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Hard money loans are a form of collateral-backed loan that real estate assets secure. Those who have the necessary collateral can obtain them, even if they don’t have good credit. What makes it strange is that the lender doesn’t rely on you to pay the loan back. That’s why your credit doesn’t play a significant role in the process.

Your hard money lender will base your loan primarily on how much your collateral is worth. For example, if you default on your loan, they will take possession of the property you used for security. Let’s find out more about what hard money loans are and how they work.

Hard money loans and how they work

Most loans often need proof that you can repay them. Lenders usually check your income and your credit score to see if you have the capacity to repay the loan. If you have a history of borrowing money and repaying them on time, your chances of getting your loan approved are higher.

The process for traditional loans is slow, regardless of your credit score and income. It means that even if you have good credit and lots of income, it will take time to receive the money. And if you have negative items in your reports, then it’ll take even longer.

With hard money loans, things are different. They are less concerned about your capacity to pay the loan. Instead, they look at the collateral you use to secure the loan. If things don’t go smoothly, the lender will get their money back by possessing the collateral and selling it. Ultimately, the value of your collateral is more important than your capacity to pay.

Hard money loans typically last from 1 to 5 years. It won’t be a good idea to keep them longer. After all, interest rates for hard money are higher compared to traditional loans.

Why should you be careful of hard money loans?

The flexibility, low requirements, and speed of hard money loans guarantee that the real estate investors are getting what they need to complete the project. And while this is the case, there are also reasons why you need to be careful of them.

A down payment or equity is important

For some, down payments or equity are necessary requirements that prevent them from getting a loan. Hard money lenders can look past different shortcomings and issues. That’s because they need enough equity in the property to serve as security for the loan. After all, hard money uses hard assets in securing the loan. Banks only focus on FICO scores, a clean credit report, and income. With hard money business loans, there is no loan if there is no hard money.

If you don’t have enough down payment or equity, then the hard money lender is taking all the risks. And if you only put down a 5% down payment and get a loan for the remaining 95%. It means that a 10% drop in the property value would put you at a 5% loss on the property. If the property value doesn’t increase in value in the future, or if the decline would continue, you’ll only get a little incentive to complete the project. You might abandon it later.

If you put in a 30% down payment and not 5%, then you’ll get a 10% decline in the property value. It will still give many incentives to stick with your project and property to safeguard the equity.

In commercial hard money loans, the down payment is usually at around 40%. And when it’s larger, it becomes harder to sell a commercial property. That’s because there are fewer buyers for commercial properties than residential properties. If you default on a commercial collateral-backed loan, and the hard money lenders take the property back, it will result in a discounted sale price.

Higher interest rates

Interest rates for hard money loans are always higher than traditional loans because of an increased risk for lenders. It’s also because of how easy it is to access the capital. Generally, interest rates go up from 9% to 15%, depending on several factors. Also, hard money lenders charge a loan origination fee, which is a percentage of your collateral-backed loan amount.

Just like in any other business, competition can bring prices down. You can find many hard money lenders in large metropolitan areas. You could benefit simply by checking the rates at a few lenders before investing in a hard money lender.

However, some hard money lenders don’t offer trust deeds on properties. Those who do, charge higher rates on 1sts and 2nds. Interest rates on 2nds are usually higher than for 1sts, about 2% to 3% higher. This increase means there’s a higher risk for the lender being in the second position. If you go into default, the first lien holder can wipe out the second lien holder’s interest in the property.

Hard money loans are for short-term use

As you already know, most hard money business loans are only good for up to 5 years. The longer the term is, the riskier it is for the lender. If the interest rates drop, you’ll have the option to refinance the loan to the lower current rates. If the interest rates increase, you can keep their lower interest rate loan. Doing so will force the lender to wait until the collateral-backed loan is due.

And while waiting, their investment in the trust deed will yield less than what they could get for a new trust deed investment. It means that the lender is at risk, which encourages them to offer short-term loans only.

Banks usually offer higher interest rates for longer terms and lower interest rates for shorter loan terms to deal with the interest rate uncertainty. For instance, a 20-year fully amortized loan will have a much higher interest rate than an 8-year fully amortized loan.

Hard money loans aren’t always a bad thing. They do benefit people who need quick loans. But just like any significant decision you make, you should do your due diligence before signing up for a collateral-backed loan deal. If you are unsure, your best bet is to get in touch with someone familiar with hard money contracts.

The post Three Big Reasons Why You Should Be Careful of Hard Money Loans appeared first on The Startup Magazine.