Hard money loans are based on the value of real estate or another asset, rather than credit score or debt-to-income ratio. Is this the right type of financing for your business?
Hard money loans are a common type of financing in the world of private lenders, which are considered more flexible than banks or other traditional lenders. Because this type of funding requires the borrower to use their assets as collateral, private lenders are often more willing to work with borrowers with bad credit or more modest cash reserves.
Although hard money loans can give you faster access to cash, there are substantial risks associated with them. It's vital to understand the pros and cons before accepting any money from a private lender.
What is a hard money loan?
A hard money loan is a type of financing based on the value of some collateral, generally real estate, offered up by the borrower. A private lender will offer a loan as a percentage of the asset's appraised value.
"What a hard money loan does is allows a company or individual to turn a real estate asset to cash, which they could use for any legal business purpose they desire," said Jon Hornik, chairman of the Private Lender Group. "It's a way to convert a hard asset into cash."
A major benefit of hard money loans is that they don't require the same underwriting criteria conventional lenders use. Conventional lenders, like banks, look at the borrower's credit score, debt-to-income ratio, revenue and more when reviewing a loan application. Although private lenders look at these elements as well, the value of the collateral is the overriding factor for hard money loans.
"The focus is mainly on the value of the asset," said Matt Cole, executive managing director at Silver Arch Capital Partners.
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How do hard money loans work?
Hard money loans are short-term loans backed by a collateral asset, typically some form of real estate. They are funded by a private investor rather than depositors at a banking institution. The fact that the money is privately funded gives lenders more leeway when determining which loans to approve and which to deny.
When you apply for a hard money loan, it's important to recognize that each private lender might have their own unique underwriting requirements. Two private lenders might handle a loan application in very different ways; however, a hard money loan generally always comes back to the value of the collateral asset. You'll request a percentage of the value of the collateral asset as a loan, which is known as the loan-to-value ratio.
Generally, lenders charge points (or 1% of the loan value each) that are due at the closing of the loan, as well as the principal and its interest. Depending on the terms of the loan, this can become quite expensive. Here's a breakdown to simplify it.
Points: If a lender offers you $100, they might also charge points that are due at the closing of the loan. In this case, one point is equal to $1. Points essentially act as a fee for the lender above and beyond the interest they will make on the loan. Generally, the more points due at closing, the lower the interest rate, though your private lender may be different.
Interest: Interest is the cost of money borrowed. You are required to pay interest throughout the life of your loan. When the loan reaches maturity, you will have paid back the principal value plus interest, as well as any points charged by the lender. So, if the lender offered you $100 at a rate of 10%, you would ultimately pay back $110 when the loan reached maturity. On top of that, if the lender charged you five points due at closing, you would pay back the $110 plus $5.
- Principal: The principal is the amount initially owed. In this example, it is the $100. When the loan reaches maturity, you must have paid back the principal amount borrowed along with the interest, as well as any points the lender charged.
So, what do the terms of a typical hard money loan look like?
"Hard money lenders typically charge between 8% and 15% interest, which may depend on the credit history and experience of the borrower," said Melanie Hartmann, owner of Creo Home Buyers. "The borrower's relationship with the lender may also have an impact on the interest rate. Additionally, hard money lenders typically charge points that can either be paid upfront or added to the principal balance of the loan."
Most hard money loans carry a 12-month term, but it's not unheard of to find a two- to five-year one.
Do hard money loans require a down payment?
Some private lenders do require a deposit upon signing. The amount is generally based on the risk profile of the deal, which includes additional elements of the borrower's history, such as their credit score. The deposit could be 5% to 25% of the total value of the loan, Hornik said.
How do you get a hard money loan?
When seeking a hard money loan, you'll need to find a non-bank lender; traditional banks and credit unions don't offer this kind of loan. This could be a financial institution that isn't deemed a complete bank or a direct lender who specializes in this kind of funding.
Caleb Liu, owner of House Simply Sold, suggests going online to find a hard money lender.
"Google is a decent place to start," Liu told business.com. "There are a variety of nationwide hard money lenders. However, you should seek out hard money lenders that are active in your target market."
Other ways to find hard money lenders are attending networking events, joining real estate investor clubs and asking for referrals. Because this type of loan requires you to pledge your assets as collateral, it is critical to make sure the lender is legitimate and trustworthy. Liu suggests considering these questions:
- What is the lender's track record? Do you know someone who has closed with them? Are they familiar with and active in the local market? Is the hard money lender licensed?
- How many points will you be charged?
- For your interest rate, how much will you be paying each month? This is important because the rates for hard money loans are usually higher.
- Can the loan be extended if necessary? Are there fees? Will the interest rate increase?
- Are the payments interest-only for the duration of the loan, or will the principal be paid monthly as well?
- What is the maximum loan-to-value ratio (LTV)? Does this cover only the acquisition, or does it cover the rehab costs as well?
- Is there a prepayment penalty?
- How long is the loan period?
- What happens if you cannot sell the property or come up with the cash before the loan is due? Will your credit score be impacted?
- How quickly can the hard money lender disburse the cash?
What are the pros and cons of hard money loans?
A hard money loan can provide a business with much-needed capital quickly and without the strict underwriting criteria required by conventional lenders. This means businesses, even those with mediocre credit scores, can generally get the cash they need more easily and quickly than if they applied through a conventional lender.
"Cash flow is like oxygen to businesses," Hornik said. "Without cash flow, you go down pretty quickly. The liquidity provided by private lenders is key in some cases to businesses' survival."
