New real estate investors quickly learn that using traditional mortgages to buy investment properties doesn’t work well. Instead, experienced investors turn to hard money loans as an alternative to this traditional financing. As a result, people often ask me: Ryan, what are the pros and cons of hard money loans for real estate investors?
Rather than lending on your personal financial qualifications, hard money lenders issue loans based on the property itself. This allows investors who wouldn’t qualify for traditional financing to get a hard money loan. But, these loans also cost more than a traditional mortgage – a hard money con.
In addition to these major pros and cons, I’ll use this article to dive into all the hard money considerations real estate investors need to know. Specifically, I’ll cover the following topics:
Prior to reviewing the pros and cons of hard money loans, we need to first define them. And, to understand hard money loans, it helps to understand traditional mortgages first. With these mortgages, lenders like banks and credit unions issue loans based on two broad criteria:
Hard money exists as an alternative to the above traditional financing. And, hard doesn’t mean challenging. Rather, it means that these lenders solely concern themselves with the “hard” asset, that is, the property itself.
As stated, traditional lenders require minimum standards with the borrower’s “soft” assets. Hard money lenders don’t concern themselves with this. These lenders look at a property and ask, what will this property become? They base their decision to lend on the projected after-repair value (ARV) of a property.
This system provides real estate investors two key advantages. First, you can secure a hard money loan even if you don’t have a great credit score (but, lenders likely won’t work with you if you have bankruptcies or judgements in your credit history). Second, you can use hard money loans for distressed properties, making them ideal for fix & flip investors.
Traditional lenders want to confirm that, if foreclosed upon, a property will cover the loan balance now. Hard money lenders assume more risk. They lend based on what they believe the property will be worth in the future. While each hard money lender offers different terms, at Do Hard Money we’ll lend up to 70% of a property’s ARV. As such, if a borrower fails to successfully rehab a property, hard money lenders need to recoup their outstanding loan balance with a distressed property sale. And, selling a property in the middle of a repair likely won’t pay off the outstanding loan balance, as the loan was based on what the property would become.
Due to this increased risk and the shorter term nature of hard money loans, they have higher rates than traditional mortgages. Depending on your investing history and the quality of the deal, you can expect an interest rate from 7.99% to over 15%. However, investors can also close these loans extremely quickly. Traditional mortgages typically require 45 days or more to close . You can close a hard money loan in less than a week or two.
Once again, hard money lenders base their loans on what a property will be worth. But, how do you value something that doesn’t exist yet? To do this, hard money lenders require an ARV appraisal prior to issuing a loan.
With a traditional appraisal, appraisers look for recent sales comps for the property in its current state. ARV appraisals also include “as-is” comps and determine an “as-is” value. But, they also account for the planned renovation and what the house will look like after they’re complete. More precisely, an appraiser will analyze your submitted contractor bids for work, find properties that have had similar levels of work, and determine an ARV based on those comps.
While more expensive than standard appraisals, these ARV appraisals provide hard money lenders the information they need to determine how much they’ll lend.
While the above provides an overview of what hard money lenders do, it helps to see a concrete example. Assume you find a great deal on a distressed property. It’s selling for $120,000, and you think that with a $100,000 renovation and sale budget, you’ll be able to sell it for $310,000. With a little back-of-napkin math, that’s a nice $90,000 profit.
But, as you don’t have $220,000 cash for the purchase and repairs, you apply for a hard money loan to cover these costs. While you think you can get $310,000 for the property after the rehab period, the hard money lender will need assurances from an ARV appraisal. You submit all of your contractor bids, and the professional appraiser determines ARV to be $300,000 – $10,000 less than your initial estimate.
With a $300,000 ARV, the hard money lender (assuming 70% ARV loan), will lend you $210,000 ($300,000 ARV times 70%). However, your deal budget totals $220,000. This means that, to move forward with the deal, you’ll need to put in $10,000 cash to cover the difference between the $210,000 hard money loan and your total budget.
