Hard money loans are growing in popularity within the real estate industry because they are most commonly secured by physical property. Typically, hard money loans are funded by private investors or companies instead of large commercial banks. Private hard money lenders are usually able to provide faster approval and closures in addition to offering both borrowers and lenders the opportunity to negotiate the terms of a deal.
If you or your business are in need of a funding solution, pursuing a private loan may be an ideal solution. To help you determine if a hard money loan is the right option to meet your borrowing needs, take a look at the pros and cons to see if they’re right for you.
Pros of a Hard Money Loan
Quick closes and approvals
One of the greatest benefits of hard money loans is that they can often close in as little as a couple days. Unlike a typical bank loan that can take upwards of 30-60 days to be approved, you can usually expect a quick turnaround with a hard money loan. Hard money lenders tend to look more at the value of a property over a borrower’s credit score because the property itself is the collateral of the investment. This enables you to close the deal and not be left waiting over a month to finance your next investment.
Investor willingness to make riskier investments
The relationships you build with investors can help you over time. If you are able to prove that you honor contracts over time, investors may be more likely to grant you quicker closes and better rates. Hard money lenders don’t have the same restrictions that commercial banks do. They can fund properties that they see will have value after modifications or renovations.
Banks on the other hand do not always have this same flexibility. Since private lenders are focused on the property itself rather than strictly credit history, these lenders can also agree to fund projects banks typically would turn down. Funding a renovation project is riskier, and banks may be less likely to approve these types of loans.
Willingness to issue loans to borrowers with lower credit scores
Hard money lenders look less specifically at credit scores than banks do. Instead, they assess how profitable the property itself is and is predicted to be. If you have a less than ideal credit score, a hard money loan may be a well-suited choice for you because you can still secure the loan without your credit score inhibiting approval. Most lenders approve credit scores of 650 or higher, but if it’s below that, it doesn’t mean you’re out of luck.
No prepayment penalty
Paying loans ahead of time gives you the opportunity to save money by avoiding interest rates over time. Plus, you’re able to move onto your next project. However, most commercial banks will penalize you for paying off your loan early with a prepayment penalty.
Prepayment penalties are often included in the details of a traditional commercial loan because it doesn’t benefit lenders in the long run. They lose out on earning potential from interest if you pay off the loan before the end of the term. If your bank gives you a loan at 3% for 15 years and you pay it back in only 8 years because you sold the property or refinanced. the lender may likely charge you a previously established prepayment penalty. While this repayment option may support your new business strategy, it conflicts with the lenders underwriting when they reviewed and approved the loan. Depending on the scenario, prepayment penalty should be considered.
Well suited for fix and flip projects
Hard Money loans are a popular choice for fix and flip homes because you can secure a loan quickly, the property is the collateral, and they’re typically easier to pay back following the sale of the flipped property. Most fix and flip properties are purchased at lower market prices because they are vacant, dated, or otherwise in need of substantial updates.
Those who decide to take on a fix and flip project will purchase a property, complete necessary and desired renovations, and resell it at a profit. Commercial banks cannot fund uninhabitable properties, which often rules out the commercial funding of many fix and flip properties.
Cons of a Hard Money Loan
Medium-high interest rates
Interest rates for hard money loans are typically higher than traditional commercial loans. In 2020, hard money loan interest rates averaged about 11%. Since these loans are typically geared more towards real estate properties and quick turnarounds, most borrowers aim to buy and sell properties quickly to reduce overall interest rate costs. As a result, borrowers often charge higher interest rates for shorter loan terms.
The interest rate set by the lender is impacted by a myriad of factors, but having a positive history with the lender along with a higher credit score may help.
Origination Fee
There are other costs associated with a hard money loan that borrowers may not experience with other loan types. An origination fee is a lender charge to process the loan itself. It usually costs a percentage of the loan you are taking out. Since hard money loans are often a riskier investment, lenders typically charge higher origination fees.
Down payment required
Lenders usually require a down payment from investors because it keeps everyone incentivized. This reduces the risk of investors quitting mid-project and leaving the lender high and dry. It also reduces the risk of a foreclosure on the property. This is another way lenders layer on protection for themselves.
Extension fees
Each loan has a repayment plan that includes the duration of time the borrower has to repay the loan. If a project requires an extension on loan repayment, you may encounter charges if you attempt to extend the terms (length) of the loan. Doing so may include an increase in the monthly payment or the addition of extra fees.
Risk of foreclosure/default
Different variables may result in a foreclosure:
- Failure to pay monthly interest payments
- Failure to repair or maintain the property
- Unpaid loans
Foreclosure is typically a last result for lenders because it can be a costly expense for the lender. It’s advisable to maintain close communication with your lender regarding any issues that may arise during the project. They are more likely to want to create a game plan to get the project back on track rather than taking the chance of losing out on their investment. It’s important to note that in the event that you default on the loan, you will likely lose the property and ownership will transfer to the lender.
Curious about our lending process? Take a look at our private money underwriting guidelines here. Innovative Capital Corporation has the resources and expertise to help you find the right funding for your next project. If you’re looking to finance your upcoming business venture, real estate acquisition, fix and flip project, or more with a private hard money or commercial loan, contact our team today.