Complete Guide to Hard Money Lending

By Moolah List

Complete Guide to Hard Money Lending

By Moolah List

What Is a Hard Money Loan?

Hard money loans (aka, private money, bridge or trust deed loans), are a form of short-term financing secured by real property; usually real estate.

They are typically funded by individuals or companies as opposed to traditional mortgages which are financed by lending institutions such as big banks or credit unions.

When underwriting a loan, a hard money lender is primarily focused on the value of the underlying asset being used as collateral rather than the many factors banks use to determine if a borrower qualifies.

Once considered a last resort funding option for real estate investors, hard money loans have gained in popularity due to federal regulations and mandates preventing predatory lending practices in the industry. 

 Hard Money Loans vs Traditional Loans 

Hard money vs traditional morgages: A comparison of the different factors lenders used to determine if you qualify for a loan.
Hard Money Loans Traditional Loans
Down Payment Most hard money lenders require 20% to 30% down along with 3 to 6 months cash reserves to show ability to make interest payments. Fannie Mae requires a minimum of 15% down for single-family investment properties and 25% down for multi-family investment properties.
Processing Time Closing can be done in less than a week, with little documentation required. Usually 6 weeks or more to close, with larger documentation requirements.
Interest Rate Interest rates depend on various factors such as local real estate market, property type and loan to value ratio. Expect to pay between 7% to 15%. Rates are determined by a borrower’s credit score, income-to-debt ratio and numerous other factors.
Credit Score Credit score plays a smaller role. Lenders are more focused on the value of the underlying asset being used as collateral. Most banks have a minimum credit score requirement of 600.
Loan Terms Hard money loans are usually interest-only, a duration of 12 to 60 months and come with a 6 month pre-payment penalty. Traditional loans are usually amortized at a fixed rate over a 15 to 30 year period.
Employment History Employment history is not a major factor. Most banks want to see a minimum employment history of 2 years.

How Does a Hard Money Loan Work?

Most hard money lenders want borrowers to have skin in the game.

Borrowers should expect to put down roughly 20% to 30% of the property purchase price.

The initial down payment and interest rate are dependent upon the level of risk a lender is willing to assume.

For example:
A hard money loan on non-income producing land or ground-up construction will have a higher interest rate and require a larger down payment than a single-family or multi-family apartment complex in a large city since the former is a project with more risk.

When trying to obtain a hard money loan, most lenders will want to know the borrower’s exit strategy; be it fix and flipping, refinancing into a traditional bank loan or selling other assets to repay the lender.

If a borrower fails to make their monthly interest payments, the lender will foreclose on the property to recoup their investment.

Foreclosure is a timely and costly process that most lenders try to avoid; hence why underwriting (aka, loan origination), is an important part of a lender’s due diligence. 

What Is an Interest-Only Loan?

Most traditional bank loans are amortized over a 15 to 30 year period. 

This means for every monthly payment, part of the payment is applied to the interest, while the other portion is applied toward the principle of the loan.

With an interest-only loan, the monthly payment is only applied toward the interest of the loan — not the principle.

When the term of an interest-only loan expires, the borrower is obligated to make a balloon payment of the entire remaining balance.

Interest Only-Loan Example:

If you take out a hard money loan of $1.5 million at an 8% interest rate for a one year term: 

$1,500,000 * 8% = $120,000 annually

Your monthly interest-only payment will be $10,000 dollars:

$120,000 / 12 = $10,000

At the end of one year, you‘d make a balloon payment of $1.5 million to pay off the loan.  

Why Use a Hard Money Loan?

In most situations a hard money loan is used as a financial tool to give an individual or business access to a large amount of capital for a short period of time.

They are most commonly used to finance the purchase, construction or relocation of a property.

This is why these loans are also referred to interchangeably as “bridge loans.”

They bridge a short time frame when an investor, individual or business needs some cash to accomplish a specific goal.

For example:
In commercial real estate a business may want to buy a property for relocation purposes. While the business may be successful, they might not be liquid enough to purchase another property outright.  

It's common for businesses in this situation to obtain a hard money loan to bridge the gap of time between the purchase and relocation of the new property and the sale of their existing property.

Other Common Uses of a Hard Money Loan 

  • Fix and Flips (aka, rehabs) - A fix and flip loan is a type of hard money loan used by real estate investors to purchase an undervalued property, improve it and then sell it for a profit.
  • Inheritance Loans (aka, probate, estate or trust loans) - These loans are used to settle estates after a loved one has died. For example if a sibling wanted to buy out another sibling but doesn’t have enough liquid cash to complete the transaction they can borrow against the value of the estate to settle the inheritance.
  • Commercial Bridge Loans - A type of hard money loan often used to relocate a business or to provide cash-flow to a business when it has a gap in funding.
  • Refinance (aka, refi for short) - Refinancing a loan involves taking out a new loan to pay off an existing expiring loan. This can occur when a borrower finds more favorable terms with another lender.
  • Cash-out (aka, cash-out refinance) - This type of hard money loan allows existing property owners to pull cash-out from a property they have equity in. It is often used for fix and flip improvements, debt consolidation or other financial needs.
  • Purchase - Real estate investors will sometimes use hard money loans to purchase properties because an offer accompanied by a hard money loan is considered by most to be as good as an all cash offer.

