advantages and disadvantages of hard money loans in California

Advantages and Disadvantages of Hard Money Loans in California

Financing a new real estate project can go two ways; traditional lending or hard money loans. The latter is a tool that many real estate professionals in California utilize to finance a property. Experienced investors who have been taking advantage of these types of loans know all about the advantages and disadvantages of hard money loans. However, for those who are new to this alternative type of lending, the issues aren’t as clear. Read on to learn everything you need to know about hard money loans, including the most important advantages and disadvantages.

Hard Money Loans have a Quick Turn Around

Compared to a traditional loan, hard money loans are approved and financed much faster. The process for a hard money loan includes the lender looking at a few things, including the property in question, how much the borrower can put down, the borrower’s equity in the property, the exit strategy for the property, and how much cash the borrower has in reserve to make their loan payments. Hard money lenders want to loan money so as long as the borrower meets these requirements, the lender will quickly approve the loan. In fact, a real estate investor in California can expect to have a hard money loan approved and funded within three to five days as opposed to the 30 or more days it takes to approve and fund a traditional loan. In addition, borrowers who have first sought a traditional loan only to have it not approved after sitting in escrow often turn to hard money lenders to get the funds they need for their real estate investment.

Hard Money Loans Have Fewer Requirements Compared to Traditional Loans

Banks and credit unions in California have lengthy requirements for a loan and these requirements often change from year to year. In fact, many borrowers are unable to meet these demands, which include:
• No recent foreclosures
• No recent short sales
• No recent bankruptcies
• Bad credit
• Four current mortgages or more regardless of credit rating
• Self employed borrowers or those with a lack of steady employment for at least two years are unable to get a bank approved loan

On the other hand, hard money lenders have fewer requirements. As stated earlier, these include:
• Satisfactory equity in the property
• Or a substantial down payment (25% to 30%)
• Enough available cash on hand to make loan payments
• A clear and reasonable exit strategy
• Experience in real estate investment
• Credit score and employment history is a non-issue

Hard money loans are easier to get versus traditional loans. In addition, a borrower can opt for a short term hard money loan to purchase a property they intend to live in, and once they meet the requirements of traditional lenders, they can always refinance the loan with a bank or credit union for a longer loan at a lower interest rate.

Projects that Can’t be Financed Elsewhere Qualify for Hard Money Loans

There are certain real estate projects that traditional lenders have no interest in financing. These include flipping properties in California for a profit. Borrowers who intend to flip a property need a short-term loan, usually up to 12 months, to make the necessary repairs and renovations before quickly selling the property for a profit. For banks and credit unions, this type of loan does not fit into their business model. Instead, they prefer to offer lengthy loans of 15 years or more at a lower interest rate. Also, traditional lenders find these projects too risky. This is because the property in question often has issues that prevent them from qualifying for a conventional loan, such as problems with the property’s structure, plumbing, electrical work, and other factors that make the property’s value quite low upon purchase. Overall, banks are not in the business of risk. They prefer sound investments that fit into their strict lending requirements and offer little to no risk, even if the borrower defaults on the loan. If this were to happen, the bank then has the property for collateral and can resell it to another investor without losing any or very little on the loan they sold.

Disadvantages of Hard Money Loans

So far we’ve touched upon the advantages of hard money loans. These include the fact that they are easier to obtain and take much less time to secure. However, there are some disadvantages of hard money loans that borrowers in California also need to take into consideration before taking this lending route.

Higher Interest Rates

Due to the increased risk associated with hard money loans and the convenience they offer to the borrower, interest rates are always higher when compared to conventional loans. Typically, hard money loan interest rates fall between 9% to 15%. In addition to a higher interest rate, hard money lenders in California also charge a loan origination fee, referred to as points, which is a percentage of the entire loan amount. Borrowers can expect to pay from two to four points on a hard money loan, although some lenders may charge more depending on the specific factors of an individual loan.
For real estate investors in California where there are more hard money lenders than in many other areas of the United States, this competition brings rates and points down. For this reason, it’s important for borrowers to compare the rates and points of many hard money lenders in their area before making a commitment.

