(312) 270-1618 What are the pros and cons of using a hard money lender to finance a real estate investment project?
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Question: What are the pros and cons of using a hard money lender to finance a real estate investment project?
Overview
Pros
Cons
- More expensive capital
- Less scrutiny
- Not well-suited for longer term financing
- Higher leverage (again)
If you are looking to finance your next fix & flip, or other similar real estate investment property, you have probably heard of using a hard money lender as an option.
Consequently, you might be wondering why use a hard money lender? What are the benefits and drawbacks to using this type of lender as opposed to a bank, or more conventional financing? This post will aim to articulate the various pros and cons of using a hard money lender to finance your next real estate investment project.
Hard money lenders are a frequent option for investors in specific types of situations, namely;
- Investors who are looking for fast capital.
- Investors who don’t qualify for conventional financing.
- Investors who are looking for quick construction draws.
- Investors who are looking to maximize leverage.
The above list, naturally, ties in quite closely with the pros of using a hard money lender to finance your real estate project. For certain types of real estate investors in specific situations, using a hard money lender can make a lot of sense. For others, such as those whose primary focus is on minimizing their cost of capital, hard money lenders might not make much sense at all.
Pro 1: Fast capital
Let’s take a look at the first pro of using a hard money lender, fast capital. Hard money lenders are able to offer fast capital because they generally require less documentation than banks, and they have less stringent underwriting guidelines than banks do. Hard money lenders are often set up with the express purpose of funding real estate investors, and as such, they recognize the “need for speed” that most real estate investors have. Because of the minimal documentation required, it’s common for hard money lenders to refer to their lending programs as “low-doc”, or even “no-doc” in some instances. Some hard money lenders don’t even require an appraisal in order to fund! (These lenders are the exception and not the rule).
The typical “time-to-fund”, or time from when you submit your preliminary application to when your hard money loan funds, is typically around a couple of weeks, including the appraisal (often the most lengthy part of obtaining a hard money loan). For comparison’s sake, many banks will take months to fund.
Pro 2: Fast construction draws
As mentioned, many hard money lenders are set up for the express purpose of financing real estate investors, whereas banks will often have a division that is focused on real estate lending. This contrast can result in a significant operational difference; hard money lenders often have quick, user-friendly construction draw processes, whereas many banks have more tedious draw processes. Note that this is not the case for all banks, but since banks are not solely focused on financing real estate investors, they, quite naturally, are not as focused on the construction draw process as hard money lenders are.
The construction draw process is fairly straightforward. Generally speaking, you contact the lender and ask for an inspection. An inspector will come out to your property and evaluate the work that has been done. The inspector will then send a report back to the lender, and the lender can then reimburse you for the work that has been completed. If the lender is not focused on construction draws, sometimes this process can get delayed, which can lead to missed construction timelines and late payments.
Pro 3: More flexible borrower standards
Hard money lenders are typically more lax on their borrower standards than traditional lenders. One of the reasons for this is that hard money loans are typically shorter in term-length (often 9-36 months), and so traditional financial metrics such as FICO score are less important. The factors that affect a borrower’s ability to repay in the short-term are naturally going to be different from the factors that affect a borrower’s ability to repay in the long-term.
In the short-term, a hard money lender might be more focused on the following data points;
- Your liquidity
- Your comparable deal experience
- The scope of the project and their LTV (often the primary form of risk measurement for a hard money lender)
On the other hand, a bank that is evaluating your loan might be focused on things like;
- Your global cash flow (cash flow from your job and other investment properties)
- Your personal financial statement
- Your credit history
Some hard money lenders don’t even have a FICO score minimum! Borrowers who don’t qualify for traditional financing, e.g. financing from a bank, can many times find a hard money lender who is willing to lend them money based on the aforementioned criteria.
Pro 4: Higher leverage
Hard money lenders will often offer higher leverage than banks. To use a simple example, let’s use the below numbers for an investment property:
| Purchase price: | $200,000 |
| Rehab amount: | $100,000 |
| After-repair value: | $400,000 |
A hard money lender may be willing to lend to you at 85% LTC (loan-to-cost).
This translates into a $255,000 loan amount (.85 * ($200,000 + $100,000)).
A bank, assuming that they are willing to finance a project with that significant of a rehab budget, may be willing to lend to you at 70% LTC.
This translates into a $210,000 loan amount (.70 * ($200,000 + $100,000)).
Some real estate investors seek to maximize leverage in order to enhance their cash-on-cash returns and grow their wealth as fast as possible in spite of the increased risk.
Now that we’ve provided an overview of the benefits of getting a hard money loan, let’s take a look at some of the drawbacks, or cons, of getting a hard money loan.
Con 1: More expensive capital
Hard money lenders are almost always quite a bit more expensive than traditional sources of financing. The capital that hard money lenders provide is riskier, and as such, commands a premium.
Cost is a consideration for every real estate investor, and for real estate investors that prioritize cost of capital minimization, hard money lenders might be out of the question.
On a typical bridge loan provided by a hard money lender, you can expect to pay somewhere between the high single digits and low double digits in interest rate. Meanwhile, banks often end up charging in the low to mid single digits for a similar product. This can result in a drastic difference in the overall cost capital, particularly if the money is borrowed for an extended period of time.
Con 2: Less scrutiny
Hard money lenders are significantly less regulated than banks, and as such, their practices are not nearly as scrutinized. Consequently, if you choose to work with a hard money lender, it’s extremely important to work with a lender that is trustworthy and has a sound reputation.
Banks and hard money lenders broadcast their reputations through satisfied customers. If you are just diving into real estate investing, are thinking about using hard money for the first time, or are thinking about switching lenders, it’s worth it to speak with some investors who have used that lender’s services.
Reputable lenders should have at least some satisfied customers who can vouch for their performance.
Con 3: Not well-suited for longer term financing
Because they are relatively expensive, hard money loans are often not suitable for longer-term financing. Paying 12% or 13% to borrow money for less than a year can sometimes be justified. If that cost of capital is dragged out over 5+ years, that picture can look quite dreary.
The exit from a hard money loan is often to refinance; this means replacing the hard money loan with another loan, often a bank loan.
With that said, there are hard money lenders who offer long-term products that possess reasonable interest rates, even for longer periods of time. Regardless, hard money is typically focused on short term lengths (think 36 months or less), and was not designed to be a long-term financing solution.
Con 4: Higher leverage (again)
Higher leverage was mentioned above as a pro, and it is also listed here as a con.
While some investors seek to maximize their leverage, or the amount of debt they take on for a project or set of projects, other investors seek optimal leverage. This optimal leverage may not be the maximum that a lender can offer them, but rather a predetermined % that the investor believes will minimize their risk whilst allowing them to achieve a satisfactory return.
More leverage is not always better, and some real estate investors learn this the hard way.
Conclusion
There are both pros and cons to getting a hard money loan. If you are looking for faster capital, more flexible borrower standards, faster draws, maximum leverage, and are fine with paying a premium to do so, then a hard money loan might be a great solution for you.
On the other hand, if minimizing your cost of capital and holding onto a property for the long-term is a priority, then you may want to look at more traditional routes of financing.
Do you have any upcoming fix and flip projects you need financing for?
If so, you can fill out our preliminary application at this link to get started today.