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:
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:
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.
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:
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.
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:
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.
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:
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:
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:
But, if you meet these criteria, private lending can be a great way to make money.
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:
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).
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.
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.
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.
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:
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:
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.
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.
Private Money
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
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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