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