This is a common situation with hard money loans. That is, you’ll typically need to find funds in excess of your hard money loan. Frankly, it’s extremely difficult to find the sort of awesome deal that a hard money loan will 100% cover. This reality means most investors have other financing techniques to meet their budget needs above a hard money loan. While not a comprehensive list, investors can do the following to bridge the gap between a hard money loan and deal budget:
While explaining hard money in the above sections, I touched on some of the clear advantages and disadvantages inherent to these loans. In the next two sections, I’ll clearly outline the most significant pros and cons to hard money. And, as should be clear now, most hard money advantages tend to be an associated disadvantage to traditional financing (and vice versa). I’ll continue building on this reality as I discuss hard money pros and cons.
Due to the fact that hard money lenders don’t need to verify all of your financial information and work history, investors can close on these loans quite quickly. Depending on the unique situation, closing between 10 to 20 days is reasonable in today’s environment. This speed allows investors to effectively seize purchase opportunities as they arise.
Most residential real estate investors use either a fix & flip or BRRR strategy. Both of these strategies hinge on investors purchasing distressed properties (or ones in need of major repairs) at a steep discount. Then, after renovating these properties, investors either A) sell them to primary home buyers, or B) refinance them to become long-term rentals.
Regardless of which of the above paths you take, you can use a hard money loan. Remember, these lenders don’t care about what the property looks like now. They lend based on the ARV, so they just want to make sure it’ll look good in the future. Accordingly, hard money loans allow investors to purchase distressed properties to support these two common real estate strategies.
Hard money lenders do not require borrowers to have solid “soft” assets, that is, sound financial health. If you don’t have a great credit score, demonstrated income, or an extensive employment history, you can still qualify for a hard money loan. This reality opens the door to a ton of potential investors: young people and those changing career fields. People in these categories often don’t have the financial situation to qualify for most loans, but they can qualify for hard money loans, which lets them get started in real estate investing.
While some hard money lenders require interest-only payments at a certain point in time (e.g. six months after the loan origination), many allow borrowers to roll interest into the principal and pay it off at once. This provides investors incredible cash-flow flexibility. As you’re renovating a home, you already need to make plenty of regular payments (e.g. to contractors, utilities, property tax, etc.). By delaying the loan payoff until resale or refinance into a permanent mortgage, hard money lenders provide investors a great deal of flexibility.
Neither the government nor hard money lenders themselves impose a limit on the number of hard money loans you can have outstanding at any one time (or over a lifetime). For most new investors, you’ll only have one outstanding hard money loan for a single investment property. But, with experience and a solid team around you, you may start working five, 10 or more deals at one time. As long as the deals make sense, you can secure hard money loans for all of them.
Having outlined the major pros of hard money loans, costs represent the major con to hard money. Simply put, hard money loans are expensive, both in terms of higher interest rates (typically 7.99% to over 15%) and larger origination fees. This increased expense is the result of two related factors.
First, hard money does not receive any government protection or subsidy, meaning the lenders themselves must underwrite all loan costs and risk. Second, due to the fact that the properties securing these loans are distressed, lenders face the risk of A) defaulting on a distressed property that may not pay off the loan balance, and B) the projected ARV falling short of the actual market value after the renovation.
Hard money loans also have far shorter terms than traditional financing. While individual deals may need to adjust this timeframe, most hard money loan terms range between five and eight months. This means that investors have a limited time to complete a deal with their hard money financing, forcing them to be extremely efficient in their renovation and marketing efforts.
Having explained the pros and cons of both hard money and traditional loans, the question remains: when should an investor use one or the other?
As a rule of thumb, I argue investors should use hard money loans for acquisitions. That is, when you’re buying a fix & flip or BRRR property – both of which wouldn’t qualify for traditional financing – you should use a hard money loan. While more expensive than a traditional mortgage, the flexibility of hard money loans allows you to purchase these distressed properties.
Next, I see three major situations investors should use traditional financing:
Final Thoughts
Hard money loans, as with all loan products, come with a unique set of pros and cons. But, for most investors, the advantages to hard money loans far outweigh any associated disadvantages, especially for fix & flip and BRRR investors.
Learn how to make money flipping real estate with us by attending our next webinar.