You’ve heard of these terms…hard money loans and conventional loans.
Especially if you’ve been around real estate for any length of time! Being a hard money lender myself, I know I get this questions a lot when people ask about what I do for a living.
What are the differences between hard money loans and conventional loans? which one should I choose? So here’s my complete guide.
We’ll talk about the definition of each, how they’re used, and when & why to use each one! When we’re done here, you won’t have any questions left about hard money loans vs conventional loans!
What is a Conventional Loan?
Conventional loans are the ones that you’re constantly hearing about, seeing ads for, and reading those billboards with the digital interest rates that change every morning when you drive past! When people are talking about buying and selling a home, this is typically the loan they’re talking about. They’re for residential loans, usually are for 30 years, and charge you a low interest rate. We’ll get into all the nitty-gritty details as we go.
What is a Hard Money Loan?
Hard money loans are designed specifically for real estate investors, and especially for fix & flips. You can find other uses for them (like a BRRR loan, which we’ll cover later), but because they’re short term loans with high interest rates, they’re mostly for investors who are trying to get in and out of a deal in a matter of months, not years. You can also use it for townhomes, mobile homes, duplexes, commercial properties, and more. Any sort of short-term deal lends itself well to a hard money loan.
Conventional Loan Requirements
Most banks require a much more rigorous process for determining your fitness for taking on the loan! They’re going to want to know your credit score, your debt-to-income ratio, how long you’ve had your job, how steady your income is, and more. In other words, they’re lending the money based on you.
It makes sense if you think about it. They’re lending you this money with the idea that you’ll be paying it back over the next 30 years, with no other income other than your job. They need to be sure that you’ve had a steady work history and have made enough money consistently over the past two years in order to sufficiently pay off your loan!
In reality, your debt-to-income ratio is more important than your actual income, because it tells them more about how much money you’ll really have every month to pay off a mortgage. Someone who makes $50k a year but with no debts can pay their mortgage easier than someone who makes $80k but has two car payments, credit card debt, and student loans.
Then things get a bit more complicated after that depending on the type of loan you want to get! For example, there’s the FHA loan, a USDA loan, or a standard 20% down loan.
Hard Money Loan Requirements
A hard money lender differs from conventional loans in one big way: they loan money based on the value of the asset. In other words, they care about how much profit is in your deal. It’s pretty standard that a hard money lender will fund up to a certain percent of the after repair value of the property you’re looking to flip. 70% is a pretty standard number.
So, let’s say that you’ve found a property that the seller will give you for $100,000.
You do the research and think that after you rehab the house that it will sell for $200,000. That’s called the after repair value. At the 70% number, the hard money lender will loan you $140,000!
Remember that you’re original price was $100k, and then you’ll have to add in rehab costs, origination, title fees, and other loan costs. You’d probably have to bring some money to the table for that deal to work.
This is where hard money lenders start to differ from each other (more than conventional lenders differ from each other).
Each hard money lender will have their own requirements for what they want in a borrower. Some will require a minimum credit score, at least 1-2 flips under their belt, and to bring a certain percentage of the costs to the table. However, those requirements are usually less stringent than a conventional lender will require.
There are hard money lenders that don’t require any of those qualifications, and there are others that require more. It’s up to them. With The Investor's Edge, we don’t require any prior experience, no minimum credit score, and if you find a deal good enough, you don’t have to bring any money to the table.
It’s up to the discretion of the lender. With The Investor's Edge, for example, we have lots of training, tons of hands-on help, and we’re conservative in our values, so I’m more comfortable lending more. I’ve seen over the years that my borrowers tend to do very well and experience little risk.
Other lenders are more worried about churning through lots of loans and find that their business model works better when they require stricter borrower prerequisites.
Conventional Loan Closing Times
Like I mentioned before, a conventional lender is going to want to know as much about you as possible! This requires tons of paperwork, tons of research, and tons of signing papers. I recently had an employee of mine qualify for a USDA loan, which is an extremely strict loan that requires even more paperwork. His direct boss ended up writing 5 different letters to the bank to try to verify his income! It’s a nightmare of red tape.
