What is a Hard Money Loan & How Do They Work?

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Hard money loans are a way for borrowers to take out a real estate loan without having to work with traditional lenders, like banks, credit unions, or mortgage agencies. Traditional lenders usually base their willingness to lend you money, and the interest rate they’ll charge you, on factors like your income and credit score.

➔   Hard money definition: a hard money loan is a loan borrowed against tangible collateral, rather than by using a credit assessment

However, for those who want to close on property sale quickly, or those who have a low credit score, hard money can be an enticing alternative. In this post, we’ll cover the basics of hard money loans, like how they work, what you can use them for, and some of the advantages and disadvantages of using a hard money loan. You can skip ahead to any of those topics by using the links here:

Before you can decide whether a hard money loan is a reasonable option for your situation, it’s good to know how they work. Let’s take a look at that now.

Hard money basics

It’s easiest to understand how hard money loans work by contrasting them with traditional loans or mortgages. Few people have the liquid cash on hand to simply buy a home outright. So, instead, they take out a loan from a bank or credit union. You purchase the property with the money they’ve lent you, then you make payments back to them over the course of ten to thirty or so years, all as part of a manageable debt repayment strategy.

Traditional mortgages come with some requirements. For instance, banks want to know that you’re a reliable lender. They can assess that by looking at your credit history, your personal track record when it comes to borrowing money (say, for college, or to buy a car). This is measured by your credit score.

Your credit score lets banks and other agencies know how likely you are to pay the money they lend you back, based on how reliably you’ve done that in the past. The higher the score, the more likely you are to pay your borrowed money back — and, crucially, the more likely you are to get a reasonable interest rate from the bank.

How do hard money loans work?

Hard money loans, on the other hand, usually do not work by assessing your past credit. Instead, they work by taking collateral, or hard money, against the loan. They won’t check your credit, but they will ask that you offer something you own in exchange if you cannot pay back the loan. What is hard money? Basically, a tangible asset, like gold, silver or property. Here are a few examples of items that might be used for collateral:

  • Any real estate you may already own
  • Equity in property
  • Your car or other vehicles
  • Expensive jewelry, watches, or gold and silver items
  • Savings accounts
  • Investment accounts and retirement accounts
  • Cash

If you fail to keep up with payments, the loan agency may have the right to possess the things that you’ve offered up as collateral. That’s where the term hard money comes from; it’s borrowed against a tangible asset, rather than based on your merits as a borrower in the past.

Because the hard money lending agency typically does not perform an extensive check on your credit history, the process can be completed and your loan approved much more quickly. These loans are also sometimes appealing for those with poor credit, such as those who have defaulted on a loan in the past, or those who have been through bankruptcy.

Importantly, hard money loans also have comparatively high interest rates. In fact, rates can be as high as 15%, as opposed to traditional loans, which are often closer to 4%. That makes the loans fairly expensive, especially once other expenses like closing costs, service fees, and signing fees are factored in.

Most hard money loans have shorter repayment periods, however — anywhere from one to five years, meaning there is less time for the interest on the loan to accrue. Though they are expensive, they do have their purposes. Let’s go over a few cases where borrowers might use a hard money loan.

What are hard money loans used for?

Hard money loans are most often used to buy property. Though in most ordinary cases, a traditional mortgage is likely a more financially stable option, there are times when a hard money loan may come in handy.

  • One common use for hard money loans is in real estate investing, and specifically house-flipping. That’s when someone purchases a run-down home, fixes it up, then sells it, hopefully for profit. Hard money loans can be useful in that case because the term that borrowers have the loan is short — just until they’re able to fix and flip the property, then sell it.
  • A cash bidding battle may also be a case where a hard money loan can be handy. Say you absolutely want a piece of property, but don’t have the time to go through the intensive and time-consuming mortgage application process. A hard money loan can be approved quickly, getting you the cash you need to put down a competitive offer, and so can be used as a bridge loan. There are risks associated with this, though, which we’ll cover in the next section.
  • Hard money loans may also be used by those who simply want to purchase property but do not have the credit to afford a traditional mortgage. If, for whatever reason, you’re flush with owned tangible assets but have a lackluster borrowing history, a hard money loan could be a plausible workaround. This may be a higher-risk option, however, because, unlike a traditional mortgage with a 30-year repayment term, a hard money loan may only have a 3-year term.

Next, let’s cover the pros and cons that come along with a hard money loan.

Pros and cons of hard money loans

As with any financial product, hard money loans come with pros and cons. Before getting serious about looking into a hard money loan, it’s smart to be thoroughly versed in their advantages and disadvantages. Let’s take a look.

Pros

  • Hard money loans are accessible to those with lower credit, making them more widely available than a traditional mortgage might be. This would mostly apply to a case where a borrower had a lower credit score, but possessed a number of high-value assets that can be used as collateral when taking out the loan.
  • They typically have faster approval and disbursal times because loan agencies do not need to perform an extensive credit check. So, if you need cash ASAP, you’ll likely have access to it more quickly than you might when using other loans.
  • Some hard money loans offer flexible repayment schedules. Because they are borrowed against tangible assets, and because you’re working with a smaller company rather than a larger corporation, the agency may allow some wiggle room when it comes to your repayment plan.

Cons

  • As noted above, hard money loans have notoriously high interest rates. If you’re not certain you can comfortably pay back your loan within a short amount of time, you may end up paying a huge sum in interest — much more than you would with a traditional home loan. Not sure how having a long-term high interest rate will affect your finances? Check out our explainer on debt and your worth.
  • Hard money loans by their very nature require you to risk your personal assets. If you’ve put your priceless family heirlooms or childhood home up for collateral, take out a hard money loan, then are unable to pay it back, you risk losing those belongings to the loan agency.
  • Using a hard money loan for house flipping may be risky due to market shifts. As with any business venture, house-flipping requires taking on a certain amount of risk. If something happens and the housing market tanks after you’ve taken out a loan for a house-flip, you could be left without enough money from the sale of the house to pay off the loan. Risk is unavoidable, but it’s always smart to make sure you’re not taking on too much real estate risk.

Because of these fairly significant disadvantages, it’s always advisable to approach hard money loans with caution. Typically, if you can comfortably consider a traditional mortgage, that tends to be a safer alternative when your aim is purchasing property. Banks and credit unions tend to be more reputable than many hard money lending companies, and the amount you’re likely to spend in interest is substantially lower.

Hard money loan takeaways

Before you go, keep these hard money loan takeaways in mind, and remember to consider them before taking out a hard money loan in the future.

  • Hard money loans are usually real estate loans used to purchase homes or land quickly, as these loans do not take as much time to complete as a traditional mortgage.
  • Instead of using your credit score and other financial factors to assess trustworthiness, hard money lenders lend you money against collateral.
  • Hard money loans typically have much higher interest rates than mortgages, frequently in the double-digits.
  • Many use hard money loans to fix and flip houses, though this comes with some risk.
  • They are also useful to those with lower credit, but it’s important to remember that hard money loans can be highly risky. Check out our post for tips on how you can improve your credit score.
  • Ultimately, they have specific use cases where they may be a plausible option, but on the whole carry a significant amount of risk, and are expensive.

Sources

Investopedia | Debt.org

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