For those new to hard money lending, using private funds for the first time might be intimidating. Direct hard money lenders work differently from traditional banks. However, few new borrowers understand these differences. Like everything else in life, hard money lending has its pros and cons. Hard money loans are not for everyone and not everyone would qualify for them. However, working with a direct hard money lender vs. a traditional bank could offer flexibility and leverage not available anywhere else. Think about hard money lenders as a narrow subset of mortgage companies that provide a unique type of financing to borrowers in very specific circumstances.
Often the only thing that borrowers know about hard money lenders is that they charge higher interest rates than traditional banks. While this might be true, reputable hard money lenders are not loan sharks taking advantage of consumers down on their luck. Direct hard money lenders should not be confused with subprime lending. In their heydays, subprime lenders financed high loan-to-value consumer mortgage loans for borrowers with less-than-perfect credit histories and unverifiable incomes. As the result, many folks received subprime mortgage loans they could not afford in the long run. Mass defaults lead to the burst of the housing bubble and, eventually, to the great recession of 2008.
Hard money lenders are lenders that work exclusively with real estate investors. Hard money loans are considered business loans. Direct hard money lenders cannot originate consumer loans. That means that you cannot use them to finance your primary residence. Hard money lenders do not exist to promote homeownership. Their goal is to offer asset-based transactional financing to real estate investors looking to get from point A to point C. Point A is usually a purchase of distressed property and point B is the renovation of such property. Point C is the sale of this newly renovated property for the maximum price tolerated by the local market.
Now that we determined that hard money lending is for real estate investors only, let’s take a look at hard money pros and cons compared to the financing offered by traditional banks.
Pros and Cons of Hard Money Lending
Hard Money Pros:
Hard money is used to finance distressed properties.
The most obvious reason to use a direct hard money lender vs a traditional bank is to finance a property that does not qualify for traditional loans. Many conventional lenders do not want to lend on properties that require repair, no matter how much you’re willing to pay them. Such properties are often listed in the MLS with disclosures such as “investor financing only,” “sold as is,” or “handyman special.” These are the code words that indicated that the property would not pass an inspection required by a bank. In contrast, direct hard money lenders specialize in financing such properties.
Hard money offers are equivalent to cash offers.
In real estate investing cash rules. If you’ve done some real estate investing in the past, you know that sellers prefer cash offers. Why? Because they come with fewer strings attached. There is no need to do extensive home inspections. There is no need to wait and see if a traditional bank would approve a loan or not. No need for an as-is appraisal. A cash offer is an offer that is most likely to close. This is exactly why it’s also an offer the seller is most likely to accept.
Proof of Funds letters by a reputable hard money lender are universally accepted as cash offers. They give you a rare opportunity to compete with cash buyers and put you on the same footing with even the most well-heeled real estate developers.
Hard money loans use streamlined underwriting.
Hard money loans are asset-based loans. That means that their underwriting puts a strong emphasis on the collateral against which they are secured. Does this real estate transaction make sense? Would the borrower make money by fixing and flipping this property? These are the questions that the underwriters would be asking when working on the file.
With this type of underwriting, many other aspects that are important to conventional lenders become less important. For example, when comparing direct hard money lenders vs banks, you might notice that hard money lenders have more flexibility when it comes to income and credit scores. For example, at New Funding Resources we are not credit score driven and don’t have minimum credit score requirements. We also do not verify income. That means that a real estate investor can qualify for our loans even if she does not declare her full income. Pretty nifty for real estate agents on commissions, contractors with many expense items, and for any other types of entrepreneurs!
Super quick closing.
Early this year, the interest rates hit rock bottom. This prompted me to refinance some of my own investment properties. Or should I say “attempt” to refinance them since I started the process in mid-January? We are in late March now. It’s been at least 60 days and will likely be closer to 90 days when I actually sit down at the closing table. Admittingly, I am under no time pressure and am willing to wait three months to lock in the best rates. However, this is not how real estate investing works.
