New real estate investors face a variety of challenges. In particular, they need to learn what seems like a whole new language of real estate related vocabulary. And, much of this jargon relates to financing deals. As such, many new investors ask me to explain the difference between hard money and private money.
Functionally, hard money and private money lenders are the same. They both lend based on the deal itself – not a borrower’s personal financial profile. But, whereas private lenders are typically individuals, hard money lenders exist as formal companies and can provide far more support to investors.
In the rest of the article, I’ll dive into more differences between hard money and private money lenders. Specifically, I’ll cover the following topics:
- An Overview of Traditional Financing
- What Hard Money Lenders Do
- Difference Between Hard Money and Private Money
- Questions to Ask a Hard Money or Private Money Lender
- Qualifying for a Hard Money or Private Money Loan
- The Importance of Off-Market Deals for Hard and Private Money
- Hard Money or Private Money?
- Final Thoughts
An Overview of Traditional Financing
To understand the differences between hard money and private money, it helps to understand traditional financing first. More precisely, investors need to understand why this financing doesn’t work for investment properties. With these mortgages, lenders like banks and credit unions issue loans based on two broad criteria:
The Borrower’s “Soft” Assets
These include the borrower’s general financial picture. Lenders will want to ensure that credit scores, income, debt-to-income ratios, and cash reserves all meet certain minimum standards. Basically, lenders want as much assurance as possible that the borrower has the ability to continue making payments.
This soft asset verification automatically disqualifies many first-time investors. Simply put, people often decide to buy investment properties because they don’t want to pursue a traditional career. Accordingly, these same people often haven’t spent years A) building their credit scores, B) raising cash reserves, and C) establishing long track records of W-2 income. Lacking these elements, investors will find it extremely difficult to meet a traditional lender’s strict underwriting standards.
The Property Itself
If a borrower defaults on a loan, that is, stops paying, the bank still wants its money bank. For this reason, lenders require formal home appraisals during the mortgage loan closing process. They want to make sure that they’re not lending you more than the house is actually worth. That way, if you stop paying, they know that they can foreclose on and sell the property, with the proceeds paying off the loan balance. In this vein, most traditional lenders will not provide mortgages for homes in need of major repairs.
And, most residential investing strategies inherently depend on a property’s distressed nature. In particular, both of the following commonly embraced strategies rely on purchasing a distressed property, one that likely wouldn’t qualify for traditional financing:
- Fix & flip: With this strategy, investors find a distressed property – typically at a deep discount. They purchase this home and renovate it to a standard that will meet traditional financing standards. Once renovated, these investors then sell the property to someone using a traditional mortgage, normally a primary homebuyer. Investors pocket the difference between this sale price and their acquisition/rehab/holding/transaction costs as profit.
- BRRR: This stands for buy, rehab, rent, refinance. And, these investors look for a similar property to the above, that is, a distressed home at a deep discount. Next, they complete the rehab process, but they have an aim to rehabbing a home for tenants – not owners. Once renovated, investors then lease the home to quality, long-term tenants. Once leased, investors can refinance their short-term, high-interest hard money loans into long-term, traditional mortgages. As such, they profit three ways: 1) cash flow from tenants, 2) property appreciation, and 3) loan amortization.
In addition to being common investing strategies, both of the above clearly hinge upon finding distressed properties in need of major repairs. And, if investors can’t use traditional mortgages to finance these properties, what can they do?
What Hard Money Lenders Do
Enter hard money loans! Regardless of whether you opt for a fix & flip or BRRR strategy, hard money loans provide a means of financing a deal.
An Overview of Hard Money Loans
More precisely, hard money exists as an alternative to the above traditional financing. And, hard doesn’t mean challenging. Rather, it means that these lenders solely concern themselves with the “hard” asset, that is, the property itself.
As stated, traditional lenders require minimum standards with the borrower’s “soft” assets. Hard money lenders don’t concern themselves with this. These lenders look at a property and ask, what will this property become? They base their decision to lend on the projected after-repair value (ARV) of a property.
