowers and lenders engage in hard money lending.
For instance, those involved in flipping properties may find it useful to purchase, renovate, and sell real estate properties using hard money loans for real estate as opposed to traditional mortgage financing.
The flipper’s objective is to acquire a property, quickly renovate it, and sell the same property at a profit.
In the context, a lender may strictly consider the value of the property in granting the loan as opposed to the creditworthiness of the borrower.
Considering this type of business model for lenders requires lending in high volume to earn profits and involves a higher level of risk, many financial institutions and banks do not engage in such loans.
Instead, you may find individuals or private companies operating in this segment earning profits by issuing short term, high interest, loans.
The hard money loan terms are generally below one year but can go anywhere between a few months up to three years.
There are several advantages in engaging in hard money lending.
For borrowers, the most notable advantage is that the loan is issued quickly.
As such, from the moment the borrower files an application to the day the funding is issued, the turnaround time is much faster than the loan approval duration by traditional banks.
One reason why loans are processed faster is that the lenders will focus primarily on the borrower’s equity or real estate property offered as collateral as opposed to the borrower’s credit profile and finances.
Lenders can expedite the loan application review process by focusing their attention on fewer variables, looking at fewer income and financial documents, and doing less research on the borrower and its collateral assets.
Although there are key benefits in seeking hard money financing, there are disadvantages to both lenders and borrowers.
For borrowers, the main disadvantage is that the loan-to-value ratio is much lower.
In other words, a borrower can expect to receive less financing than traditional loans as the lenders will want to stay conservative and potentially look for a LTV ratio of 50% whereas banks may go up to 80%.
Another disadvantage to borrowers is that they should expect to pay a higher rate of interest compared to bank loans.
For lenders, they recognize that they are dealing with a type of clientele that may have poor credit scores or bad credit history.
As a result, it may be likely that the borrower defaults on the loan forcing the lender to take foreclosure measures to realize the collateral.
This will result in their money tied up for some time and forces them to engage in many administrative tasks.
However, lenders factor such commercial risk into their lending rates and the amounts they finance.
It turns out that for many lenders, they stand to earn higher profit if the borrower goes into default.
Hard Money Loan Example
Let’s look at an example to see how the “hard money” loans work in real life.
Imagine John is looking to purchase a property, renovate it and quickly sell it (flip).
The real estate property costs $400,000.
However, John does not have a great credit score but has the ability to put 50% cash down payment to purchase the property.
In this case, the lender, Hard Money Lending Company, evaluates the property and considers that it can finance the remaining 50% of the property for a period of one year at a rate of interest of 12%.
If John considers that he can renovate and sell the property within a year, he can then take the loan, purchase the property and quickly sell it.
So, what is hard money loan?
Let’s look at a summary of our findings.
Hard Money Loan Meaning
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