Hard money loans are an alternative to seeking financing from traditional lenders. Private investors and finance companies are the more likely sources of hard money. In most cases, these loans work very well for both the lender and the debtor. They are not without some degree of risk for both parties. If you are considering extending or accepting a hard money loan, it pays to be aware of these risks.
The Interest Rate
It’s not unusual for real estate investors to seek hard money loans to finance the purchase of a property. The plan may be to buy a property that is in distress but happens to be located in a desirable part of town. Once the sale is complete, the debtor makes repairs to the home and puts it up for sale at a profit. When successful, the loan is retired early and the investor has a return on the venture.
Lenders will protect themselves by imposing an interest rate that is above the current prime rate. Coupled with the fact that hard money loans are asset-based loans, the lender keeps the risk within a reasonable range. That doesn’t guarantee everything will be fine even if the debtor defaults. What it does mean is the lender will at least recoup most of the investment, partially because of the interest on the loan.
Lenders who offer hard money loans focus less on an applicant’s credit score and more on the ability to repay the debt. Expect more questions about how much money you have coming in and what you will do to ensure the installment payments are made on time. You can also expect to pledge some type of collateral in order to receive the funding.
Consider what happens if you plan on using the hard money to buy a residential property. The plan is to either renovate the home and sell the property at a profit, or to keep it as rental property. Assuming the plan works out and the property does generate the income you need, paying off the loan will not be a problem.
The situation changes quickly if you can’t find a tenant or the renovated home languishes on the market for a long time. Paying the loan installments may become difficult. Start falling behind on the payments or get a few months in arrears, and the lender is likely to seize the property and sell it to pay off the balance owed. That leaves you with no debt, but also with nothing to show for all that hard work.
The Loan Term
Hard money loans are often considered to be short-term solutions that allow you to get the money needed now and work out other financial arrangements later on. The loans typically run no more than two years, although you may be able to find a lender who will extend a longer term. If you don’t settle the debt within that term and you can’t get financing with a longer term, you could end up losing everything that you invested in the venture.
Loan to Value Ratios
Applicants seeking hard money loans need to understand what is meant by loan to value ratios. Remember that these types of loans are considered non-traditional. That means they are offered by entities other than the local bank or credit union. One of the ways those lenders protect their interests is to only approve up to a percentage of the collateral’s current market value.
For example, you may be purchasing a distressed property with the plans to renovate and flip it. The lender is not all that interested in what the property will be worth once you make the renovations. If you are using that real estate as the collateral, the lender may only offer you a loan that is equal to half of the property’s current market value.
You could use as different asset as collateral, such as the home you live in and own outright. Remember that if you don’t flip the investment property and can’t pay off the loan on time, the lender could seize your home and sell it to settle the debt.
The Impact on Your Credit Scores
It’s true that hard money lenders don’t generally pay a lot of attention to your credit score. That doesn’t mean they won’t pull reports and take a look at the comments submitted by other creditors. They will be looking for anything that has to do with slow payments, loan defaults, and other signs you have difficulty paying your bills.
If the lender does approve your hard money loan and end up defaulting, you can bet that the default will be reported to at least one of the three major credit bureaus. The next time you try to obtain a loan from this type of lender, expect to answer some serious questions about those notes on the credit report. Count yourself lucky if you get the chance to answer those questions. Many hard money lenders will take one look at the default and decide you pose more of risk than the lender is willing to take on.
Hard money loans are excellent resources for many financial ventures. Make sure you know the risks and are prepared to face them if necessary. Doing so will make it easier to determine if this lending arrangement is the best strategy, or if you need to work with a lender who offers more traditional terms.