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by Ben Luxon August 10, 2019 5 min read

When it comes to investing in your perfect investment property there are occasions when the banks aren’t as eager to give you money as you might want them to be. 

Perhaps the property is in pretty bad shape - which makes the investment look poor, but you are convinced that it’s a perfect opportunity fora flip to make some serious capital gains quickly.

Enter the hard money loan. 

What is a hard money loan? And what are the benefits and risks for a property investor?

What is a Hard Money Loan

A hard money loan is a loan borrowed from a direct lender as opposed to a banking institute. The exact terms of the loans will be worked out between the borrower and the lender.

The advantages of a hard money loan are simply that direct lenders are often more likely than a bank to invest in "riskier" projects.

Normally, the lender will receive monthly interest (much like mortgage interest) on the loan until the loan is repaid in full. The lender will also charge an upfront processing fee.

In the case of getting a hard money loan for property investment, you can expect the property to be used as collateral against the loan. Meaning if you fail in your payments you will lose the investment property. More traditional loans are based on the borrower’s credit score instead.

Hard money loans

Where Do You Get One?

Hard money loans can be obtained from individual investors or an investor group.

Who Uses Hard Money Loans?

Hard money loans are quite common in real estate investing. As we mentioned before, banks are often more wary of what they deem "risky investments", preferring to lend on investments they strongly believe will be repaid, this tends to be more traditional investments like a standard residential mortgage for someone with a 580+ credit score.

This leaves a big gap in the market for lenders hungry for the riskier projects which come with bigger rewards.

Because of this real estate investors who want to flip distressed houses often turn to hard money loans. 

When it comes to purchasing a rental property, it's less regular for people to turn to hard money loans as the interest rate will be higher than a banking institute. However, one strategy some people utilize is to purchase the rental using hard money and then, once the property is stabilized and proven to be profitable they go to a bank to get a mortgage to pay off that hard money loan. Then they can pay the banks back at the lower interest rate.

Benefits

Here are four of the top reasons an investor might obtain a hard money loan:

A Fast Process

Typically getting a hard money loan is quicker than getting a traditional loan as you are working with another individual or a small group of lenders. There are fewer hoops to jump through, as it were.

Hard money lenders aren't interested in your credit score or how much debt you have, they are interested in the viability of the investment opportunity. In the case of real estate investing, that means the potential they see in the property and whether they believe that you can make it perform.

Depending on your lender, you could have your loan in a few days or a few weeks. It could take months to secure a more traditional mortgage.

Hard money loans

Leverage More

With a traditional loan, banks prefer that you put down at least 20% of the purchase price. The more you put down the better the terms of the loan they are likely to offer you. And if you put down less than 20% you will need to purchase mortgage insurance which will increase your monthly payments further.

When you get a hard money loan, depending on the lender, they may well be willing to give you 100% of the purchase price. It is in their interest for the project to succeed as well.

Establish a Relationship

It’s easier to build a relationship with an individual than it is with a company like a bank.

Establishing a relationship with a lender, or group of lenders will allow you access to funds that would otherwise be unavailable to you. After the first successful loan repayment, they will be more likely to lend to you again.

This will enable you to repeat your winning formula on house after house, and increase your potential earnings exponentially. And with every loan you honor in full, you will gain a little more trust from your lender.

Getting Started

Hard money loans aren’t good for everyone, nor are they the right option for every investment. But they can be a great starting point. When you’re just starting out, these loans allow you to leverage someone else's money to make a profit. Once you are more established as an investor with a track record of success you are then more likely to be able to secure a favorable line of credit with a bank that will have a much lower interest rate. 

Risks

We’ve run over some of the key benefits which all sound pretty good. However, as with any kind of investment, there are associated risks that should not be ignored.

High-Interest Rate

The first thing you need to be aware of, which we’ve mentioned a couple of times already in the article is the high-interest rate on the loan.

It is not uncommon to see interest rates between 10 percent and 20 percent on these types of loans. Compared to a bank where you might be looking at something like 3% - 5%. 

In this scenario, the lenders have the upper hand and they know it, which means they can charge what they want. They want the money returned in full and quickly, so they incentivize that to minimize their own risks whilst also maximizing their own profits.

High Origination Fee

The origination fee is the fee that the lender will charge to process the loan and is usually a percentage of the loan - meaning the more you borrow the higher the origination fee.

Again, since they are investing in a riskier venture the hard money lender will want to mitigate their risks with a large upfront fee. It is not uncommon for the lender to charge as much as five times the amount of a bank or mortgage broker!

Not Long Term

These loans are not designed for longer repayment periods like a traditional mortgage. There will be no 30-year repayment plan. Depending on the specific contract you will be required to repay the lender back within anything from a couple of months to a couple of years. If the loan is not paid back within the first few months or year, the already high-interest rate could increase.    ​

Losing the Property 

As we mentioned at the beginning of the article, the property itself in this scenario is the collateral. What this means is if you cannot pay off the loan for any reason, then you will lose the property. If this happens all the money you’d invested - from the origination fee to the renovation costs, and the interest on the loan - will be lost. This potential for huge loss makes hard loans very risky.  

We hope you found this blog interesting! However, do note that it should not be used as a substitute for competent legal and/or other advice from a licensed professional.

Ben Luxon



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