This system provides real estate investors two key advantages. First, you can secure a hard money loan even if you don’t have a great credit score (but, lenders likely won’t work with you if you have bankruptcies or judgements in your credit history). Second, you can use hard money loans for distressed properties, making them ideal for fix & flip and BRRR investors.
Traditional lenders want to confirm that, if foreclosed upon, a property will cover the loan balance now. Hard money lenders assume more risk. They lend based on what they believe the property will be worth in the future. While each hard money lender offers different terms, at The Investor's Edge we’ll lend up to 70% of a property’s ARV. As such, if a borrower fails to successfully rehab a property, hard money lenders need to recoup their outstanding loan balance with a distressed property sale. And, selling a property in the middle of a repair likely won’t pay off the outstanding loan balance, as the loan was based on what the property would become.
Due to this increased risk and the shorter term nature of hard money loans, they have higher rates than traditional mortgages. Depending on your investing history and the quality of the deal, you can expect an interest rate from 7.99% to over 15%. However, investors can also close these loans extremely quickly. Most traditional mortgages typically require 30 to 45 days to close. You can close a hard money loan in less than a week.
I touched on it above, but hard money lenders only have a few criteria regarding personal background when reviewing an investor’s loan application:
- Not in collections: If you have an outstanding judgement against you and are in the collections process, most hard money lenders will not provide you a loan. These individuals simply pose too much of a risk of repayment.
- No bankruptcies: If you have a bankruptcy on your record, you also likely won’t qualify for a hard money loan – for the above reasons.
- No major criminal background: Hard money lenders will absolutely run a criminal background check on investors. Minor misdemeanors can be waived on a case-by-case basis, depending on the nature of the crime. However, if you have a felony on your record, it’s highly unlikely that a lender will approve your hard money loan.
Assuming you clear the above hurdles, hard money loan approval really just comes down to two items. First, what loan-to-value (LTV) terms will a lender offer. That is, how large of a loan will they provide, based on a property’s ARV. This leads directly into the second item hard money lenders closely scrutinize: a property’s ARV.
Once again, hard money lenders base their loans on what a property will be worth. But, how do you value something that doesn’t exist yet? To do this, hard money lenders require an ARV appraisal prior to issuing a loan.
With a standard appraisal, appraisers look for recent sales comps for the property in its current state. ARV appraisals also include “as-is” comps and determine an “as-is” value. But, they also account for the planned renovation and what the house will look like after they’re complete. More precisely, an appraiser will analyze your submitted contractor bids for work, find properties that have had similar levels of work, and determine an ARV based on those comps.
While more expensive than standard appraisals, these ARV appraisals provide hard money lenders the information they need to determine how much they’ll lend.
Difference Between Hard Money and Private Money
In function, hard money lenders and private lenders are largely the same. They both provide alternative financing to real estate investors, frequently for house flip deals. And, both lenders make money through a combination of loan origination fees and loan interest:
- Origination fees: These are the fees a private or hard money lender charges to actually originate, or put together, a loan. Loan originations take time and administrative effort, and lenders require compensation for this work. Depending on the lender, these fees can be charged as 1) a flat fee, 2) a percentage of the loan amount, or 3) a combination of these options.
- Loan interest: This is what lenders charge for letting borrowers use their money. In conceptual terms, interest is how lenders are compensated for the risk they’re taking by lending money. And, private and hard money lenders assume greater risk than traditional mortgage lenders, because these loans are secured by properties that still need to be renovated. If a borrower defaults prior to completing the rehab, private and hard money lenders need to foreclose on a partially-rehabbed property. Due to this increased risk, these lenders charge higher interest rates than traditional lenders.
Rather, private lenders differ from hard money lenders in terms of organizational structure. Private lenders are individuals. On the other hand, hard money lenders are established companies. This organizational difference leads to some key advantages for hard money lenders over private lenders:
- Established systems and support: As a formal company, hard money lenders have established business processes and administrative support. These characteristics mean you’ll likely have a far more reliable partner in a hard money lender over a private lender. For instance, if you have a question about your repayment schedule, what happens if the private lender is on vacation? With a hard money lender, you’ll have the customer support of an actual business – not just a single person.
