What Is a Hard Money Loan? With a Practical Example

Hard money loans are a segment of non-traditional financing primarily utilized in real estate transactions, distinguished from conventional bank loans by being secured predominantly by the value of the underlying asset, rather than the borrower’s creditworthiness or financial history. This asset-based approach allows for a different set of lending criteria and facilitates quicker access to capital for specific real estate endeavors.

Characteristics of Hard Money Loans

Hard money loans are offered by private investors or specialized lending companies, not by traditional banking institutions. The loan is primarily secured by the real property itself, serving as collateral, with the property’s value, condition, and potential being the main factors for approval, rather than the borrower’s personal credit score or income.

Loan-to-value (LTV) ratios for hard money loans are lower than those for traditional financing, commonly ranging from 60% to 75% of the property’s current value or its after-repair value (ARV). For instance, a lender might offer up to 70-75% LTV for fix-and-flip projects or 65-70% for bridge loans. These loans also feature shorter repayment terms, spanning from six months to three years, unlike conventional mortgages.

Interest rates are higher due to increased risk and funding speed, falling between 8% and 18% annually. Additionally, borrowers pay origination fees, also known as points, which are 1% to 5% of the loan amount and are charged upfront.

The Hard Money Loan Process

The process of obtaining a hard money loan begins with an initial inquiry and submission of basic project information, including details about the property, its estimated value, and the scope of the planned project. Lenders then focus on evaluating the property through an appraisal or other due diligence to determine its market value and potential.

Underwriting for hard money loans is streamlined and emphasizes the value and equity of the collateral asset. Once the property evaluation is complete and the lender sees potential in the deal, a term sheet is issued, outlining the loan amount, interest rate, fees, and repayment terms. The closing process is quicker than traditional loans, taking one to two weeks, and funds can be disbursed in a few days once all required documents are received.

Typical Uses for Hard Money Loans

Hard money loans are used in scenarios where speed, flexibility, or less stringent credit requirements are paramount. Real estate investors utilize these loans for fix-and-flip projects, where distressed properties are purchased, renovated, and resold quickly for a profit. The rapid funding characteristic of hard money loans allows investors to seize time-sensitive opportunities.

Another application is bridge financing, which helps borrowers acquire a new property before an existing one is sold. This bridges the financial gap, preventing missed opportunities due to the slower pace of traditional financing. Hard money loans also fund construction or renovation projects, particularly when the property’s current state or the speculative nature of the project makes it unsuitable for conventional bank loans. Hard money loans are also a viable solution for borrowers who do not qualify for traditional financing due to credit issues or properties that do not meet standard lending criteria.

Practical Examples of Hard Money Loans

Consider a real estate investor, Sarah, who identifies a distressed single-family home for $200,000. The property requires an estimated $50,000 in repairs, but its after-repair value (ARV) is projected to be $320,000. Traditional lenders are unwilling to finance the purchase due to the property’s condition and Sarah’s need for fast closing to secure the deal.

Sarah turns to a hard money lender who offers a loan at 70% of the ARV, totaling $224,000. This loan covers the purchase price and provides funds for a significant portion of the repairs, allowing Sarah to acquire the property swiftly. The loan comes with a 10% interest rate and 3 points, with a term of 12 months. Sarah completes the renovations in six months and sells the property for $315,000, repaying the loan and realizing a profit from the quick turnaround.

Another scenario involves David, a homeowner who found his dream home for $550,000 but needs to sell his current residence, valued at $350,000, before he can qualify for a traditional mortgage on the new property. The seller of the dream home requires a quick closing, which conventional financing cannot accommodate. David secures a hard money bridge loan for $357,500, representing 65% of the new home’s purchase price, enabling him to close on the new property within two weeks. This loan has an 11% interest rate and 2 points, with a six-month term. David successfully sells his old home within three months, using the proceeds to repay the hard money loan, thus avoiding the loss of his new dream home.