What You Should Know About a Hard Money Mortgage
A hard money lender, also known as a private money lender, lends to people who cannot get a mortgage from a traditional lender. Hard money loans are structured differently than traditional mortgages and charge significantly higher interest rates and fees so borrowers need to feel comfortable with the extra upfront and ongoing costs. Hard money mortgages are used by people with low credit scores, significant negative credit events or house flippers as these borrowers usually cannot qualify for a traditional mortgage.
Although most hard money lenders allow lower borrower credit scores, they usually apply stricter qualification guidelines in other areas. For example, the maximum loan-to-vale (LTV) ratio for a hard money loan is usually lower than for a regular mortgage which means borrowers are required to make a larger down payment or have more equity in the property. This provides more protection for lenders but also means borrowers have more at stake if they cannot repay the loan.
Similar to a traditional mortgage, hard money lenders must verify that applicants can afford the loan but sometimes the higher interest rate and costs create significant financial challenges for borrowers. Plus, hard money loans may charge extra fees such as prepayment penalties which can make the situation even worse.
In short, a hard money mortgage is usually the financing option of last resort for borrowers. Although hard money loans are a viable, hopefully short-term, financing solution for some borrowers, you should fully understand the higher costs, unique loan structure and any potential penalties before you apply. Below we outline what you should know about a hard money mortgage. We recommend that you review these points to understand if a hard money loan is right for you.
Hard Money Loans Are Expensive
The interest rate on a hard money loan is typically 4.000% to 7.000% higher than the interest rate on a mortgage from a traditional lender such as a bank, mortgage bank, mortgage broker or credit union. Additionally, the lender fees are two-to-three times higher than fees for a mortgage from a traditional lender. Paying a higher mortgage rate and lender fees costs you thousands of dollars so getting a hard money mortgage should not be taken lightly. In a best case scenario, if you absolutely need a hard money loan you can refinance it with a traditional mortgage within a relatively short period of time.
Review How a Hard Money Loan Works
In addition to charging a higher interest rate and closing costs, hard money loans may also impose extra fees including a prepayment penalty if you payoff your loan before a specified period of time. Any late fees may also be higher and the overall loan terms are typically less forgiving as compared to a traditional mortgage. In other words, you do not want to be late or miss a payment on a hard money mortgage. You should review all mortgage documents and loan terms carefully to understand any applicable fees and penalties before finalizing your loan.
Because of the higher costs involved with a hard money loan it is more important that borrowers shop multiple lenders to find the best terms. You know your mortgage rate and fees are going to be significant so you should make every effort to save as much money as possible. Use the FREEandCLEAR Lender Directory to find hard money lenders in your area. The more lenders you compare, the more likely you are to save on your loan.
Look out For Extra Fees and Penalties
In addition to charging a higher interest rate and closing costs, hard money loans may also impose extra fees including a prepayment penalty if you payoff your loan before a specified period of time. Any late fees may also be higher and the overall loan terms are typically less forgiving as compared to a traditional mortgage. In other words, you do not want to be late or miss a payment on a hard money mortgage. You should review all mortgage documents and loan terms carefully to understand any applicable fees and penalties before finalizing your loan.
The Financing is Short Term
A hard money mortgage is typically structured as a short-term loan. Many hard money loans are structured as two-to-three year interest only loans with the mortgage balance due in full at the end of the term. While interest only loans have lower monthly payments -- because you are not paying principal -- the entire loan balance is due at the end of the mortgage. So if you take out a $100,000 interest only mortgage with a two year term, you owe the full $100,000 at the end of the second year because you have not paid down any of the loan.
Borrowers with better credit scores or lower loan-to-value (LTV) ratios may be able to obtain 10/30 or 15/30 amortizing mortgages where the interest rate is fixed for the first ten or fifteen years of the mortgage (and the borrower pays both principal and interest) and the loan balance is due in full after ten or 15 years. In this case because the loan amortizes you have paid down some of the mortgage balance when it is due. You still have a significant principal balance because you are only ten or 15 years into the loan but it is less than your original mortgage amount.
Low Loan-to-Value (LTV) Ratio
Most hard money lenders require a loan-to-value (LTV) ratio below 70% with some lenders requiring an LTV ratio of 50% or less. Most traditional lenders require an LTV of 80% or less (in order to receive their lowest interest rate) and some low down payment programs permit an LTV ratio of 100%. So in comparison, a hard money lender requires a greater down payment or equity contribution from the borrower. This provides more collateral or protection for the hard money lender and means borrowers have more equity in the property, so they could potentially lose more money if they default on the loan. This also means that you qualify for a lower mortgage amount with a hard money loan despite offering the lender greater collateral in the event of foreclosure.
What is the Loan-to-Value (LTV) Ratio for a Mortgage
The Borrower Must Prove Thier Ability to Repay the Loan
Like with a mortgage from a traditional lender, borrowers must demonstrate that they can afford the monthly payment on a hard money loan as well as total monthly housing expense which includes property tax and homeowners insurance plus HOA fees, if applicable. The borrower must also demonstrate the ability to repay the loan. Hard money mortgage lenders review applicants' income, assets and collateral to verify that they can afford the mortgage and pay back the loan even with the higher interest rate and closing costs.
Get Approved with a Low Credit Score or Significant Credit Issue
One of the main reasons to use a hard money lender is because you have a low credit score (below 500) or significant recent credit issue such as a bankruptcy, short sale, default or foreclosure and cannot qualify for a mortgage with a traditional lender. For example, after your bankruptcy is discharged you may be able to afford a mortgage but a traditional lender imposes a waiting period of several years before you can apply for a loan. A hard money lender may approve you for a mortgage the day after your bankruptcy which enables you to buy a home sooner. It is important to highlight that just like with a traditional mortgage, the lower your credit score, the higher your interest rate with a hard money loan.
Review the Credit Score Required for a Mortgage
If you currently have a low credit score but you would like to buy a house you can get a mortgage from a hard money lender and then refinance the loan with a regular mortgage at a lower interest in one-to-two years when your score improves.
Great Financing Option for House Flippers
Another common use of a hard money mortgage is to finance house flipping when an investor purchases, renovates and then quickly sells a property. Because traditional lenders many not lend against the post-renovation value of the property, house flippers use hard money loans, also known as fix & flip loans, to obtain short-term bridge financing for the property rehabilitation. The house flipper pays off the hard money bridge loan after the property is remodeled and sold, hopefully within a matter of months. Also, because most hard money bridge loans are structured as interest only loans, this reduces the expense and improves the cash flow for the house flipper during the property renovation period.
Understand How a Bridge Loan Works
Sources
“What is a subprime mortgage?” CFPB. Consumer Financial Protection Bureau, February 24 2017. Web.