- Experience: As a business, hard money lenders deal with real estate loans every day. This gives them a tremendous amount of experience, and they can translate this experience into direct assistance for their borrowers. Conversely, private lenders may have little to no experience issuing these sorts of loans, meaning they won’t be able to provide you a guaranteed level of advice and assistance.
- Reliability: Unfortunately, private lenders – as individuals – are more likely to flake out of a deal than an established hard money lender. I personally dealt with this situation. At closing time, my private lender failed to show and stopped answering all phone calls. Fortunately, at the time I had a solid relationship with a hard money lender who was able to move in and close the deal.
Becoming a Private Lender
After explaining the differences between hard and private money, I’ll briefly discuss becoming a private lender, as advantages definitely exist to this strategy. You profit from real estate deals – without the hassle of actually doing any fix & flip work yourself. You screen borrowers, lend money, sit back, and make money. However, it’s not for everyone. Before diving into private lending, you’ll need:
- Cash: It should be obvious, but if you don’t have a bunch of money sitting around to lend, you can’t be a private lender.
- Experience: While private lenders may not do the rehabs, they need to know everything about these deals. They need to intimately understand real estate risk, valuations, contractor bid processes, lending legal requirements, how to administer loans, and more.
But, if you meet these criteria, private lending can be a great way to make money.
Questions to Ask a Hard Money or Private Money Lender
Before jumping into a hard money or private money loan application with the first lender you find, you should be aware of some potential pitfalls. That is, make sure to do your due diligence prior to committing to a specific lender. In particular, I recommend that you ask – at a minimum – the following questions:
What is the maximum LTV you will offer?
Depending on the amount of cash you’re willing to contribute, this will make or break a deal. And, from a return on investment perspective, the more leverage you can use in a deal, the larger your return on contributed capital. (NOTE: Increased leverage also increases risk, which is why we harp on the importance of properly analyzing deals before committing).
What is the maximum loan amount you will offer?
This relates directly to the above question. For instance, a hard money or private money lender may offer 75% LTV loans – a fairly high standard. At first glance, this seems like a great opportunity, as you can finance a larger portion of a deal than a 60% or 70% lender will allow. But, if that same lender caps maximum loan amounts at $150,000, you’ve significantly limited your pool of available deals.
Do you finance a particular type of property?
Many hard money and private money lenders focus their lending on a particular property type, normally something with which they have a lot of experience. I made this mistake as a new investor. I found what I thought were great deals, but I couldn’t find a lender interested in those properties. As such, I learned the hard way – it’s better to find out what sort of properties a lender will finance before you go out looking for deals.
How do you handle loan repayments?
This is a hugely important question. Some lenders require monthly interest (or principal and interest payments) after a certain amount of time. This can seriously challenge your cash flow and disrupt your deal’s budget. Alternatively, at The Investor's Edge, we accrue all interest up front, meaning that investors pay everything off at once at the end of a deal, which simplifies the budgeting and cash-flow process.
Qualifying for a Hard Money or Private Money Loan
Now that I’ve provided a brief overview of hard money and private money loans and, for comparison’s sake, traditional financing, I’ll discuss the best ways to qualify for the former. As stated, hard money and private money lenders don’t care about your financial health (as long as you don’t have judgments or bankruptcies on your credit history). Rather, they want to make sure you have a quality deal. That is, a property’s ARV justifies your requested loan amount. In other words, a hard money or private money loan application shouldn’t exceed 70% of a property’s ARV if you hope to qualify.
Having said that, here are a few techniques I recommend to help you qualify for a hard money or private money loan:
- Confirm lender requirements – early!: I made this mistake as a new investor. I found what I thought were great deals, but I couldn’t find hard money or private money lenders willing to approve a loan. Accordingly, I learned an important lesson: every one of these lenders has slightly different requirements and target properties. Before looking for a property, confirm what a hard money or private money lender is A) willing to approve, B) requires for documentation to approve a loan.
- Establish a relationship with a general contractor: Hard money and private money lenders assume increased risk due to the fact that their loans are secured by distressed properties. As such, they’ll want to confirm that you have a detailed, feasible plan to rehab the property from its “as-is” state to finished product. And, they’ll confirm this by reviewing bids from a general contractor (GC) outlining exactly A) what work you’ll do, and B) how much it’ll cost. If you have an established relationship with a GC, it’s far easier to get this information to the hard money or private money lender for review.
