A quick summary
Hard money loans can be a quick solution for investors who need cash quickly, however there are still some concerns from investors around using hard money lenders instead of traditional financial institutions. In this article, we’ll answer the question, what are the risks of hard money lending? Then we’ll show you how to alleviate these concerns.
Main Topics
Hard money loans are short-term loans that come from private investors or companies that use the asset as collateral. These loans are becoming more popular for investors, particularly those in real estate who need funding fast for fix and flips, and investment and commercial real estate purchases. This is because the biggest advantages of hard money loans are that they provide quick and more easily accessible funds. In other words, hard money loans are a useful alternative to traditional financial institutions and can be instrumental in some real estate investing deals where funds are needed fast.
However, hard money loans are still considered by some as a risky source of funding and not everyone believes that they’re a good or safe option. We’ll take a look at some of the risks of hard money loans and how to mitigate these.
Why is hard money lending considered risky?
When it comes to the risks of hard money lending, they work both ways. Both the borrower and the lender undertake some sort of risk to make the deal work. Lenders provide loans with more lenient requirements which means that borrowers don’t need to be as qualified as they would for a traditional mortgage. Hard money lending is also a fast way for investors to get funding, so the speed of the process adds to the risk for lenders having to analyze deals quickly.
This means that the asset (usually property) is used as collateral to mitigate the lender’s risk and lenders will have higher interest rates. However, this poses risks for borrowers as they’re essentially paying more for the loan and in terms of costs, and if their deal doesn’t work out as planned, they could lose their asset.
Having said that, there are ways and means to mitigate the risks for both parties and once we’ve delved deeper into what the risks are for both the borrower and the lender, we’ll outline some advice on alleviating these.
What are the risks of a hard money loan?
Risks for the borrower
1. High interest rates
Hard money loan rates are higher than traditional loans, this is largely because these loans are shorter and hard money lenders have a higher risk. So, these high interest rates are necessary for lenders to mitigate their risk. Interest rates on hard money loans typically range from 10% to 15%.
2. Shorter loan period
Hard money loan repayments are usually structured over a shorter period of time, which means that borrowers have less time to pay the loan off. Loan periods are usually between 6 and 18 months. For borrowers, this means that they simply have less time to pay off the loan and must make sure that they can meet their repayment obligations in time. If things don’t go according to plan, this short time frame can be a risk for borrowers.
3. Higher costs
Another risk for borrowers is that there are higher origination fees and closing costs with hard money lenders. Alongside bigger down payments which can be up to 30% for some hard money lenders. These extra costs are something to bear in mind because they also add to the total financial risk for the borrower. Here are some costs to prepare for:
- The down payment
- Points
- Referral fee
- Underwriting
- Processing
- Document prep fees
- Other interim costs
4. Lower Loan-To-Value ratio
The loan-to-value ratio (LTV) compares the size of a loan to the value of an asset that is purchased using the funds from the loan. Due to the fact that hard money loans use the asset (property) as collateral, a lower LTV is associated with these loans so that borrowers have to pay more upfront. You can expect a maximum LTV of 70-90% for hard money loans, and the lender will likely have the interest rate, amortization schedule, penalties, and points all set to work in their favor.
5. ARV isn’t fully covered
Hard money loans will typically only cover between 60% and 70% of the ARV (After Repair Value) on a real estate project, and the borrower will be on the hook for the rest. You may be relying on the ARV to finance a rehab project, however, you’ll be liable for a large part of this if your calculation is off, or if you run into construction problems.
6. Real estate market changes
Any drastic changes in the real estate market can leave borrowers in hot water because they are often relying on the sale of their investment property to cover the hard money loan. If the sale doesn’t result in the desired amount, borrowers can be left with a lot less than they had planned on having. Thus, the risk comes into play with any downward spiral of the real estate market.
Risks for the lender
1. The borrower might fail to pay back the loan amount
The biggest risk for hard money lenders is the chance that the borrower’s deal might fall through, and they cannot pay back their loan. Hence, hard money lenders use the asset as collateral, to mitigate this risk and get their money back if the borrower defaults on their loan repayments.
