If you’re interested in a real estate investment, you might have heard of a type of mortgage financing called “hard money loans.” Usually used for real estate transactions, hard money loans offer certain advantages to borrowers, but there are some risks to be aware of.
Hard money loans are generally riskier than mortgages. Consider the negatives, like higher interest rates, of hard money loans and look into alternatives before taking on this kind of financing.
Hard money loans, explained
A hard money loan is one in which the lender’s investment is secured by real property. Unlike traditional home loans, in which the borrower’s financial position and creditworthiness are essential, a hard money loan relies on property collateral.
Usually, lenders for hard money loans are individuals or companies, not banks or financial institutions. Hard money loans on real estate transactions usually have shorter repayment terms, higher interest rates, and a lower LTV (loan-to-value) ratio.
Often, hard money loans are used by property flippers or those looking for investment property. This type of loan can be beneficial in that case because they plan on a faster timeline for renovation and resale of a property.
Risks of a hard money loan
Hard money loans are secured loans, which means that the lender has the right to take over ownership of the asset used as collateral in the event that the borrower defaults on the loan. Lenders assume risks when granting hard money loans since the borrower’s financial situation isn’t considered and the timeline is much quicker.
To mitigate the risks to the lender, interest rates are usually much higher than with a traditional mortgage. In addition, lenders have the right to take over the property if the borrower defaults on the loan.
The fact that people can get hard money loans who wouldn't be able to secure traditional financing should tell you that it's a riskier loan. Rocket Mortgage recommends seeking other options like improving your credit or trying the FHA program. According to Rocket Mortgage, hard money loans should be used as a last resort.
Differences between mortgages and hard money loans
Several key differences usually exist between mortgages and hard money loans—the timeline, interest rates, and how a lender evaluates a loan application.
The timeline is shorter with hard money loans. A mortgage can be over a month-long process from application to closing, while a hard money loan could close within just a few days. The approval requirements might be easier for hard money loans.
The repayment terms are also shorter with hard money loans—often just a few years compared to traditional mortgages that are usually 15-year or 30-year terms.
Interest rates on hard money loans can be as high as 8 percent–15 percent compared to an average of 2.77 percent on traditional fixed 30-year mortgages as of Aug. 5, according to Freddie Mac.
A mortgage lender evaluates a borrower’s ability to manage credit based on income, credit scores, and other financial data. A hard money lender bases a loan decision on the value of the property being purchased. This can benefit borrowers with lower credit scores, but they still have to be able to make the payments.