How Do Hard Money Loans Work?

Typically issued by private money lenders, a hard money loan is a type of asset-based loan in which a borrower receives funds secured from real property.

As with any form of financing, there are pros and cons to hard money loans. While each case is different, there are some common reasons why you may require a hard money loan — including a change in income or employment, or if your property does not meet the requirements for a typical bank loan.

There are also several factors involved in obtaining funds from a hard money lender, so it is important to know how these loans work.

What is a hard money loan?

Hard money loans are usually short-term because they rely on collateral rather than the financial status of the applicant.

They are also primarily used in real estate transactions, with private money lenders generally being individuals or companies, instead of banks.

If you do not qualify for a conventional bank loan, a firm like ours can help you get possession of the property. We are not credit score-driven like the bank, so we have more flexibility in what we can do for you.

However, hard money loans usually have higher interest rates. Fortunately, most hard money lenders do not require the same level of vetting — such as examining your financial history, credit score, and existing debt — as traditional lenders do, which makes this type of mortgage much more accessible.

How hard money loans work

Hard money loans are based mainly on the value of the property being used as collateral, not on the creditworthiness of the borrower. That means our firm can work with a variety of scenarios, such as poor credit scores, bankruptcies, or collections.

One group that often seeks hard money loans are property flippers who plan to renovate and resell, and then use the real estate as collateral for the financing. The higher cost of the loan is offset by the fact that the borrower intends to pay it off relatively quickly.

At our firm, we generally write the loan for a 30-year payment plan, with the balloon payment being due in about five years. This means the loan recipient should have an exit strategy in mind when they initially acquire the loan.

While there are several exit strategy options, it’s dependent on the situation. For example, if you have poor credit when you receive the loan, the five years give you time to improve your credit score and possibly qualify for a conventional bank loan. Or, if you are flipping the property, you have time to renovate and resell it for a profit.

Pros and cons of hard money loans

One advantage of hard money loans is the approval process, which tends to be quicker than applying for a mortgage or other traditional bank loan. Additionally, the private money lenders who back the loan can make decisions faster because they are focused on collateral rather than an applicant’s financial status.

However, since the property is used as the only protection against default, hard money loans usually have lower loan-to-value (LTV) ratios than traditional loans — around 50% to 65%, vs. 80% to 100% with a typical bank.