If you are investing in real estate and need financing, you might be thinking you have two options: a traditional mortgage or a hard money loan. Though most people understand the basics of a traditional mortgage, many may wonder, what is a hard money loan? Here are some common differences between the two types of loans and when it makes sense to use them.
Traditional vs. Hard Money
A traditional mortgage involves financing typically done through a mortgage broker, or small and/or local/regional bank. Loans done through a mortgage broker are typically for 30-years and have fixed interest rates, while local/regional bank loans are for 15 – 20-year terms and have an adjustable interest rate built into the loan. The rate on these loans can adjust every 3 – 5 years, depending on the bank’s tolerance for interest rate risk.
A traditional loan, sometimes referred to as conventional, is one that conforms to Fannie Mae or Freddie Mac underwriting guidelines. They have 30-year terms and offer the lowest market rates available. These types of loans are sold on the open market, many of which end up in some type of bond fund.
Hard money loans are private lender loans. The money may come from individual investors, lines of credit, or various types of investment funds. Most hard money loans are not sold to anyone, remain with the originating lender through payoff, and are usually serviced by that lender. Interest rates are higher, and the term of the loan is much shorter. Typically a 12-month term is common, although some can go shorter or longer.
Leverage
The most important benefit for using hard money financing is that it allows you to use leverage. This means you can borrow more money from the lender and bring less of your own money for the purchase. Most hard money lenders will loan up to 70% of the after repair value. This percentage is referred to as loan-to-value. These loan-to-values can go as high as 75% in some situations as well. A typical traditional lender will require 20% of the purchase price as a down payment, while a hard money loan can have zero out of pocket costs at closing.
Closing Timeframe
One of the biggest differences between a hard money loan and a traditional loan is how long it takes you to close the purchase transaction. Traditional mortgage products can take 30-45 days to close the transaction. With hard money, you can usually close within a week, sometimes less. The time it takes you to get money can be crucial when you are buying from someone who wants to close quickly. It is commonly known that not having the ability to pay cash or close with hard money may cause an investor to lose a deal.
Interest Rate
Across the board hard money rates are higher than other forms of financing. This is because hard money lenders are loaning the money for shorter periods of time, and not for 30 years where they would be collecting large amounts of small interest payments over that term. Hard money interest rates are also higher due to the fact that the majority of the properties financed are distressed. The higher rate corresponds to the higher risk involved in these types of properties.
Property Type
Lenders offering traditional mortgages will typically loan on residential properties used for personal residences, as well as rental properties. These lenders place a larger emphasis on the credit-worthiness of the borrower, as well as the condition of the underlying asset. Properties that are distressed cannot be approved for a traditional mortgage. Hard money lenders lend for both residential and commercial properties, but never lend money for owner-occupied properties, or properties being used for personal or household use. Hard money loans are designed for distressed properties and are used by investors looking to buy and renovate, either to flip or refinance and keep as a rental.
Conclusion
If you have a deal that needs to close quickly and/or has an extensive scope of work, hard money is going to be your best option. Neither traditional nor conforming loans can be used for investment properties on the purchase side if the property is distressed. Also, traditional and conforming products are designed to be a long-term solution and are best for refinancing out of hard money.