How Does Hard Money Lending Differ from Conventional Lending?
Hard money lending is, in some ways, like a conventional loan. You apply for the loan. If you are approved, the loan is funded. You repay the loan, with interest, over a predetermined term.
However, hard money lending differs from conventional bank loans in the details. Specifically, the application for hard money loans, the loan terms, the use of the loan, and the repayment of the loan differ in substantive ways from conventional loans.
Application for Hard Money Lending Compared to Conventional Lending
The application process for hard money loans generally involves less documentation than a conventional loan. Moreover, the applications for hard money loans and conventional bank loans require different documentation.
Debt to Income (DTI) Ratio
A bank is primarily concerned about your creditworthiness in deciding whether to approve conventional bank loans. The question banks ask is whether you have enough income to be able to repay the loan. This is the reason that banks require proof of employment, income verification, and a credit report with your loan application.
The banks use this information to determine your DTI ratio. DTI is calculated by dividing your monthly debt payments by your monthly gross income. Taking a simple example, if your monthly car payment and monthly credit card bill total $1,000 and your monthly gross income is $4,000, your DTI would be 25%.
For a bank to consider you for a conventional mortgage, generally it needs to see a DTI of less than 45%. Moreover, the average credit score to obtain a mortgage in the U.S. is about 685.
Loan to Value (LTV) Ratio
Hard money lenders focus primarily on the soundness of the investment in deciding whether to approve hard money loans. The question hard money lenders ask is whether the value of your investment asset can cover the loan. This is the reason that hard money lenders will want to see a property appraisal with your loan application.
Your asset’s LTV ratio is calculated by dividing your requested loan amount by the after-repair value (ARV) of your asset. In other words, if your project involves a fix-and-flip, the ARV is the appraised value after the “fix.” If your project is a straight flip, the ARV is just the appraised value. For example, if you need a loan of $60,000 to buy an investment house and the ARV is $100,000, the LTV ratio is 60%.
Most hard money lenders prefer an ARV less than 70%, although the exact cutoff will vary. Stated differently, hard money lenders need a cushion of at least 30% in case you default, and the asset needs to be sold to repay your loan. Moreover, a 70% LTV ratio ensures that you have a stake in the success of the project and will have a disincentive to simply walk away from the hard money loan.
Speed of Approval and Funding
Another result of less documentation and fewer data points to consider in approving a loan is that hard money loans can often be approved quicker than conventional bank loans. On average, banks take around 30 days to approve a mortgage application. This is the reason that mortgage pre-approval was created. Most sellers will not wait 30 days for a buyer to receive loan approval.
Once the bank approves the mortgage, it often takes an additional three business days to fund the loan. For example, if an offer is accepted on Friday, closing would not be scheduled until Wednesday or Thursday.
Hard money loans, on the other hand, consider fewer data points in approving loan applications. Moreover, hard money lenders know that time is of the essence for real estate investors who have found a good investment property. While times vary, some hard money lenders can approve and fund a hard money loan within seven calendar days.
Comparison of Loan Terms for Hard Money Lending and Conventional Lending
Loan terms will vary depending on the hard money lender, but they are intended to be repaid over the time span of months rather than 30 years like a conventional mortgage. This difference in loan terms is due to the different purposes of the loans.
Mortgages are for Owner-Occupied Residences
Mortgages are structured based on the assumption that the property is a primary or secondary residence that will be owner-occupied for the long term. As a result, mortgages are often repaid over 15, 20, or 30 years. This keeps payments low but also results in a loan in which the first decade or so of loan payments goes largely to interest.
Hard Money Loans are for Investment Properties
Hard money loans are intended for investment properties that will be sold or used to generate rental revenue. As a result, hard money loans are often repaid over a span of six months to two years. The structure is intended to give you the time to monetize the asset, then clear the debt so you can move on to acquire the next investment asset.
In fact, hard money lenders often specifically exclude borrowers from using hard money loans to purchase owner-occupied residences. This is because mortgage regulations resulting from the Dodd-Frank Act limit the flexibility of lenders to approve mortgage applications. These regulations would handcuff hard money lenders’ ability to move quickly and take on the risk of financing investment properties.
How the Differences between Hard Money Lending and Conventional Lending Influence Your Decision
Hard money loans are a business product. They are not for ordinary home buyers who would be much better suited for conventional mortgages. Rather, hard money loans are intended to finance investment property that can be purchased, fixed if necessary, and returned to the market within a span of months. As such, they facilitate serious real estate investors who have the time, resources, and energy to turn around real estate investments quickly.
To aid in that purpose, hard money loans likewise turn around quickly. Loan applications can be reviewed, approved, and funded in a matter of days to avoid delaying a borrower’s real estate investing.
This is merely an overview of the differences between hard money loans and bank loans. Contact Longhorn Investments to discuss other benefits hard money lending provides compared to conventional lending.