A brief outline
Whether you’re looking to buy your first home or your next investment property, there are many financing options available. The trick to deciding which is best for you and your specific purpose, is to get to know how each loan type works to see if it will fit with your needs. We take a look at hard money loan vs mortgage to see how these loan types are similar and different.
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There are a variety of financial solutions for people wanting to purchase property, from crowdfunding to using the equity in an existing home, borrowers are spoilt for choice. One of the most common ways to get funding is via a traditional loan or mortgage. Another option that is growing in popularity is to get a loan from a hard money lender.
In this article, we’ll delve into a brief explanation of each and what the similarities and differences are between a hard money loan vs mortgage.
Hard money loans are typically short-term loans used by real estate investors to fund fix and flip properties or other property deals. The property itself is used as collateral for the loan, and the quality of the real estate deal is therefore more important than the borrower’s credit history when it comes to qualifying for the loan.
Borrowers apply for hard money loans using criteria such as the Loan To Value (LTV) ratio, the After Repair Value (ARV) of the home, and other factors that show how likely the property is to earn a profit. Usually, applications are accepted or rejected quickly, and the entire process then happens faster, with funding being provided in some cases within a week.
Once an application for a hard money loan has been made, the lender will do the necessary checks to determine if the borrower can make the monthly repayments of the loan. This process is quicker for hard money loans because these lenders won’t need to dig as deep into the borrower’s personal financial history. However, this also means that the risk is higher on these loans and so the interest rates are usually higher too.
How does a normal mortgage work?
Conventional loans or mortgages are used for real estate purchases and they allow the borrower to loan the money for the entire purchase upfront and pay it off over a period of time, along with interest. A mortgage that has been taken on a property is also called a lien against the property. If a borrower can no longer make their mortgage payments, a property can then be foreclosed by the lender who will then own the property.
The process begins with a borrower applying for a loan, after which the lender will assess their financial suitability to pay off the loan. This includes a credit check, proof of employment, bank statements and more personal financial records. Once the lender has deemed the borrower fit for a loan, they will specify the amount that the borrower is approved for, and the borrower will receive a pre-approval.
The borrower can then go out and find a property to purchase, and once this has been done, the loan can be issued and repayments begin. The buyer will take ownership of the property and will remain in ownership until the loan is paid off, unless they default on their mortgage repayments.
Key differences between a hard money loan and a traditional mortgage
While both of these financial solutions can be very effective, they are used for different purposes and have some key differences that are important to be aware of.
1. Loan use
Hard money loans are generally used by real estate investors who are buying a property that they can make money from. Whereas mortgages are often used by people who are buying a home to live in, or owner-occupied homes.
2. Approval criteria
In accordance with what the loans are being used for, mortgages are typically based around the borrower’s financial standing and whether they can pay the loan off over the allocated time, while hard money loans are centered around the investment opportunity of the property. While mortgages will be focused on a borrower’s income, bank statements, credit score and other personal financial indicators, hard money loans are focused on the LTV, ARV and potential profit that the property will make.
3. Turnaround time
Hard money loans tend to be quicker to get approval and to get funding. The reason is because there are less checks into the borrowers’ personal financial history, and hard money lenders are more focused on the property itself. So, the approval process is quicker, and the entire loan process is quicker as the underwriting takes less time.
4. Loan terms
Hard money loans have different loan terms, depending on the loan type and the lender. For example, fix and flip loans may require only the interest to be paid for a period of the loan, and then a balloon payment of the remaining principal amount at the end. Hard money loans are usually short-term loans that range from 6 to 24 months in length.
Mortgages, on the other hand, are longer loans that can be anywhere between 5 and 30 years. There is the option to choose between fixed rate and adjustable rate, as well as loan length, but outside of this there isn’t much room for flexibility.
5. Interest rates and fees
Hard money loans have higher interest rates because they pose a higher risk for lenders, and they’re shorter. Hard money loan rates are anywhere between 6% and 12% generally. While mortgage rates are lower because they’re taken over a longer time period and come with less risks. Mortgage rates are around 4% to 6%, depending on the loan length and whether the rates are fixed or adjustable.
6. Rules and regulations
Hard money loans aren’t bound by the same rules and regulations as mortgages because hard money lenders aren’t a part of the financial institution world where certain rules need to be followed.
7. Funding source
Traditional mortgages are funded by the financial institution who sells the loan to a larger bank or other investors, whereas hard money loans are usually funded by private lenders, either individuals or companies.
Key similarities between a hard money loan and traditional mortgage
1. Used for real estate
Real estate is the common denominator between hard money loans and traditional mortgages. While they’re used for different purposes within this field, they’re both used for real estate purchases.
2. Property used as value
For both types of loans, if the borrower defaults on their payments, the property can be seized by the lender. For mortgage loans, this means that the lender can foreclose on the property, and for hard money lenders this means that the lender can use the property as collateral.
3. Loan process
There are certain elements of the loan process that remain similar, and this is the process to determine whether a borrower is capable of paying back the loan in the given time frame, at the set amount. While each loan type places importance on different aspects here, they both require various checks to be done and an underwriting process.
4. Down payments
Another similarity that hard money loans and mortgages have is that both will often require some sort of down payment. The percentage can be quite different, depending on the lender, but it’s a good idea for borrowers to budget for a 20% down payment at least.
When should you use a hard money loan?
Hard money loans are well suited to real estate investors who need fast funding to beat the competition on a real estate deal. Due to the fact that these are short-term loans that often only need the interest to be paid until the balloon payment at the end, they are well suited to fix and flip projects.
These loans can be used to purchase and renovate an investment property, during which the interest can be paid, and the principal amount can be covered once the house has been sold again. For investors who don’t qualify for traditional loans or need financing faster than other financial institutions can provide, hard money loans are a great solution.
When should you use conventional financing?
Traditional mortgages are mostly used by those who plan on living in the house that they’re buying. These loans are geared for borrowers who are planning on paying off the loan in a gradual pace with the principal amount plus interest every month. These loans range from 5 to 30 years in length, so they’re suited to borrowers who are going to keep the property for a long time and would prefer smaller monthly repayments over this extended period.
There are various types of conventional financing options for different purposes, such as reverse mortgages, adjustable-rate mortgages, fixed-rate mortgages and so on. These are suited to different borrowers, depending on their financial position and payment goals.
The bottom line
Both traditional loans and hard money loans have their pros and cons, the best thing to do is be aware of each and weigh these up against your personal goals and financial situation. This will help you make the best decision for you and your family, or your real estate investing journey.