For many people investing in real estate can be exhilarating. First, however, you have to think of fantastic marketing ideas to attract new tenants, evaluate them in a thorough screening process, and do your best to keep high-quality renters happy.
However, before dealing with the many challenges of being a landlord, you must cross the first hurdle. For many investors, that means purchasing a rental property. Thus, completing this step might be tedious if your credit score is low or you struggle with getting a loan from a traditional lender.
If you’re in that scenario, this guide for new investors is precisely what you need. This article answers the question, ‘how do hard money loans work?’ At the end of this article, you’ll discover an alternative to buying your first rental property and know if it’s the right path for you. Let’s get started:
What are Hard Money Loans
Before getting into the nitty gritty of how hard money loans work, we must understand what they are. A hard money loan is one in which a lender provides you with sufficient credit for a valuable piece of property as collateral. In other words, it is a secure loan when the borrower agrees to give up the rights to their property if they default on their repayment. This collateral is often in the form of a car or a house.
Most banks are unwilling to provide such loans, so investors are more likely to acquire hard money loans from alternative lenders. In addition, since most people seeking this type of mortgage are often in a tight financial state, private companies require collateral to reduce risk.
Whether you intend to flip houses or become a landlord, a hard money loan could work for you. You won’t have to give up whatever you use as collateral if you can put the money to good use and improve your rental business. In addition, if you’d like to mitigate your risk, you could hire a rental property management service to help maximize your investment.
Pros and Cons of Hard Money Loans
- They Have a Fast Turnaround
You should consider a hard money loan if you need quick cash. Unlike traditional lenders that require a thorough screening, private lenders are more concerned about your collateral. Thus, reviewing your financial reports, income statements, and tax forms is less critical. As a result, their approval rates are often faster and easier to get.
- They Have More Flexible Terms
When you appeal to the bank for a loan, you often have to do so on their terms. However, with a private lender, you have more power on the negotiation table. In addition, without a standard underwriting process, borrowers can more easily adjust their loan terms. Hence, if you’re a great negotiator, you could beat down your interest rate or ask for a more extended repayment period.
- They Allocate a Higher Approval Amount
When you get a loan from a bank or another traditional lender, they often allocate the exact amount needed to purchase your house. Thus such arrangements leave you hardly any leftovers for renovations or other projects. But with a hard money loan, the amount you can borrow depends on how much collateral you have.
- There’s the Risk of Losing Your Collateral
One of the most prominent disadvantages of hard money loans is the risk of losing collateral. Unlike unsecured loans, you could suffer more than penalties and extra fines for missing your repayments. If you cannot return the money per the terms of your arrangement, you could lose your car, house, or whatever you used as collateral. Considering most people resort to hard money loans because they’re in a financially challenging situation, you could end up worse off than when you started.
- They Acquire Higher Interest Rates
Another factor that makes hard money loans a risk is the high-interest rates. Despite requiring collateral, private lenders still bear a lot of risk with this type of financing. Even when a borrower defaults and they assume ownership of their property, selling it off comes with taxes that eat into the profit. Besides, most people acquire loans worth several times more than their collateral. Thus, to make a profit, lenders have to charge interest rates that are much higher than their traditional counterparts.
- They Require a Large Down payment.
Besides the higher interest rates, hard money loans require a sizeable down payment. Moreover, as we highlighted in the previous point, private companies that grant these loans have to take on more risk. Thus, they can charge interest rates as high as 25% or more. On the other hand, if you have a credit score of 700 and above, you could get a personal loan at a 15% or lower interest rate.
- They Don’t Provide Long-term Loans
Finally, this option would be ill-suited if you need a long-term loan. Hard money lenders have to bear the significant risk and thus are unwilling to do so for long periods. Most private companies offer borrowers backing for six to twelve months. However, under certain circumstances, you can arrange a loan of up to three years. Still, it’s significantly lower than traditional lending, which offers 5 – 10 years.
A hard money loan can be a quick and easy way to secure a rental property for your business. They have a swifter turnaround; you can negotiate more freely and acquire large amounts of money with a low credit score. For anyone under difficult financial circumstances, it is certainly worth considering. However, remember that it has its drawbacks. These terms often come with a high-interest rate and limited options for long-term payments. Most of all, you also risk losing your collateral if you default.
Thus, it would be in your best interest to find someone that can help you maximize your financial resources. A property management company can expertly help you navigate the rigors of being a landlord and ensure you make better financial decisions.