Everyone loves a good episode of HGTV, but the art of house flipping is hard to master. Navigating the financing aspect of getting a home — which isn’t usually shown on screen — can be a real challenge.
Enter: hard money loans.
When you can’t or don’t want to go through a traditional lender, a hard money loan can be an option. Intended for home flippers and real estate investors, these short-term loans are generally underwritten based on the home being used as collateral, instead of your credit.
However, these loans tend to be expensive and risky, especially if you’re new to flipping. Here’s what you should know about hard money before signing on the dotted line.
What Is a Hard Money Loan?
A hard money loan, sometimes called a rehab loan, is a type of loan backed by a “hard” asset, where the collateral is evaluated instead of the borrower’s financial profile. House flippers will often use this type of loan to secure short-term financing for renovations.
“As an investor, if you’re looking to flip a property, you don’t want to hold onto that property for three months. You want to get your money in and your money out,” says Leslie H. Tayne, Esq., debt attorney and the founder of Tayne Law Group, P.C.
There are short-term, conventional loans, such as rehab or fix-and-flip loans, which have a rigorous underwriting process that may take weeks or months for approval. But with hard money loans, you can get approved in as little as a day or a week, if you qualify. Hard money lenders are largely uninterested in your income and credit history (many don’t ask for that information at all) and underwrite loans based on the house instead, which is then used as collateral.
Are Hard Money Loans a Good Idea?
Hard money loans can be valuable to both first-time and established investors who ordinarily would not qualify for a traditional loan. With hard money, loans are individually underwritten based on the property and the experience or know-how of the borrower. Conventional rehab loans often require proof of income, evaluation of existing assets and debts, a good-to-excellent credit score, and a low debt-to-income ratio, and the application process tends to take longer.
However, you’ll need to be aware of pitfalls. “You really have to be careful about it. […] They’re a good funding source, but you could be taken advantage of,” says Tayne, who has represented clients trapped in debt cycles from taking out hard money loans.
Ask what happens if your rehab project runs into issues and takes longer than expected. It’s a common situation with house flippers, but you don’t want to be caught unaware if your hard money lender doesn’t offer extensions.
Hard money is more expensive than a conventional loan. Interest rates are higher, and you’ll also have to make a down payment and pay potential origination and appraisal fees. It’s also important to factor in potential construction delays, which are common in house flipping and could incur further costs.
“If you’re off and it’s too expensive, the all-in cost will be more than what you’re selling,” says Loren Howard, managing member of Prime Plus Mortgages, a hard money lender in Phoenix.
Benefits of Hard Money Loans
1. Good Credit Usually Not Needed
Hard money loans are asset-based loans, meaning lenders are looking at the value of the house itself and vetting your rehab plan to make sure it’s realistic for the amount of money you’re requesting. Howard says his firm doesn’t do background checks or credit checks on applicants, and that’s true for most of the industry as a whole. Just keep in mind that each deal is individualized and not subject to a uniform underwriting process.
2. You Can Close On the Loan Quickly
Conventional rehab loans can take weeks or even months to close, as banks tend to take a 360-view of your financial health, which includes your income, employment status and history, existing assets and debt, and your credit scores. With a hard money loan, you can close on the loan within a week — or sometimes even as quickly as a day.
3. They’re Short-Term Loans
Hard money loans are typically taken out for a term between six to 18 months (or longer), says Tayne. House flippers only need the loan for the length of the renovation. Depending on the lender, you may be able to extend the life of the loan if the project takes longer than expected, but you’ll have to check how easy that extension is to acquire before signing any contracts.
Downsides of Hard Money Loans
1. High Interest Rates
Hard money loans are typically considered riskier. While traditional lenders are able to offer more competitive interest rates because the underwriting process is more rigorous. Interest rates on hard money loans can run between 8% and 12% (or higher), depending on the terms of the loan.
2. They Come with Hidden Costs
You’ll have to put up quite a bit of your own money to get hard money for your project. In addition to the down payment (between 10% and 20% of the loan), you’ll have to pay the fees required by each lender — typically, an origination fee (at least 2% of the loan amount), an appraisal fee (often a flat $500, though it depends on the area), and a document fee for processing paperwork, says Bill Samuel, founder of Blue Ladder Development, a residential real estate developer specializing in rehabbed houses in the Chicago area.