2. Flexible lending criteria leave hard money lenders exposed to more risk than traditional lenders
While hard money lenders aren’t bound to traditional lending criteria for borrowers, this increases their risk because they have to form their own criteria and take each borrower on a case-by-case basis. Which means that they need to research and analyze a deal to form their own opinion, often very quickly, about whether they’re going to fund a deal or not.
Benefits of hard money lending
- Low barrier to entry: Since hard money lenders choose who they lend to, a borrower’s credit score and other stringent criteria that are applicable for traditional lenders will fall away. This makes hard money loans easier to get and is a saving grace for many who don’t qualify for traditional mortgage loans.
- Fast funding: Hard money loans are a quick way to get funds, with some lenders, such as New Silver, providing funding in as little as 5 days. These lenders usually provide proof of funds letters almost immediately as well.
- Flexible loan terms: One of the big advantages of not being bound to traditional lending criteria is that hard money lenders can offer flexible loan terms, depending on the situation. These can be discussed and negotiated because borrowers are dealing with lenders themselves and not going through a middleman.
- Convenience of cash: Going the hard money loan route means that borrowers can get a lump sum of cash paid out to them, which cuts out the middleman and allows borrowers to make time-sensitive deals or cash-only deals.
- Competitive edge: Hard money loans give borrowers, particularly those who are investors, a competitive edge because they can get access to funds quickly and make offers even quicker. Which means they can beat the competition and get the transaction speeded up to work in their favor.
- Higher loan amount: Hard money loans can offer a higher loan amount than banks, for example. The reason is that the loan amount is based on the property itself and not on the borrower’s credit history. So, this means that hard money loans can be approved for larger amounts.
Why don't traditional lenders like banks offer short term real estate loans?
Typically, traditional lenders are unwilling to take risks and when it comes to short term loans, there is a certain amount of risk involved. Particularly for real estate loans that are used for fix and flip projects, or other short term real estate investment purposes. This is why hard money lenders came into existence. They take on the risk that traditional lenders are unwilling to and provide a different type of loan that’s more freely available and hinges on the deal and the property itself.
As such, hard money lenders are a valuable partner for real estate investors. A hard money lender helps an investor source capital and takes on this responsibility in the deal. In return, hard money lenders charge a higher interest rate than a traditional lender, to compensate for the additional risk, and the challenge of sourcing capital through non-traditional channels.
How to alleviate the risks of using a hard money loan
Analyze your deal
Much of the risk associated with hard money lending lies in the fact that the asset itself is used as collateral. As such, it stands to reason that borrowers should analyze the deal that they need funds for, to make sure that it’s going to be a successful deal. This includes:
- Finding the applicable data and information
- Calculating cash flow
- Analyzing the investment location
- Looking at the return on investment annually
A popular method for deal analysis amongst real estate investors is the 70% rule. What is the 70% rule? It offers a quick and convenient way for real estate investors to calculate the maximum purchase price when flipping a property. To use the 70% rule, you’ll need to know the After Repair Value (ARV) of the investment property that you are hoping to flip. Once you have the ARV, you simply multiply it by 70% and then deduct the expected rehab costs, to work out the maximum price that you should offer on the house.
Find a reputable hard money lender
A simple online search will show you many hard money lenders, however finding a reputable one like New Silver is key to your investing journey. It’s important to check their reviews and if you’re unsure, contact a real estate broke to inquire about the lender. You can also check if the lender is a member of the American Association of Private Lenders. This is a trusted authority in the industry and a good sign that the lender you have chosen is reputable.
Another option is to pop into your local real estate investor club meetings, where hard money lenders often go to network with borrowers.
Check for hidden costs
There are various costs associated with hard money loans that extend further than just the interest rate, such as higher closing costs and origination fees. Make sure that you’re well aware of these costs ahead of time, and that you’re financially prepared to cover these. This will ensure that there are less surprise expenses, and therefore lower the risk.
Know your finances
Knowing what you can afford is paramount to lending money from anywhere, because you need to know that you can afford your repayments. This may sound simple, but many people take on debt that they simply cannot afford and land in hot water soon after that. So, minimize your risk by making sure that you can afford the repayments, before you take the loan.
Final thoughts
While hard money lending may have its risks, the advantages of these loans are difficult to beat. It’s a good idea to find a reputable lender like New Silver, and then use our tips above to mitigate the risks as much as possible, while still taking advantage of the opportunities that hard money loans allow for.