How Much Does a Hard Money Loan Cost?

The actual costs associated with a hard money loan can differ from lender to lender. The most common costs are:

  • Points: Points are a one time loan origination fee. 1 point is equal to 1 percent of the total value of the loan. Hard money loans generally carry 1 to 4 points.
  • Interest Rate: Interest rates range from 7% to 15%. A borrower's interest rate will depend on numerous factors including, location of the property, loan to value ratio and property type to name a few. Generally speaking the most important factor is the stability of the local real estate market.
  • Appraisal Fee: Most hard money lenders will hire their own appraiser to value the property and will normally ask the borrower to pay the cost.
  • Pre-Payment Penalties: It’s common for lenders to charge a 6 month pre-payment penalty.
  • Referral Fees: If your loan were to be funded through a real estate agent, broker or other 3rd party there might be some referral fees either baked into the cost of the loan or as a part of the fees.

Hard Money Loan Example With Costs

Jimmy is a part-time real estate investor living in Southern California. 

One day he comes across a $750,000 single-family home for sale in Simi Valley, California.

Jimmy thinks this property is undervalued and with $50,000 of repairs the home will be worth between $900,000 to $950,000.

However, Jimmy only has $200,000 in cash.

In order to purchase the property he intends to use a hard money loan which he will repay after 4 to 6 months.

He uses EmpireLenders to select a verified and licensed hard money lender from California.

Within a matter of days the hard money lender has given Jimmy a Proof of Funds letter, allowing him to make an offer and edge out a few other competing buyers.  

An offer on a property using a hard money loan is considered as good as an all cash offer.

Once Jimmy’s offer was accepted, the hard money lender provides the $600,000 in funding for a 12 month term. 

With Jimmy’s down payment of $200,000 and the $600,000 from the hard money lender; he completes the $750,000 purchase and has $50,000 remaining for repairs.

In this example the loan to value ratio is 80%. 

Alternatively, the loan to cost ratio is 75% (this ratio includes the cost of repairs).

Jimmy is now required to make monthly interest payments to the hard money lender for the duration of the loan.  

Failure to make these monthly payments will result in the lender foreclosing on the Simi Valley home in order to recoup their investment.

Now let’s look at the terms of the loan:

  • Jimmy’s origination fee is 2 points on the $600,000 loan
  • His interest rate is 8% 
  • It comes with a 6 month pre-payment penalty 
  • There’s an appraisal fee of $500 
  • Underwriting fee of $1,000
  • There is a pre-payment penalty of 2% if the loan is paid off within 6 months
  • There are no referral fees or other fees in this example
  • There are holding costs of $2,000 per month (holding costs include property taxes, home insurance, HOA dues, utilities, maintenance and other fees)

All his upgrades to the fix and flip go well and after 6 months of ownership he sells the property for $950,000.

Jimmy was able to avoid any pre-payment penalties since the payback occurred after the 6 month pre-payment penalty period.

Let’s add up the loan fees and other costs to see where we are at:

  • Origination fee (points) = $12,000
  • Carrying costs and fees = $12,000
  • Interest rate for the 6 month loan (interest-only) = $24,000
  • Other fees (appraisal and loan documents) = $1,500 
  • Repairs = $50,000

His gross profit from the sale is $200,000 and his total costs were $99,500.

That means Jimmy’s net profit is $100,500 from the renovation and sale of the home. 

This translates to a 100.5% annualized cash-on-cash return.

Not bad for only 6 months of work.

What Is a Cash-On-Cash Return?

This metric is often used in the real estate investment industry, especially on transactions containing debt.

It is a rate of return ratio that calculates the cash earned on the amount of cash invested. 

Cash-on-cash return can be used interchangeably with cash yield.

Common Exit Strategies for Borrowers

Hard money loans have higher interest rates and are therefore not meant to be used for time periods over 5 years.

Lenders will want to understand a borrowers exit strategy before administering the hard money loan.

The most common hard money loan exit strategies are:

  • Sell the subject property
  • Sell other assets 
  • Refinance into a long-term mortgage with a bank, with a lower interest rate
  • Obtain a new hard money loan from a different lender
  • Bring on an outside investor 

The Bottom Line

Hard money loans are a niche unstandardized loan product mostly used by real estate investors, individuals and businesses as “bridge loans”. 

They are generally funded by private individuals and businesses and are a great way to create leverage if you need a large amount of capital for a short amount of time.

In this guide we expore the following:

  1. What Is a Hard Money Loan?
  2. Hard Money Loans vs Traditional Loans
  3. How Does a Hard Money Loan Work?
  4. What Is an Interest-Only Loan?
  5. Why Use a Hard Money Loan?
  6. Other Common Uses of a Hard Money Loan
  7. How Much Does a Hard Money Loan Cost?
  8. Hard Money Loan Example With Costs
  9. What Is a Cash-On-Cash Return?
  10. Common Exit Strategies for Borrowers
  11. The Bottom Line

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