For that reason, closing times tend to be more in the 2-month range. They can do it faster if necessary, and if the borrower brings the paperwork quickly, but even so it will still take several weeks on average.
Hard Money Loan Closing Times
On the other hand, hard money lenders pride themselves on fast closing times! It’s essential to their business. As a fix & flipper, you’ll be going out and placing lots of offers on properties. Even if you’re just looking for a single property to flip, you’re looking at likely 25-50 offers placed before you get a deal! And when one of these gets accepted, you need to come up with the money fast or you’ll have to back out before closing.
Other investors who have the cash on hand or a faster hard money lender will have the advantage every time. Add to it that there are fewer government regulations and requirements for a hard money loan and you can close pretty fast…often in 1-2 weeks! Many times the thing that holds these loans from being funded is a borrower who doesn’t have all the paperwork ready to go.
Conventional Loan Origination & Points
On a conventional loan, you can expect an origination fee of around 1-3%. If you’re looking at a $300,000 house, that’s $3k – $9k.
Often you’ll have the option to buy mortgage points. Usually a point costs you 1% of the total loan and lowers your interest rate by .25 percentage points. So with this example, you could pay $3,000 and have your interest rate drop from 4% to 3.75%. In my experience, this isn’t usually worth it. You’ll save $20 a month but be out $3,000. Plus if you move within a few years, you don’t get to take full advantage of having a lower interest rate.
Hard Money Loan Origination & Points
With hard money loans, you’ll pay a higher loan origination, typically about 1-3 points higher than with a conventional loan. That will put you at 2-6%, depending on the hard money lender. On a $200k property, that amounts to $4k to $12k. While this is more expensive, you’re also expecting a profit at the end of it, and with some hard money lenders, you can pay the points out of that profit.
With a hard money loan there isn’t really an option to pay down the points. Paying down the points on a conventional loan only makes sense over a long period of time, and you won’t be in a hard money loan long enough for paying down points to make a difference. Furthermore, fix & flippers usually want to pay as little up front so as to reduce their risk with these loans. Keeping more money in your pocket also means you have more funds free to make other deals. All in all, paying down points isn’t really part of a hard money loan.
Conventional Loan Interest Rates
With a conventional loan, you’re going to pay a much lower rate because the bank is counting on you having your loan for a long period of time. That’s why over the past few years loan rates have typically been in the 3% to 5% range.
Of course, the average person moves about every 7 years—and some people much more often than that. So how do they make money on such a low interest rate if you’re going to get out of the loan early?
A couple of ways:
- Your down payment (we’ll cover this next)
- Amortization schedule – With your mortgage comes an amortization schedule, which is just showing you a break down of your monthly payment for the next 30 years. They can be a little depressing to look at, but you can also get a good sense where your money is going. At first, you’ll have a huge chunk of your payment going towards the interest rate. This way if you pay off your loan in the first few years, the bank has still collected a good amount of interest money
- Capital gains taxes keep you in the property longer – If you live in the property for less than 2 years, you’ll have to pay taxes on any profit you make on selling your house. This incentivizes people to at least stay a bit longer in their residence.
Hard Money Loan Interest Rates
Hard money interest rates are usually double digits, perhaps in the 10%-15% range. But due to the short-term nature of the loans, often they’re calculated by month. So let’s say your interest rate is 12%. That means you’ll pay 1% interest on your loan balance per month.
So if you’re flipping a $200,000 property, that comes out to $24,000 per year in taxes. That sounds like a lot…but let’s talk about it.
First of all, you’re often in a deal for six months (our borrowers are typically paying off their loans in less than five). In that case, your total interest payment is now down to $12,000.
