5 Common Mistakes to Avoid with Hard Money Loans

Hard money loans are a popular option for borrowers to quickly fund real estate projects with minimal documentation. However, these loans come with specific risks and challenges. Borrowers need to know the most common mistakes when applying for and using these loans. In this blog post, we'll discuss the top five common mistakes to avoid with hard money loans.

Let’s get started.

1. Not Understanding the Terms and Conditions of the Loan

One of the most common mistakes borrowers make with hard money is not fully understanding the terms and conditions of the loan. Before applying, borrowers need to know that hard money loans typically come with higher interest rates and fees. Additionally, hard money loans have shorter repayment terms, known as a balloon payment, which can make it difficult to repay the full balance of the loan at maturity, or on the twelfth payment. To avoid this mistake, borrowers must carefully read and understand the loan terms and conditions before applying for a hard money loan.

2. Not Having a Clear Exit Strategy

Another common mistake borrowers make with hard money loans is having no clear exit strategy to repay the loan. Hard money loans are typically for real estate projects, and these borrowers need a well thought-out plan for how they'll use the loan to complete the project. Without a solid plan, borrowers may struggle to repay the loan at maturity. This can result in a technical default, if the borrower and lender haven't already agreed to extend the loan for an additional three to six months.

I'll give you a recent example. An investor from Seattle called me for a $600,000 second mortgage on their existing rental property, with proceeds going toward the down payment on a $2 million investment purchase. When I asked how they would repay the second mortgage, the investor didn’t have an answer. I couldn’t place this loan with a trust deed investor or mortgage fund — who don't want to lend to a borrower with no plan to pay off the loan before the maturity date.

3. Being Overleveraged on the Property

Hard money loans require real estate collateral of either one or more properties, like a blanket or cross-collateral loan. However, many borrowers make the mistake of overleveraging their property with a hard money loan, or multiple hard money loans, in the form of a first, second, third or even a fourth trust deed. An overleveraged loan or loans is very difficult to refinance, if that is the exit strategy.

I work with many long-term investors with rental portfolios, and I often help them unwind overleveraging problems. (Note: they buy properties with other hard money lenders and come to me to get out of their overleveraged hard money loans and into long-term financing). It can be very difficult to refinance these properties. Sometimes borrowers need to sell a property (and pay the capital gains taxes) to pay down the balances of the existing hard money loans and obtain a long-term bank loan on their rental property.

4. Not Having a Good Credit Score

Many borrowers make the mistake of applying for a hard money loan without a good credit score. Hard money lenders typically require a credit score of at least 650, and borrowers with lower scores may struggle to get approved.

Why 650? A 650 credit score is at the low end of the credit spectrum for conventional, NonQM and portfolio bank lenders. A hard money lender wants to know the prospective borrower pays their bills on time and has a high chance of refinancing into a traditional loan (if the plan is to hold the property).

A low credit score (450-650 range) raises many red flags for the hard money lender. It increases the chance the borrower will file for bankruptcy in the near future, or default on the loan payments leading to a Notice of Default — often the first step in a foreclosure. Lenders don’t want that.

Make sure to have good credit. If your credit is bad, work on improving it prior to applying for a hard money loan.

5. Unrealistic Opinion of the Value of Your Property

Some borrowers can be very unrealistic about the value of their property. As a broker, I’ve experienced this many times over the years, with borrowers adamant that their property is worth 10-20% more than the market will bear.

For example, I recently spoke to a property owner developing land to sell to a nationwide home builder. The conversation was standard talk about where he was in the process — until he mentioned that his property value wouldn’t be impacted by the downward pressure in the market. Somehow, his land would defy the gravity of plummeting land values all around him.

In another instance, a home builder with four completed homes for sale refused to lower the prices, holding out hope that buyers will meet his asking price. He builds great homes, but isn't factoring in rising interest rates during the second half of 2022 and early 2023. As a result, though the market moved down 5-10%, this builder is still clinging to the original price he predicted before he broke ground on the homes. Underneath it all, he has a $2 million construction loan with a 12% note rate, eating into his profits at $20,000 per month.

Conclusion

Hard money loans can be a great option for borrowers to fund real estate projects quickly and with minimal documentation. However, borrowers need to know the top five common mistakes to avoid before applying for and having hard money loans. By understanding these mistakes and taking steps to avoid them, borrowers can increase their chances of success.