A hard money loan differs greatly from a mortgage. For starters, it is not from a traditional bank. Instead, you would do business with a private lender. Some people even call them “loan sharks.” With this loan, there is no secondary market or “Ability to Repay Rules.” Instead, the rules are whatever the lender decides. They may differ from person to person. Some lenders do not even use the house as collateral, although this is rare. Whether you should use this type of loan or not depends on your circumstances. There are two types of people who fare the best with it – real estate investors and those with undocumented income.
Real Estate Investors
Real estate investors often purchase “fixer uppers.” These are homes that need plenty of work. Investors like them because they sell for a fraction of their original cost. Banks hate them because they do not meet local codes or the bank’s property requirements. Because of this, most banks will not provide a loan for this type of purchase. Yes, there are rehab loans, such as the FHA 203K or Fannie Mae HomeStyle loan, but the requirements can be steep. The investor looking for a quick buy and quick turnaround on the market, the hard money loan can be a good solution.
Borrowers with Undocumented Income
If your income is rather irregular, you may want to opt for this type of loan. Lenders providing conventional or government-backed loans need proof of regular income. This means weekly, bi-weekly, or monthly pay. It also means regular deposits of the same amount in your bank account. They do allow exceptions for those who work on commission or are self-employed, but these borrowers have more stringent income guidelines. For instance, they must provide their tax returns for the last two years, rather than just pay stubs or W-2s. Lenders must make sure these borrowers report a profit, rather than a loss on their tax returns.
If you work in any industry where you get paid cash or you just receive irregular pay, finding a mainstream loan may be difficult. This is where the hard money loan comes into play. These lenders look at your situation differently. They do not have specific guidelines they must follow. This makes it easier to secure funding for a loan.
How Does the Hard Money Loan Work?
If you fall into one of these categories, you must know how the hard money loan works. Hard money lenders can provide you with the necessary funds in less than a week in most cases. This differs greatly from a traditional bank who can take anywhere from 4-8 weeks to finalize a loan. Hard money lenders do not look at your credit or income. Instead, they focus on the value of the property you purchase. They focus on how much you borrow compared to the value of the property. If you purchase a fixer-upper, they will focus on the “after repaired value” of the home.
Something to keep in mind regarding hard money loans, however, is the interest rate. It is not uncommon to see interest rates hitting 10% or higher. This differs immensely from today’s mortgage rates. The tradeoff for the simple approval system and fast access to the cash is the interest rate. These loans are also short-term, so the lender wants to make money fast. It is unusual to see a term that exceeds 5 years on this type of loan. Many investors call it a bridge loan, because it bridges the gap between purchasing the home and being able to secure regular financing.
Hard money lenders typically require the following:
- The loan must be in first lien position; they will not take second
- You must have some skin in the game, meaning equity in the home
- If your equity in the home is not at least 30%, they may ask for additional collateral, such as equity in another property or a retirement account
As you can see, they do not look at your income or pull your credit. Your income and debts do not play a role. The most important factor is the equity you have in the home and that there are no other liens on the property.
No Red Tape
The largest benefit of the hard money loan is the lack of red tape. Today, the government oversees most of the lending process. There are two rules most banks must follow, especially when it comes to primary residences – the Dodd Frank Rules and the Ability to Repay Rules. Both rules make it harder to secure financing on a primary residence. The lender must make sure beyond a reasonable doubt that you can afford the financing not only now, but in the future as well. This means full documentation and many questions from the underwriter. Banks could experience legal ramifications if they do not follow these rules.
Hard money loans do not experience this type of red tape. No one oversees them. However, most private lenders will not provide funding on a primary residence. These are too highly governed. Instead, they will provide quick cash for borrowers who wish to purchase an investment property. These are the more lucrative borrowers anyways since they usually keep the properties short-term and then turn around and do it again.
The bottom line is if you are in the market for an investment property, a hard money loan can work in your favor. If you have straightforward income, meaning you report your investment properties on your tax returns, you may be able to go the traditional route. If you don’t report your income, which many investors don’t, then this loan is the way to go. Keep in mind the short repayment period, though. Carefully choose properties you know the renovations can be done quickly so you can either sell the property fast or apply for traditional financing to pay off the alternative loan.