Also, many hard money lenders don’t require you to pay any interest payments for a while, with the logic being that hopefully you sold your completed flip and now you can pay the interest out of your profits instead of trying to find the money along the way. With us, we don’t require any interest payments for the first five months. A cash-strapped investor has a better chance to flip the house, they don’t have to stress over making payments, and it incentivizes them to finish faster (not to mention just having a lower overall interest bill for finishing early).
Now, $12,000 may still sound like a lot. That’s something that newer investors focus on. It’s not about how much you have to pay, it’s about how much you’re going to make—especially if you don’t have to make payments along the way. When calculating your profit numbers in the beginning, you’ll include your interest bill. If you can see that you’ll make $33,000—which is what our average borrower who completes a deal makes—all of a sudden, that $12,000 doesn’t seem like a bad thing.
But why are hard money interest rates so high?
A couple of reasons:
- Short-term loan – Because these loans are usually around six months, charging 4% interest just wouldn’t be worth it to a hard money lender. Over 6 months on a $200,000 loan, the lender would profit just $8,000 but had to risk $200,000 of their money.
- Greater risk – It’s obviously tied into the one above, but because we’re talking about investing, there’s always risk. There’s always a chance that the market could crash and the resell value of the home tanks. Perhaps there were unique circumstances that led to misevaluating the value of the house from the start. Plus, some hard money lenders (like us), offer to cover up to 100% of the total costs of the loan. That’s a lot of risk for little reward if the interest rates are super low.
Conventional Loan Down Payments
Alright, the down payment! What everyone wants to know…how much do I have to bring to the table to purchase this home!
Of course, there are a ton of options.
A standard down payment is considered to be 20%. That’s obviously a lot of money for most people. With that much down, you’ll be able to secure a nice interest rate and you won’t have to pay any private mortgage insurance (PMI). Your monthly payment will be significantly lower than someone who puts down less money and has to cover PMI along the way.
However, most people don’t put 20% down. Even on just a $200,000 home, that’s $40,000! The vast majority of people do not have that kind of cash…and usually only do if they’re very well off or if they just sold their previous home and made a chunk of change on it. The average down payment on a house is just 6% of the home value.
The most common option is to do an FHA loan. These are government backed loans that provide a bit more security for the lender and allows them to accept a smaller down payment. FHA loans start at 3.5%, but you can pay more if you’d like to have a lower payment. At 5% and 10%, you can pay a lower PMI. Another cost of FHA loans are that you have to pay a flat 1.75% of the loan amount, which is either due at closing or financed into the loan itself.
There are other loan programs out there that can be extremely favorable, such as a USDA loan (which means you can put ZERO down on the house!) or even some local programs that offer cash grants.
Hard Money Loan Down Payments
Down payments for these loans vary widely. Some companies will require 10% down on just the purchase cost of the house, while others will require 10% of both the purchase and the rehab. Others will have you pay loan costs up front, along the way, or at the end.
With The Investor's Edge, we’ll actually require $0 at closing for the very best deals. Even ones that don’t qualify often only have to bring $5,000 or less to the table.
The qualification for us (and some other hard money lenders) is that we’ll fund up to 70% of the after repair value (ARV) of the deal. If you can fit the purchase price, rehab costs, and loan costs into that 70%, you can do your deal without even opening up your wallet. Some hard money lenders will do similar down payments like this, but I’ve never seen another one do a true 100% financed loan.
Conventional Loan Payoff
Typically you’re getting a 30-year loan for your primary residence with a conventional loan. There aren’t usually any penalties for paying it off early, but you’re also not typically incentivized to pay off a loan early, especially when interest rates are under 5%.
Sounds strange? I know most people will tell you that paying off your house is the holy grail…and there certainly are benefits, but they’re more intangible benefits, such as “wow, this is nice to completely own this property” or “I don’t have that debt any more!”
But let’s do the math…
That money that you owe on the property costs you 5% to keep, right? That means that instead of using your chunk of money to pay off the house, you invest it and all you need to do is have a greater than 5% return on the money in order to come out on top! And almost any way you’re going to invest it is going to produce returns higher than that. If you just go to any robo-advisor, like Betterment or Wealthfront, they’ll likely return you closer to 8% or higher.