No sellers in the right mind would wait so long. But unfortunately, this is a reality when you are using a conventional type of financing. This is where the main difference between hard money lenders vs traditional banks comes in. The hard money process is designed to close your loan as fast as if it were a cash offer. There are no lender-mandated home inspections, no income verifications, no recession periods. Any reputable hard money lender should be able to easily close within two weeks as well as accommodate more urgent closing time frames.
Ease of escrow management
Loans to purchase and renovate a distressed property are few and far in between. Perhaps the best-known non-hard money program is a 203K loan. However, it primarily serves homeowners who are planning to buy and rehab a primary residence. The only viable alternative to buy and renovate an investment property using a 203K loan is to purchase a 2 to 4 unit property and live in one of those units for at least a year. Obviously, such a requirement prevents many real estate investors from using it Those who are still interested in 203K financing and can pull it off will be faced with a monumental challenge of managing construction escrows.
If you are not familiar with construction escrows, you can read our previous blog here. The bottom line is that any lender who is basing its loans on the after-repair value of the property would like to ensure that the renovation actually takes place. Most likely, the lender would hold the construction funds in escrow and release them to the borrower as different stages of renovation are completed. A major difference between direct hard money lenders vs banks offering programs such as 203K is the ease of escrow management.
203K FHA rehab loans come with strict requirements their borrowers must meet before receiving the next installment. They need to use licensed contractors that are FHA-approved. They need to get all the permits possible. They need to pass rigorous inspections by FHA-approved home inspectors. And they need to engage in forensic accounting to report all their expenses.
Many direct hard money lenders offer simple guidelines on when and how they release the draws back to their borrower. For example, at New Funding Resources we don’t require any receipts. We simply release construction draws based on what work has been completed. We also don’t require you to use licensed contractors if it appears reasonable that you can do without them. Whether to obtain permits or not is also left up to our borrowers.
Now that we’ve discussed the advantages of using hard money, let’s discuss some of its potential negatives.
Hard Money Cons:
Higher interest rates
When discussing hard money pros and cons, one of the first things that usually comes up is that direct hard money lenders charge a premium for their loans. It’s true that hard money loans typically come with interest rates that are significantly higher than traditional loans. The most important reason for that is that direct hard money lenders take a significant risk by financing high LTV loans on distressed properties. Their rates are the bi-product of supply and demand for private financing of such nature. It hangs in equilibrium between what borrowers are willing to pay for this type of financing and the minimum return acceptable by direct hard money lenders for the risk they take.
Typically, direct hard money lenders use a sliding scale when pricing their loans. That sliding scale depends primarily on the strength of the transaction and the strength of the borrower. Different direct hard money lenders might use different criteria to evaluate the strength of the borrower. The most common factors are borrower’s real estate experience, their credit profile, and how financially secure they are. You can read more about interest rates on hard money loans here.
Hard money loans are typically short-term loans. It means that they mature within twelve months of loan origination and need to be repaid in full. Borrowers need to have a solid exit strategy when working with direct hard money lenders. One of such strategies is selling the property after its renovation is completed. This is commonly called “fix and flip.” Another strategy is refinancing into a conventional loan with a traditional lender. Such strategy is typically referred as “buy and hold.” One thing for sure: you don’t want to be stuck with a hard money loan for too long. It might provide a flexible source of financing not available from anywhere else but because of its high costs, it’s too expensive to keep for too long.
Business Loans Only
As we discussed above, hard money loans are for narrow business purposes only. They should not be confused with subprime loans that provide financing to consumers with less-than-stellar borrower profiles. They are also asset-based loans meaning that you need to have an asset (a property) to pledge. As such, they are not personal loans or payday loans. They also cannot be used to finance starting a business (unless of course, your business is investing in real estate).
If you are new to real estate investing, it’s important to understand all pros and cons of hard money. Direct hard money lenders work differently from traditional banks. They provide a unique source of financing to real estate investors looking to start or expand their real estate investing business. The cost of funds is higher than that of traditional banks. However, their flexible underwriting, speed of closing, and the short period of time for which they are held, makes them a viable option for both novice and experienced investors.
About New Funding Resources:
New Funding Resources is a direct private hard money lender working with real estate investors in the DMV area.