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If you're looking to buy a house to flip or as a rental property, it can be challenging to get a traditional mortgage. If your credit score isn't where a traditional lender would like it or you need cash more quickly than a lender is able to provide it, you could be out of luck. In situations like these, some borrowers might turn to what are known as hard money loans.
What Is a Hard Money Loan?
Hard money loans are short-term secured loans that use the property you're purchasing as collateral. You won't find one from your bank: Hard money loans are offered by alternative lenders such as individual investors and private companies, who typically overlook mediocre credit scores and other financial factors and instead base their decision on the property to be collateralized. While you might jump through fewer hoops to get a hard money loan, this type of lending comes with risks and isn't the best option for many people.
Folks who might take out a hard money loan include:
- House flippers: House flippers buy fixer-uppers to rehab them in hopes of selling them at a hefty profit. In some cases, a house flipper might put hard money toward both the purchase price and repair costs.
- Rental property investors: Investors in rental properties might rely on hard money loans as a quick source of cash to finance a deal.
- Business owners: Business owners might take out hard money loans to purchase commercial real estate when they can't qualify for traditional financing.
Benefits of Hard Money Loans
Hard money loans provide several benefits for borrowers. These include:
- They often close faster than a traditional loan does. From start to finish, a hard money loan might take just a few days.
- Their underwriting process is less rigorous than with a traditional loan. Why? Hard money lenders tend to place more weight on the value of a property used as collateral than on a borrower's finances.
- Hard money lenders pay less attention to a borrower's credit score and debt-to-income ratio. That's because hard money lenders aren't required to follow the same regulations that traditional lenders are.
For these reasons, a hard money loan can be a compelling alternative for people who are unable to qualify for a traditional loan, but these loans can be very risky. It's key to consider all the perils they expose.
Risks of Hard Money Loans
While hard money loans come with benefits, a borrower must also consider the risks. Among them are:
- Interest rates are typically higher. Hard money lenders typically charge a higher interest rate because they're assuming more risk than a traditional lender would.
- They may require a higher down payment than a traditional loan would. Again, that's because of the risk that a hard money lender is taking.
- The term is typically much shorter than what's offered on traditional loans. While a regular mortgage typically can be repaid over the course of 15 or 30 years, hard money loans often require repayment in one to three years.
All of that adds up to mean that a hard money loan can be an expensive way to borrow money.
Should You Get a Hard Money Loan?
Deciding whether to get a hard money loan depends in large part on your situation. In any case, be sure you weigh the risks and the costs before you sign on the dotted line for a hard money loan.
As with any debt, be sure to have a plan for paying it off before you borrow. You certainly don't want to lose the loan's collateral because you weren't able to keep up with the monthly payments. In addition to losing the asset you put forward as collateral, defaulting on a hard money loan can result in major credit score harm. Both of these outcomes will leave you worse off financially than you were in the first place—and may make it much harder to borrow again.
When to Avoid Hard Money Loans
So, when might you want to explore alternatives to a hard money loan? Here are a few reasons:
- You're uneasy about the risks associated with a hard money loan—namely the potential loss of the property you put up as collateral.
- You're unsure whether you can afford to pay off the hard money loan in a short period of time.
- You've got a solid credit score and should be able to qualify for a traditional loan that likely carries a lower interest rate.
Alternatives to hard money loans include traditional mortgages, home equity loans, friends-and-family loans or financing from the property's seller.
How to Get a Hard Money Loan
Finding a hard money lender isn't difficult—but you don't want to borrow money from just anyone. It's important to take into account factors such as the lender's reputation and interest rates. You might ask a trusted real estate agent or a fellow house flipper for recommendations.
Once you've nailed down the right hard money lender, be prepared to:
- Come up with the down payment, which typically is heftier than the down payment for a traditional mortgage
- Gather the necessary paperwork, such as proof of income
- Potentially hire an attorney to go over the terms of the loan after you've been approved
- Map out a strategy for paying off the loan
The Bottom Line
Just as with any loan, review the pros and cons of a hard money loan before you commit to borrowing. You might find that a hard money loan is the best option for borrowing, or you might decide to pursue an alternative. Regardless of what type of loan you choose, it's probably a good idea to check your free credit score and free credit report with Experian to see where your finances stand.