what is a hard money loan and when is it used?

Hard money loans provide a needed resource for holders of both residential and commercial properties. Unlike conventional or even subprime mortgages, they are asset-based loans. Because hard money lenders base their loans completely on the value of the underlying asset, they use a different qualification standard.

When borrowers are unable to qualify for traditional mortgage loans, are in financial distress, need a loan approval faster than a conventional lender provides, or need a loan for rehab and repairs, hard money loans often provide the most practical and cost-effective solution.

What is a hard money loan?

Hard money loans are short-term loans, similar to the bridge loans used in construction projects. Lenders usually grant terms between a few months and a few years. Payments remain affordable because the borrower does not pay back the entire principal during the loan term. Rather, each month, the borrower pays a portion of the principal similar to a 30-year mortgage, though some hard money loans are interest only. When the term expires, the rest of the principle becomes due in a balloon payment. Most borrowers either sell the property of refinance it before the balloon payment comes due.

Hard money lenders base approval on the loan-to-value (LTV) ratio. Typically, the LTV must be below 80 percent. Most hard money lenders pay little or no attention to the borrower’s credit history. In these types of loans, approvals are based on property value instead of credit history.

The LTV becomes of primary importance because the lender does not review the borrower’s credit profile or verify the borrower’s income. The only security the lender has comes from the value of the property. Because an 80 percent or lower LTV indicates that the property has sufficient equity, the lender knows that it can repossess the property and sell it, to recoup its losses if the borrower defaults.

As an asset-based loan with no credit checks, hard money loans are considered high risk and come with proportionately high interest rates. Rates range from 8 to 20 percent. This broad range ties to a number of factors.

Borrowers on properties in excellent and good locations can usually qualify for hard money loans at the lower end of the interest-rate spectrum. Borrowers with properties in bad and remote areas often must pay much higher rates. The condition of the property also affects the interest rate. The better the condition of the property, the easier it is to sell; therefore, it presents less risk to the lender.

Like conventional banks, hard money lenders charge points. Each point represents 1 percent of the loan amount. For example, a $100,000 loan at three points means that the lender charges the borrower $3,000 in points. Unlike conventional banks, hard money lenders do not base points on credit profiles. Instead, points are assigned based on the location and condition of the property. Good locations and excellent property conditions merit just 2 or 3 points, while poor locations with properties in bad condition mean borrowers have to pay more points, to compensate the lender for the increased risk.

When are hard money loans used?

Borrowers often opt for hard money loans during times of financial distress. Because hard money loans have few credit requirements, they are the optimum resource for homeowners with equity in their home when they suffer financial setbacks. Often, they provide the lifeline that prevents the homeowner from losing their home and its equity in foreclosure or bankruptcy.

For example, a borrower may owe $300,000 on a $400,000 home when he falls into financial trouble. He falls many months behind on the mortgage and the bank starts foreclosure proceedings. Any attempt to refinance with a conventional loan fails because his credit score has sunk too low.

This borrower can save his house through a hard money loan! Because his equity places him below an 80 percent LTV, he qualifies for a hard money loan, regardless of his credit score. He can then use the hard money loan to pay off the foreclosing lender and save his home and keep his equity. Then, depending on his circumstances, he could sell the home and cash out his equity or refinance the hard money loan into a long-term mortgage once his financial situation improves.

Investors also benefit from hard money loans. Often, they need to close deals fast or lose to the competition. Conventional lenders take 30 or more days to close loans, making them a poor option. Hard money lenders can approve loan requests right away, allowing the investor to seal the deal.

Hard money loans also work great for rehab properties because the LTV can be based on the actual repaired value (ARV). When loans are based on the ARV, investors and home buyers are able to loan enough money to buy the house and complete the repairs. With a conventional lender, they can only loan enough to make the purchase. If they don’t have cash on hand for the rehab, a hard money loan is the way to go!

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