In addition, there are hard money lenders who will provide loans on second mortgages. In this case, they tend to charge an even higher interest rate than they would on a first mortgage. The additional interest rate for a second mortgage will be about 2% to 3% higher. The higher interest rate on a second mortgage is due to increased risk. If the borrower defaults on the first mortgage, the lender for that mortgage can foreclose on the property, making the second mortgage obsolete.

Short-Term Loans Only

Hard money lenders do not give out long-term loans. Typically, a hard money loan is for one to two years. In some cases, they can be for three to five years but this is the absolute limit for hard money loans. Lenders prefer giving shorter loans because the longer the loan, the higher the risk for the lender due to the uncertainty of future interest rates in the lending industry. For example, if interest rates drop, the borrower then has the option to refinance the loan for a lower interest rate, meaning the lender loses out on the profit they would accumulate through a higher interest rate. On the other hand, if interest rates climb, then the lender needs to wait for the term of the loan to end before they can jump in and charge a higher interest rate. All of these interest rate fluctuations represent a risk for the lender. Therefore, they prefer to give out the shortest loan possible to minimize risk. Conventional lenders deal with interest rate uncertainty by offering lower interest rates for shorter terms and higher interest rates for longer term loans. When a borrower takes out a 15-year loan they can expect to pay a lower interest rate, whereas a longer loan term of 30 years will see a higher interest rate charged.

Larger Down Payment

Traditional lenders require a smaller or no down payment to secure a property loan. However, hard money lenders require a down payment or substantial equity in the property to secure a loan. For this reason, hard money lenders are able to be more flexible with their requirements for issuing a loan because the equity in the property is seen as a hard asset for the security of loan. This is where the term “hard money loan” comes from. On the other hand, banks and credit unions focus more on a borrower’s credit score, stable employment history, and other requirements. In order to secure a hard money loan, however, the borrower needs to have a down payment.

If the borrower has neither a large down payment or substantial equity in the property, they cannot secure a hard money loan since the lender would be taking on the entire risk of the loan. To illustrate further, consider this example. A borrower puts down 5% on a loan and secures funding for the remaining 95%. This results in a 10% drop in the property value and a 5% loss. Therefore, if the borrower decides not to continue with the project due to a decline in property value in the foreseeable future and defaults on the loan, the hard money lender is left with a loan that can’t be paid back. On the other hand, if the borrower puts down 30% on the loan and there is a 10% decline in the property value, the borrower still has the motivation to continue with the project to protect the equity they invested in the property.

Compared to residential hard money loans, commercial hard money loans typically require an even larger down payment. This can be up to 40%. A larger down payment is required because it is more difficult to sell commercial property than residential property, thus putting more risk on the hard money lender. Overall, there are far more potential buyers for residential properties than there are for commercial properties and the hard money lender seeks to avoid as much risk as possible when giving out a hard money loan. Additionally, if a borrower defaults on a hard money commercial loan and the lender takes back the property to sell, they may have to significantly reduce the sale price of the property to recoup their investment through a quick sale. It is also more difficult to place a correct value on a commercial property as there are fewer data points to consider when compared to a residential property.

By taking into consideration all the advantages and disadvantages of hard money loans, it should be easy for real estate investors in California to weigh the checks and balances of these loans and decide whether to proceed with a hard money loan or a traditional loan for their real estate project. If a borrower intends to flip a property for profit, then a hard money loan is the best route to take, as it provides a quick and easy way to get the funds needed to repair the property and sell it in the shortest amount of time possible. On the other hand, hard money loans are also a viable option for those borrowers who do not meet the strict requirements of traditional lending institutions. If a borrower wishes to purchase real estate as a primary residence but can not do so with a conventional loan, a hard money loan is an option to take until the borrower can meet the traditional loan requirements and then refinance at a lower interest rate for a longer loan term.

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