Hard money loans, like other rehab loans, also require builder’s risk insurance (also known as course of construction). This type of policy protects buildings and materials involved in construction, including damage from fire, storms, theft, and vandalism. You’ll want to cover at least the appraised cost of the property and cost of renovations, and the policy will likely cost between 1% and 4% of the estimated project budget.
3. You Can Lose the Home
The reason most hard money lenders aren’t concerned with your credit is because they have the home as collateral. If you stop making payments, the hard money lender can repossess the house and sell it to recoup its losses. So make sure to always make payments on time, and aim to finish all home improvement projects within the given timeframe. As an established developer, Samuel considers hard money loans to be a “last resort.” But, he says, “if you have a strong deal and that’s the time to use it, it could be a good gateway in. You just have to be responsible with it — that’s all.”
When Does a Hard Money Loan Make Sense?
A hard money loan won’t work for every situation. To put yourself into the best position moving forward, you need to have a solid plan for rehabbing the home, enough money to make a down payment, and an interest rate that isn’t prohibitively high.
Here are some additional situations when this type of loan might make sense for you.
1. You Have A Foolproof Plan
If you’re new to the process of house flipping, make sure you cross all your t’s and dot all your i’s. And even if you aren’t new to investing in real estate properties, the hard money lender is going to want to know enough about you before approving you for a hard money loan.
“We ask them what their experience is, how many properties they’ve flipped in the past. They need a budget for the rehab that looks normal, and the repair value needs to be accurate with what we’re seeing. We try to validate that they know what they’re doing,” Howard says.
So make sure you’re being as precise as possible when coming up with the initial plan. “If you’re more experienced, you know how to use [hard money loans] properly,” Tayne says. “If you’re less experienced, you can get jammed. You could overestimate or underestimate what your expenses will be on the flip…and end up with a challenging situation.”
A hard money loan may also come with a draw schedule, which indicates the times you’ll be able to withdraw parts of the full loan. It’ll be negotiated during the underwriting process and ultimately determined by the lender, based on when remodeling projects are initiated during the plan. There are few circumstances in which you’ll receive the full loan amount upfront. Functionally, a hard money loan is more like a line of credit than a loan.
“If we do fund the rehab ourselves internally, we would do it on a reimbursement draw schedule,” Howard continues. “Say we’re funding a $100,000 rehab: they would pay for the first $25,000 upfront [as a down payment], we would send a third party inspector out there who will inspect the budget from the get go and they validate [with pictures that] the work is being done on budget and then we reimburse them.”
2. You Have Enough Money for a Down Payment
If you take out a hard money loan, you won’t be receiving the full amount upfront. You have to put down a percentage as a down payment. This is common for any loan used to flip houses, as most house flippers are required to put down at least some of their own money. Tayne says the typical down payment is 10%. Some lenders might require a down payment as large as 20%.
3. You Can Justify the High Interest Rate
Interest rates for a hard money loan are higher than if you go with a traditional lender. You’ll be paying interest every month, so don’t take out a higher loan amount or higher rate than you’re able to afford. Take into account the expected post-rehab resale value of the home; you may be able to offset the high interest rate with the expected profit.
Finding Hard Money Lenders
Hard money can be found at specialized hard money lenders. You won’t be able to get a hard money loan from a traditional bank or mortgage broker. Here are some tips for figuring out if a hard money lender is right for you.
Check the Company’s Reputation
Hard money loans are underwritten by smaller, local lenders instead of the established banks you’re probably familiar with. So it’s a good idea to do your due diligence when vetting a lender. “Make sure they have a good reputation. I’m a member of the Arizona Private Lending Association, as well as the American Association of Private Lenders (AAPL). You want them to have accreditations,” Howard says. You should also review the lender’s website, social media, and reviews online to get a sense of how the company communicates and how customers interact with it.
Ask a Lot of Questions
Before signing any loan agreement, you want to know what you’re getting into. Especially with a home rehab — which can often run into unforeseen construction issues. “Always plan on having it go longer than you think it’s going to go,” Samuel says. “Give yourself a buffer. A lot of these loans end up getting extended or continued. Make sure to ask your hard money lender what happens if you don’t come in on timeframe and what the extension process is like.”
Watch Out For Red Flags
If a situation seems sketchy, it probably is. There should be no surprises during any step of the process. Howard says to watch out for anyone charging application fees. No reputable lender charges fees to get into the door, and every fee after that should be disclosed upfront.