If you use that money to invest in real estate, well the returns can be much higher.
Also consider how far along you are in paying off your mortgage. That 5% interest rate is figured out over the life of your loan, but then front-loaded. Remember the amortization schedule we talked about earlier? That shows you that you’re paying much more interest up front. So if you’re in the second half of your loan, you’ve paid off a disproportionately high amount of the interest already. So paying off the rest of your mortgage actually saves you a lot less than the 5% figure.
Hard Money Loan Payoff
On the other hand, hard money loans are designed to be paid off as quickly as possible! There’s no amortization schedule, so you’re just charged the same interest every month. And like we talked about before, that interest is high. When you’ve got interest rates in the double digits, it makes sense to pay it off fast.
Not to mention a few other reasons you want to pay it off quickly:
- Get your profit…duh! If you’ve got a $30k check waiting for you, that’s all the incentive you need to pay it off quickly.
- Avoid holding costs. These are the costs associated with just having the property, like paying for insurance, security (if needed), and the utilities.
- Less interest. A $200,000 loan at 12% interest costs you $2k per month. That’s a nice thing to get out of.
- Get into your next deal. Many of the strategies I teach to investors are centered around speed—especially with the rehab and subsequent sale. I teach that the first offer you get that gives you decent profit is the offer you should take instead of holding out for more. That’s because speed is the most profitable thing in real estate investing! It’s the holding costs I mentioned before along with the interest, but more than that, it’s the opportunity cost of having less time/money to devote to your next deal!
What Types of Deals with Conventional Loans?
You can do some investing with conventional loans, just not your flips.
Buy, rehab, rent, refinance. You’re going to find a good deal, just as if you were going to do a fix & flip. You get a hard money loan (or another source of funding), rehab the property, find a renter, and then refinance the home into a conventional loan so you can have the low interest rate. This strategy will give you passive monthly cash flow! We help investors refinance their hard money loans into conventional loans—it’s a step that can often be tricky as many conventional banks don’t like taking on an investor’s loan.
Buy & Hold
It’s similar to a BRRR deal in that you’re going to have a property for a long period of time, but in this case you’re not going to get a hard money loan and do a rehab. Many people who aren’t serious investors but want to dabble in real estate will move to a new house but not sell their previous one. They’ll rent it out instead. This is a common strategy for people who buy condos or townhomes as a first home, but then when they’re ready to upgrade, keep it for a rental.
What Types of Deals with Hard Money Loans?
Hard money loans are going to be what you’ll use for the ever-popular fix & flip.
Most serious real estate investors have their goal as doing fix & flips because the profits are enormous…plus they see them on HGTV and they look fun! While they’re never as streamlined as those TV shows make them look, they’re still perhaps the greatest wealth-creation tool on the planet.
While I mostly do fix & flips for residential properties (specifically townhomes and single family homes), you can really fix & flip any type of real estate. Some types are commercial, mobile home, multi-unit (like duplexes, fourplexes, or even apartment buildings), and even things like big storage units. I’ve seen multi-million dollar deals put together around buying an old beat-up storage unit business, restoring it, and then reselling it for huge returns.
Whew! That was a lot, right?
Clearly there are some huge differences between conventional loans and hard money loans, such as…
- Hard money loans are much shorter
- Hard money lenders lend you based on the value of the asset, and not on your job history, debt-to-income or other factors related to your ability to pay a monthly mortgage
- Hard money is more expensive on a per-month basis, but cheaper over the life of the loan
- Hard money is better for the typical real estate investor
- Hard money loans get you the money much faster
- There are fewer regulations with a hard money lender
- Down payments vary widely with both hard money and conventional loans, but with a good deal, hard money loans can require a much smaller down payment.
Thanks for reading, and I hope this answered your question!
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