Some private lenders use a method of interest accrual known as “Dutch interest” for a hard money construction...
What Is a Hard Money Loan?
Hard money loans, also known as private money loans, are most commonly 6-24 month bridge loans used by real estate investors for fix and flip projects or the acquisition of investment properties. These loans are mostly issued by individual trust deed investors, family offices, or pooled investment funds operating as a lender. This article answers the question, “What is a hard money loan?” and in addition to answering that question, it provides the advantages and disadvantages real estate investors experience when utilizing hard money loans to finance properties.
Advantages of Hard Money Loans
There are many advantages to hard money loans, including:
Hard money loans can close within 48 hours when an investor is in a bind and needs to close fast. Over the past six years, First Capital Trust Deeds has closed several loans within 48 hours for our real estate investor clients.
Conventional lenders and even other hard money lenders may deny a loan “at the eleventh hour”, which, in real estate terms, is usually in the final week before the scheduled close of escrow. When this happens, buyers (“borrowers” to us) need a lender that can close quickly. Hard money lenders often come through at the last minute, providing buyers with financing to close the transaction on-time.
In the regular course of our business, most hard money loans FCTD originates in California, Oregon, and Washington close within two weeks. Usually, our loan docs are ready within a couple days, but we need to complete the other items involved in closing a transaction including title, vesting, taxes, clearing liens, judgments, insurance, etc.
To the contrary, one hard money loan may have one, two, or even twenty properties encumbered by a single lien. FCTD has worked with dozens of real estate investors over the years to structure a hard money loan across multiple properties, known as a blanket loan or cross-collateralized loan. One investor used a single blanket loan of $2,100,000 in first position across 18 rental properties valued at $3,200,000. Another investor took out an $800,000 loan on a mixed-use property in Oregon using their primary residence in California as additional collateral for a hard money loan, placing the $800,000 loan in second position on their home.
Hard money loans allow a real estate investor, mortgage broker like First Capital Trust Deeds, and hard money lenders to be creative when putting financing together. Real estate investors and house flippers are sometimes temporarily short on cash, mainly due to delays in the close of escrow on a finished project, which the proceeds will go toward the down payment on their next project. (Usually, the buyer’s financing is creating delays). A creative and flexible hard money lender can work with the investor short on cash by using the property in escrow or other properties as additional collateral to acquire the next project on schedule.
Hard money loans are known as asset-based loans. Meaning, the lender makes the loan against the property being secured by the loan rather than the financial strength of the borrower (credit, income, and liquidity).
However, most every hard money lender will want to see the borrower’s credit report to ensure they’re not making a loan to a “repeat offender” who habitually defaults on their credit obligations. Lenders also like to see a business and/or personal tax return, just to make sure the borrower has a real estate track record. They also like to check a borrower’s liquidity, even though liquid assets aren’t a prerequisite to qualifying for a loan. Hard money lenders like to make loans to strong borrowers who will pay on-time and will pay off the loan on or before the maturity date, sometime within 6-24 months.
Real estate investors often take title to a property in a Limited Liability Corporation (LLC). In additional to LLCs, First Capital Trust Deeds frequently sees vesting in a corporation, Self-Directed IRA or 401K, individual and family trusts, and 1031 Exchanges where the Exchange Accommodator (qualified intermediary that facilitates a 1031 Exchange on behalf of the real estate investor) temporarily owns the new LLC, acquiring a property until the exchange is completed whereby the borrower takes ownership of the LLC controlling the property.
Conventional residential lenders such as Fannie, Freddie, FHA, and VA only allow vesting in the name of the individual(s) on the loan. Therefore, residential properties vesting in the name of an LLC, corporation, trust, Self-Directed IRA or 401K, and many types of 1031 Exchanges either need to be financed through a portfolio bank or hard money lender, where vesting in an entity is allowed. Commercial loans are most often vested in an entity.
One thing to note, even though an entity will be “the borrower,” an individual will usually be the “guarantor,” signing a personal guaranty for the hard money loan. In 1031 Exchanges, the LLC will be owned by the 1031 Exchange accommodator company but will be guaranteed by the end-user borrower doing the 1031 Exchange for tax purposes.
Disadvantages of Hard Money Loans
Even though hard money loans help investors needing to close quickly, creatively, or inside an entity, there are some drawbacks to using a hard money loan, including:
First Capital Trust Deeds acknowledges that hard money loans are not for the faint of heart, especially for prime borrowers. If borrowers are accustomed to using low-cost bank financing to buy and sell real estate, they might have sticker shock when they see costs, fees, and rates of hard money loans.
A typical hard money bridge loan in California used by a prime borrower whose conventional financing was denied at the eleventh hour on a $1,000,000 2-4 residential investment property purchase may be structured with the following terms:
- $700,000 Loan Amount (70% Loan-To-Value (LTV))
- 9.00% Interest-Only
- 12-Month Term
- 3-Month Interest Guarantee (3 payments required)
- Closing Costs:
–2-3 Points Origination Fee
–$1,000 Underwriting Fee + Doc Prep Fee
–$500-$1,000 Appraisal / Valuation
–+ Title, Escrow, Etc
It’s fair to say that sticker shock would be a perfectly normal response for a borrower whose conventional financing (terms below) had been denied with less than one week to close. Hard money interest rates and closing costs are almost double the cost of conventional financing. See below:
- $700,000 Loan Amount
- 4.625% Fully Amortized (Principal & Interest)
- 30-Year Fixed Rate Loan
- No Prepayment Penalty or Guaranteed Interest required
- Closing Costs:
–1 Point Origination Fee
–$1,500 Underwriting Fee + Doc Prep Fee
–$1,200 to $1,500 Appraisal / Valuation
–+ Title, Escrow, Etc
FCTD originates dozens of hard money bridge loans each year for real estate investors whose conventional financing falls out at the last minute. Usually, the hard money loan will only be in place for 3-6 months, when either the borrower has filed income taxes or has stabilized the subject property with new tenants paying higher rent. At this point, they qualify for the long-term conventional loan, paying off the hard money bridge loan.
Since hard money loans are made by individuals, family offices, or pooled investment funds, they tend to be more conservative with Loan-To-Value (LTV), or leverage.
First Capital Trust Deeds originates loans with a variety of trust deed investors, where the maximum LTV ranges from 55% to 70% on bridge loans and rental property loans. Fix and flip hard money lenders range from a maximum of 70% LTV to 85% LTV, with 90% LTV going to the most experienced house flippers.
For comparison, in residential lending, the maximum LTV of Fannie Mae and Freddie Mac is 97%, FHA is 96.50%, and VA 100%, all guaranteed or insured by the US taxpayer. In commercial lending, where Fannie Mae and Freddie Mac purchase multi-family (apartment building) loans from banks, it’s common to see 80% LTV. The Small Business Administration (SBA) also finances commercial buildings up to 85% LTV. These three entities, again, have the US taxpayer insuring or guaranteeing mortgages.
Due to the local and regional nature of hard money lending, loan leverage is lower than conventional residential and commercial lending. Borrowers taking out a hard money loan should be prepared to see lower LTV ratios than they would if they were to go through conventional lending institutions where insurance or guarantees support higher leverage.
Hard money loans are generally 6-24 month bridge loans used by real estate investors to quickly close on properties without all the underwriting requirements of bank lenders. Borrowers pay a higher cost for the loans, but for many, especially house flippers, it is a necessary cost of doing business in a highly competitive market. Hard money loans serve a role in real estate financing, allowing investors to acquire properties or reposition debt across many properties to achieve their real estate and financial goals.