However, hard money loans mature quickly and bear high interest rates, making them very expensive if not paid back promptly.
"The terms and conditions associated with hard money loans usually entail high interest rates above 10%, high closing costs with many points, a draw schedule for completion of various phases of the construction, and oftentimes a prepayment penalty if the loan were to be paid off early," said David Reischer, a real estate attorney and CEO of LegalAdvice.com.
These terms make hard money loans particularly expensive and possibly restrictive. Since hard money loans are often used for short-term construction or rehabilitation projects, the lender has a vested interest in the "as-improved" value of the property. That means they might push you to meet strict deadlines for any projects.
Moreover, if you default on a hard money loan, the lender has the right to foreclose on your collateral property and sell it to cover your debt, even if you've already completed considerable work on the property. It is critical that you have a strategy to pay back a hard money loan and then execute that strategy flawlessly, Hornik said.
"One caution is … hard money loans have short maturity dates of one year or two years," Cole added. "A lot of times, borrowers look for a loan, close a loan, and don't realize that the day after they close is when they should be working on how to pay off that loan. There's no time to waste. The expense of a hard money loan over a three- to four-year period will eat you up."
When should a business consider a hard money loan?
Since a hard money loan could end up costing you so much if you can't repay it within the short maturity window, why would you take one? There are good reasons businesses take out hard money loans every day, and many successfully pay them back without incident. Hard money loans and private money lenders typically serve businesses that fall into at least one of these categories:
Can't get a conventional loan
A conventional lender must abide by strict underwriting requirements. A mediocre credit score or poor debt-to-income ratio can preclude businesses from obtaining a loan. Banks also typically cap the number of loans they will give to one individual or business entity. Hard money loans could be a way to secure more funding when you already have multiple conventional loans.
"If you have less-than-stellar credit, then hard money loans are great because the underwriting is based on the asset, not your credit history," said Shawn Breyer, owner of Breyer Home Buyers. "Banks [also] limit the number of conventional loans that an individual can have at one time. Since hard money loans are not based on the individual, the number of loans is not restricted."
Private lenders offering hard money loans have more approval flexibility because the money comes from private investors. Businesses that can't get conventional financing often seek out private lenders instead.
Need funding quickly
Plenty of businesses that could land a conventional loan still go to private lenders, because their application processes are much quicker.
"Most of the time with a hard money lender, you talk to a guy who, if he's not writing the check himself, is a decision-maker for a group of people who are," Cole said. "It cuts right to the chase." The typical conventional lender's approval process can take several months. Private lenders often approve funding within a few days.
Want a short-term loan
Hard money financing is useful for construction and rehabilitation projects as well as real estate acquisition. A short-term hard money loan for these purposes lets you use the property as collateral and clear the debt from your books quickly. For businesses that want a short-term or small-dollar loan, hard money loans are more effective than conventional ones.
Advice for businesses accepting a hard money loan
Never accept any loan, especially a hard money loan, without doing your due diligence first. Failure to repay has steep consequences, particularly when your property is on the line. Defaulting on a hard money loan opens you up to foreclosure, so take the time to develop a loan repayment plan and stick to it.
Here's some advice from the experts on accepting a hard money loan.
1. Avoid prepayment penalties.
Steep prepayment penalties basically run counter to the idea of a short-term loan. Make sure to review the loan agreement for any clauses regarding prepayment penalties. If these penalties are excessive, stay away. Better yet, find a hard money loan that doesn't carry a prepayment penalty at all.
"The most critical thing to look for in a hard money loan is whether there is a severe and egregious prepayment penalty," Reischer said. "The goal of a hard money loan is to act as short-term financing. As such, if there is a severe prepayment penalty were the loan to be paid off early, then it is usually an attempt by a hard money lender to lock a borrower into a high interest rate for a long period of time or otherwise suffer a punitive penalty."
2. Understand the terms of the loan.
You should be clear on the key elements of the loan, including the interest rate, points (a fee of 1% of the loan value per point) the lender charges on the loan, and when you can make those payments (upfront or on top of the principal). Always be especially clear on the repayment schedule of the loan to avoid defaulting.
3. Plan ahead.
The best way to make a hard money loan work for you is to first plan how and when you will repay it. Ground that plan in the terms and conditions of the loan agreement. Make sure you have multiple ways to manage the repayment amount in case unforeseen circumstances impact one of your strategies.
"Have multiple exit strategies planned before starting the project," said Cassie Villela, property manager for Silverbridge Realty. "For example, if a flipped home isn't selling by a certain date, it can be rented out and then refinanced into a conventional loan."
Hard money loans offer flexible financing at a steep cost
The benefits of a hard money loan are numerous for businesses that can't get a conventional loan, need capital quickly or want a short-term loan. However, their high cost and short maturity windows could prove problematic for businesses that are unprepared to repay quickly. Failure to repay the loan could result in foreclosure, even if you've performed significant work on the property. Hard money loans make sense for businesses that need fast capital or can't access other types of financing, but preparation is key to avoid the major pitfalls of this type of lending.
Always consult an attorney and an accountant before accepting a loan. Maintaining relationships with knowledgeable professionals can help you protect your business from costly mistakes that could even result in closure. Never sign a loan agreement without the advice of these professionals and a clear-cut plan to pay back any borrowed money.
Adam Uzialko contributed to the reporting and writing in this article. Some source interviews were conducted for a previous version of this article.