- Understand the numbers: While hard money and private money lenders may not worry about your financial health, they do want to confirm your competence. That is, can you accurately and realistically run the budget numbers on a house flip? If you show up with shoddy or overly optimistic numbers, most lenders won’t have much faith and confidence in your abilities to execute a successful rehab. At The Investor's Edge, we understand how challenging this can be for new investors, so we’ve created a house flip calculator to help!
The Importance of Off-Market Deals for Hard and Private Money
When it comes to the deals hard money and private money lenders want to support, experienced real estate investors understand that seeking properties on the Multiple Listing Service, or MLS, just doesn’t work.
Most new real estate investors understand the MLS. That is, if you’re looking to buy an investment property, you’ve probably already purchased a primary home. And, when you bought your home, there’s a good chance you worked with a real estate agent. This agent probably took your general search parameters (e.g. price, area, size, etc.) and gave you tailored access to the MLS where you could scroll through every listed property meeting your search criteria.
While this system works great for finding a primary home, finding investment properties on the MLS rarely works. More precisely, due to the following three reasons, investors will struggle to find good deals on the MLS:
- Competition: In theory, if you work with a real estate agent (or are a real estate agent), you can access MLS data from anywhere in the world. Accordingly, when investors try to find potential deals on the MLS, they’re really competing against three different parties: 1) primary home buyers, 2) other local investors, and 3) out-of-market investors. This situation significantly drives up the competition for MLS properties.
- Property Condition: While you can buy investment properties on the MLS, you’re unlikely to find a distressed property that will qualify for a fix & fix deal. People primarily list properties on the MLS for primary home buyers, meaning that these homes need to qualify for traditional financing. In other words, they are not distressed properties in need of repair. Instead, most MLS properties are in good enough condition to meet standards required by traditional lenders.
- Price: Related directly to property condition, MLS properties generally have prices that don’t support a fix & flip budget. Rather, these homes list at retail price. This means that, even if an investor does find a property to rehab, there’s a good chance that its price will not support a deal budget.
The Benefits of Off-Market Deals
Instead of dealing with the challenges associated with MLS properties, successful investors understand the value in finding off-market deals. In other words, they look for properties that A) fit their investment criteria, but B) haven’t been listed for sale.
Searching for deals in off-market properties presents two primary advantages. First, as these properties aren’t listed on the MLS, they inherently have less competition. In most situations, when you approach a potential seller, you’ll be the only investor making an offer. This lack of competition leads directly to the second major advantage: price. Off-market properties fitting an investor’s criteria will typically have major repair needs. Between these needed repairs and the lack of competition, sellers do not have the leverage to command retail prices.
Bottom line, successful investors understand the importance of crafting a strategy to find off-market homes. But, as I’ll explain in the next section, finding these homes is only one part of the problem.
Hard Money or Private Money?
Now that I’ve provided a general overview and the major differences between hard money and private money, the question remains: which option makes the most sense? As with most real estate questions, I can only give an it depends answer.
Frequently, as individuals, private money lenders have more informal processes than their hard money counterparts. This can make applying for and receiving approval for a private money loan easier.
But, the huge drawback to private money is that this informal nature relies upon established relationships. That is, most private money lenders only work with investors they know and trust, which allows them to take a slightly more hands-off approach than a hard money lender would. If you already have relationships with private lenders, you’re in a good position. Unfortunately, though, most of us just don’t have a rolodex of private money lenders to call.
Hard money, on the other hand, generally includes more formalized, stricter application processes. While this may require slightly more up-front work, it also means that anyone can work with a hard money lender. To apply for one of these loans, you simply contact a hard money lender. You don’t need to have an established relationship as you often do with private lenders. This reality democratizes the financing process, allowing any real estate investor with a solid deal to receive a loan.
Functionally, hard money and private money lenders are largely the same. But, the formalized systems and support offered by hard money lenders often make these companies more approachable for new investors. On the other hand, if you don’t already have a relationship with a private lender, it can be challenging to receive a private money loan.
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