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How a Hard Money Loan Works
A hard money lender, also known as a private money lender, lends money to people who cannot qualify for a mortgage with traditional lenders such as banks, mortgage banks, mortgage brokers or credit unions. Instead of using deposits, hard money lenders use capital from private investors to fund loans for borrowers. Hard money lenders operate outside of the regulations that apply to traditional mortgage lenders which enables them to offer more flexible qualification requirements. For example, a hard money loan may be a good option for borrowers with a poor credit score, a recent negative credit event such as a bankruptcy, foreclosure or short sale or a limited employment history. Or you may be looking to purchase an unusual property that other lenders won't finance or a fix & flip property. These are all scenarios when a hard money loan may be a god option.
Hard money lenders are a potentially attractive mortgage lending alternative if you cannot get approved for a traditional mortgage but the more flexible qualification guidelines come at a significant cost to borrowers. Hard money loan rates are typically 4.0% - 7.0% higher than the rate on a normal mortgage, depending on your credit score, loan program and other factors. Hard money loan rates also vary depending on the length of the loan and what you are using the loan for. For example, the interest rate for a loan used to buy a home is different than the rate used for a fix & flip loan.
Additionally, hard money loans have higher closing costs and lenders may charge two-to-three points in processing fees. One point equals 1.0% of the mortgage amount so if a hard money lender charges three points on a $100,000 mortgage, the borrower pays $3,000 in lender fees in addition to other closing costs. So you may be able to qualify for a hard money loan, but it will cost you a lot more than a traditional mortgage.
With a higher interest rate and fees, you may ask why someone would use a hard money lender for a mortgage? In short, it is usually because you have no other mortgage options. In some cases borrowers with poor credit or a recent bankruptcy use a hard money mortgage to purchase a property and then refinance the loan within one-to-two years when their credit score or financial profile improves.
Another common use of hard money loan is to finance house flipping where an investor purchases, renovates and then quickly sells a property. House flippers obtain a short-term bridge loans, also called fix & flip loans, from hard money lenders and then pay-off the loans after the property is remodeled and sold, typically within one-to-two years.
One less common reason is when a borrower uses the proceeds from a hard money refinancing to pay off credit card or other debt that has an even higher interest rate. Although this scenario is rare, a hard money loan may enable you to access the equity in your home and use the proceeds for any number of purposes.
New mortgage rules and regulations have reduced the number of hard money lenders so you typically have to search for smaller, local lenders. If you are contacting a hard money lender it likely means that you have no other mortgage options but that does not mean the lender should exploit you. Like with all mortgages, when you are shopping hard money lenders be sure to compare at least four proposals to find the loan with the best terms. Because there is less competition and lenders have more discretion on pricing and terms, comparing multiple hard money loan quotes is especially important.
Use the FREEandCLEAR Lender Directory to find top-rated hard money lenders in your state.
Hard money loans can be structured as short-term loans with one-to-three year terms, this is also known as a bridge loan. Short-term hard money loans or bridge loans are typically interest only loans with a balloon payment for the full mortgage amount due at the end of the loan. Bridge loans are especially popular with house flippers because they expect to complete their renovations and sell the property in a relatively short period of time, before the loan balance is due. Short term hard money loans also have lower monthly payments because you are paying only interest and no principal. The lower monthly payment provides greater financial flexibility for borrowers.
Hard money mortgages can also be structured as 10/30 or 15/30 mortgages where the interest rate is fixed for the first ten or fifteen years of the mortgage and the loan balance is due paid in full after 10 or 15 years, even though you make the same payment that you would with a 30 year loan. During the first 10 or 15 years of a 10/30 or 15/30 mortgage, the borrower pays a monthly mortgage payment that includes both principal and interest. Hard money loans typically require the borrower to pay a pre-payment penalty if the mortgage is paid in full before a specified time period which is generally six months for loans with shorter terms (one-to-three years) and five years for mortgages with longer terms (10/30 and 15/30 loans).
It is important to emphasize that while hard money lenders offer more flexible qualification requirements in certain areas, they compensate by applying stricter guidelines in other areas. For example you may be able to qualify for a hard money loan with a credit score below 500 or if you recently completed a short sale, but
Specifically, hard money lenders typically apply a loan-to-value (LTV) ratio of 70% or less, which protects them in case borrowers default on the loan. LTV ratio is your loan amount divided by your property value, so the lower the LTV ratio, the more collateral the lender holds. Offering a mortgage to a borrower with a low credit score may seem risky but using a low LTV ratio enables the private money lender to mitigate their risk.
Additionally, rather than hiring a professional appraiser, many hard money lenders conduct their own appraisal to determine the fair market value of the property used to calculate the LTV ratio. In many cases, the property value used by the hard money lender may be lower than the value determined by a professional appraiser, which means borrowers are required to make a bigger down payment or have more equity to qualify for the loan.
As long as you meet their LTV ratio requirement, hard money lenders may apply a higher debt-to-income ratio, potentially above 50%, which means the you can qualify for a larger loan amount. Debt-to-income ratio is how much of your monthly gross income you can spend on total housing expense including your mortgage payment, property tax and insurance plus payments for other monthly debt expenses such as credit cards, auto and student loans. The higher the debt-to-income ratio, the higher the loan amount you qualify for. In some cases, hard money lenders use higher debt-to-income ratio than traditional mortgage lenders.
Although hard money lenders may apply more flexible qualification guidelines when it comes to a borrower's credit score and debt-to-income ratio, they are subject to certain guidelines that apply to all lenders. For example, both hard money and traditional lenders are required to determine that borrowers can afford their monthly payment and pay back the mortgage. This means that when you apply for a mortgage all lenders, regardless of what type, should review your income and assets to confirm that you have the ability to repay the loan.
Sources:
“What is a subprime mortgage?” CFPB. Consumer Financial Protection Bureau, February 24 2017. Web.
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