Hard money lenders provide an attractive alternative that’s particularly well-suited for the real estate industry. These business financing lenders aren't banks or financial institutions. Rather, they’re typically private lenders or companies backed by investors who make asset-based loans.
In this blog post, we’ll examine the hard money loan option so that you can determine if it is the right funding option for you.
How Does a Hard Money Loan Work?
At a high level, hard money loans work similarly to any other asset-based loan. The lender evaluates the borrower’s credit risk and the value of the property being used as collateral. Based on this evaluation, the hard money lender sets terms determining the loan amount, interest rate, and repayment schedule.
Usually, borrowers use real property as collateral on a hard money loan. The lender evaluates the value of the property and extends a loan with a loan-to-value (LTV) ratio of 50 to 70 percent.
Hard money loan terms are generally short—usually around one year and sometimes up to three.
As mentioned, banks don’t make hard money loans; only individuals and companies do.
Hard Money Lender Pros and Cons:
The Pros of Hard Money Loans:
While the low LTV ratios of hard money loans make it difficult to get a large loan amount, they also make it easier to qualify. Unlike other business lender options, hard money lenders don’t require a stellar credit score for approval. All you really need is valuable collateral.
Another benefit of hard money loans is that you don’t have to apply for additional working capital through a bank loan program. Since hard money lenders are private investors, they can make much quicker approval decisions. Plus, they can generally provide you with your small business loan much faster.
Also, because hard money loans are short-lived, they’re ideal for filling in cash flow gaps. For example, suppose you want to purchase raw land to develop but you don’t have all the cash you need. With a hard money loan, you can make a down payment, develop the land, flip it, and pay off your loan with the proceeds.
Finally, since hard money loan terms are short, even though you’re paying a high interest rate, the loan has less time to accumulate interest.
The Cons of Hard Money Loans:
Because your collateral is the hard money lender’s main downside protection, LTV ratios on hard money loans are low. That means you’ll likely struggle to get a loan amount greater than 50 percent of the value of your collateral. Borrowers with existing relationships or strong track records can expect higher LTVs.
In addition, hard money loan interest rates are usually relatively high. According to Investopedia, the average interest rate in 2020 for a hard money loan was 11.25 percent in the U.S.
However, in some cases, hard money lenders charge interest rates of up to 15 percent.
Finally, because they have short loan terms, hard money loans must be repaid quickly. For example, if you have a real estate investment property and plan to flip a house in less than a year, it won’t be an issue for you to do this. However, if you don’t expect a large cash influx before your loan is due, repaying it can be challenging.
How Hard Money Loans Compare to Other Types of Loans
Hard money loans are uniquely suited for borrowers with valuable collateral who need timely access to funds for a project that will generate a return within one year.
As mentioned, this makes hard money loans well-suited for real estate investors. However, anyone with collateral can obtain a hard money loan, although that doesn’t mean they should. If you’re considering a hard money loan, you should also be considering these financing options
1. Business line of credit
Once you’ve established a line of credit
, you can access funds at any time, up to a predetermined limit. In this way, a business line of credit can provide a quick funding option, even compared to a hard money loan. However, a line of credit will typically be more difficult to qualify for, especially if you’re obtaining one from a bank.
2. Small business loan
A small business loan
from a bank or credit union isn’t a viable alternative to a hard money loan. Compared to hard money lenders, banks and credit unions are simply too slow to approve and fund a small business loan. However, online lenders can approve and fund loans in a matter of days.
Again, you’ll need a strong credit history, but small business loans from online lenders can compare favorably to hard money loans. In most cases, they’ll have lower interest rates and longer terms.
3. Bridge financing
Like hard money, bridge loans
are popular in the commercial real estate industry, especially on construction projects. Also called bridging loans or bridge financing, a bridge loan is a short-term loan that provides temporary financing while the borrower secures permanent financing. Similar to hard money loans, bridge loans usually have terms of 12 months or less.
However, unlike hard money loans, bridge loans have more stringent application processes.
Conclusion: Is a Hard Money Lender Right for You?
The stringent application process of many traditional loan options can be a blessing in disguise. Lenders are in the business of risk management, so if they think you’re too risky to lend to, you probably are. Plus, many types of business lenders are subject to regulations that protect borrowers.
Hard money lenders are less risk-averse and less subject to regulations. Also, since they require valuable collateral and provide low LTVs, they’re less invested in whether small business owners can pay off their business loan or not. In many cases, the lender may actually profit if the owner defaults.
All this to say, while hard money loans are a powerful tool, they should be wielded carefully. If you’re unsure if this is the best loan for you, we suggest also researching the financing options mentioned in this post. In addition, you may benefit from seeking an equipment loan, merchant cash advance, business credit card, or invoice financing, depending on your needs.
Editor’s Note: This post was updated for accuracy and comprehensiveness in November 2021.