Sometimes investors have a hard time securing traditional financing. Banks don’t like taking chances on risky loans and when you don’t live in the property, they consider it to be a risk. Add to that a property in ‘fixer-upper’ condition or in a high-risk area and you’ll have a hard time finding a traditional bank loan.
Hard money loans, however, offer an alternative. The qualification requirements, especially for the property, are less stringent, giving investors many opportunities to buy investment properties, increasing their portfolio and their profits.
Before you consider this financing method, though, understand what happens if you default on a hard money loan.
You May Lose Your Property
Just like a traditional mortgage, your home is on the line with a hard money loan. Since you likely bought an investment property with the funds, you won’t lose your primary residence, but you’ll lose any investment you made in the property.
Before you take a hard money loan, make sure you can pay it back as specified in the terms. Look not only at the monthly payment, but the longevity of the loan and your property. How long will you keep the property? Is it a fix-it and flip-it or property you’ll rent out and hold on to long-term?
If you’re planning to fix and flip, will the property be worth enough to pay off the loan in full when you sell it? If you keep the property and rent it out, will you have enough cash flow to keep up with payments?
Your Credit Score Will Drop
As with any default, your credit score pays the largest price when you default on a hard money loan. Because it’s a foreclosure, just not with a traditional bank, your credit score may drop from 85 points to 160 points.
How much your credit score drops depends on your current credit score and the laws in your state. Typically, the higher your credit score is at the time of default, the more it drops. Increasing your credit scores poses serious challenges, as does having a low credit score. It’s often difficult to secure new financing, get a job, or even rent a home or apartment if you have a low credit score due to a foreclosure.
You Lose Your Investment
All hard money loans require an investment from you. If you’ve had the loan for a while and made payments on it too, you lose any money you put into it. Let’s say you borrowed $100,000 for a $150,000 home. You put in $50,000 of your own funds upfront. If you made payments that totaled $8,000 in the meantime as well, your total investment is $58,000.
If you default on the hard money loan at any point, the lender takes the property and sells it, using the funds to pay off the outstanding loan. The lender would only need to sell the home for 40% – 50% of its original sales price to make its money back.
This leaves you with empty pockets and without the real estate in your portfolio.
Keep in mind, if the foreclosure sale doesn’t cover the balance of the loan, the lender may sue you for the difference, keeping you on the hook for the loan even after you lose the property.
Are Hard Money Loans Bad?
Like any loan, you must understand the terms. Hard money loans are a great way to get funds you need to increase your real estate portfolio, but make sure you can afford the terms. Like a loan from a traditional bank, if you default on the loan’s terms, you pay the price, which means losing the home and damaging your credit.
Defaulting on a hard money loan is just as bad as defaulting on a standard mortgage on your home. It puts you at risk of losing the property, your investment, and any semblance of good credit you had. Before you take out a hard money loan, look at your finances and the property. Will it hold its value, sell for a high enough price once you fix it and flip it, or bring in enough cash flow for you to cover the cost of the hard money loan?
If so, a hard money loan may be a great option. The guidelines are more flexible and the funding comes a lot faster. This gives you a chance to jump at great real estate opportunities, fulfilling your real estate dreams without going over budget.