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When Should You Use Hard Money?


A Hard Money loan is a type of loan product most commonly given by Private Lenders and can be a great resource to real estate investors who use it for the right situations.  People who are purchasing a primary residence should not use this type of loan and should instead build up their credit, create a solid and consistent income and get a conventional loan at the lowest interest rate possible.

In the past, Hard Money has carried a stigma and people commonly thought of the loans as describing more sever terms and higher costs as compared to conventional financing…which can be true as these terms vary greatly from lender to lender.  However, the more accurate meaning of the word “Hard” in Hard Money is that there is a Hard asset backing up the loan or collateralizing the loan.  A Hard Money Loan is merely another name for an asset-based loan where the loan is secured and offered to the borrower with the primary consideration being the equity in the asset.  Until the 70’s all loans were primarily asset-based loans and banks all required more significant down-payments and equity than they do today.  The more equity there is in a property, the lower the risk of default by the borrower and greater are the options to repay the loan should the borrower run into a tough spot.

The overarching reason for getting a hard money loan is the same for any type of loan.  Does the cost of borrowing the money greatly outweigh the benefit of having access to the funds?  The alternative being, that one could save the money and purchase the item with their own money.  It is this writer’s opinion that we as a society borrow too much money and have become frivolous in our spending and borrowing.  Being in debt has become common and comfortable which has not always been the case.  A loan of any type Hard Money or otherwise is best utilized to purchase an asset that will increase the wealth of the borrower…not just to by something you want which only increases the wealth of the banker.

The borrowing of money to purchase an asset that will increase one’s wealth is the primary reason a Hard Money loan should be considered.

For this reason, Hard money loans are most commonly used by real estate investors who are leveraging their cash or real estate holdings to make other profitable investments.   The reason they are utilizing a Private Lender vs an institutional lender an vary, but most commonly it is the ease and speed of which they can get the loan and funds can be disbursed.  This article intent is to give an overview of scenarios where these types of investments occure.

Acquisition of a distressed property

As in all investment opportunities there are different pools of buyers and sellers in which one could invest.  If you are buying a home to live in, the most common pool would come from Realtors and the RMLS system of conventionally financeable homes.  However most experienced real estate investors choose to swim in another pool.  The pool of distressed sellers in which Bank foreclosure, short sale, cash only, and non-conventionally financeable homes are purchased.

Institutional lenders primarily focus their loans to primary residences or properties that people can move into and live in once the loan is given.  These loans are widely considered less risky as the borrower needs a place to live, the home’s value can be easily estimated and will have the highest likelihood of being repaid over time.  Banks will require appraisals and home inspections before granting a loan to ensure that the property meets certain standards.  In contrast, a real estate investor is seeking a property which would not meet those standards so that it can be purchased at a discount.  90% of home are purchased in the USA are done so with Institutional or conventional financing.  Which means, properties that are not conventionally financeable will not command market price.   It is these properties that an investor is searching for and they will need cash or a Private Lender who has the cash to buy them.  In these scenarios it is a common requirement of the investor to take advantage of a good opportunity quickly.  A Hard money loan acts like cash and allows that investor to purchase a property at a discount.  A Hard Money Loan or Asset based loan can make since in these situations since the loan is creating value for the borrower and the loan can be repaid in a relatively short period of time.

Foreclosure Sales

Foreclosure is the process in which a bank forces the sale of a property to repay the loan.  Foreclosure sales have always required that the buyer have cash in hand.  The sole purpose of a foreclosure is to have the banks’ loan repaid.  If at the foreclosure auction the property sells for more than what is owed, the remainder of the funds go to the borrower.  The starting bid at a foreclosure sale can be no more than what the bank is owed which creates the opportunity for an investor to purchase a property at a discounted price.  In order to participate in this process, the person buying the property must have cash.  Since a Private Lenders funds can be disbursed so quickly, Hard Money is generally considered cash and is the loan of choice for foreclosure purchases.  If you can buy a property for $100K less than it is worth and it only costs you $15K to borrow the money, this would be a good reason to consider a Hard Money / Asset Based loan.

Bank owned properties

If at the foreclosure sale there are no investors willing to pay the amount bid by the bank, the bank will now own the property. When a bank is forced to take a property back in lieu of a sale, the bank trades a revenue generating asset (the Loan) into a non-performing asset (a property).  Properties cost money to hold and sell and banks generally don’t like that.  Depending on the banks’ balance sheet a bank may choose to hold the property for a period of time or liquidate the property quickly.  The condition of the property will now determine the value of the property.  It is common for a foreclosed property to be in poor condition and the bank is forced to either invest money and time to fix it up or sell the property as is.  This scenario is also a great opportunity for an investor with cash or a Hard Money loan since conventional financing will commonly not lend on these properties.  With less financing options this greatly reduces the pool of buyers, which in turn reduces the value of the home at that time.  If you can buy a property for $75K less than it is worth and it only costs you $15K to borrow the money, this would be a good reason to consider a Hard Money / Asset Based loan.

Wholesaling

Wholesaling is a strategy used by more sophisticated investors whose sole purpose is to find discounted properties in which they will quickly sell to another person.  These are the people who are very familiar with foreclosure auctions or who send out mailers or knock on doors searching for people who are willing to sell their properties at a discounted price.  A wholesaler has no intention to fix up the property but is in the business of finding discounted properties so they can mark up their newly acquired property just enough to be enticing to an investor who will purchase the property from them.  Wholesalers commonly already have a pool of buyers waiting to purchase the newly acquired property and commonly hold the property for only days or weeks at a time.  Wholesalers generally need to leverage their money and commonly use Private Lenders or Hard Money lenders to acquire the property.

House flipping / Fix and Flip / Fix and Hold

The basic strategy of a Fix and Flip is for a real estate investor to purchase a property at a discount.  They fix up the property to meet conventional lending standards and then sells the property for a profit.  The same is true for a fix and hold except the investor after renovating the property gets their own conventional loan so that they can hold the property long-term as a rental or primary residence.

Whether you find the deal on your own, through a realtor or from a wholesaler, the goal of any flip purchase is to buy the property at a discount.  It is also important to be aware of the properties flaws and be able to address those issues.  Leaky roofs, water damage, fire damage, general property distress, or the need of updating are all places where a real estate investor can add value and make profit.

Ideally a sophisticated investor will cut out wholesale market and find their own buying opportunities by looking for homes that do not have the required functioning systems of a home required by a conventional lender or cannot pass a home inspection for whatever reason.  If a home does not have a sound roof, power meter, power panel, water heater, has been gutted or hoarded can all be scenarios in which the value of the property will need to be greatly discounted in order to generate a sale.  If the real estate investor can resolve the know issues for much less than the value of the property will go up upon having resolved those issues, the opportunity for profit is made.

In these cases, the investor will rehab or renovate the property to upgrade its value.  It is very common for an investor to make 80% to 120% on their own cash investment in these types of project which easily pays for the cost of having borrowed from a Hard Money Lender.

Property development

Another way that hard money loans can be used is for the development of bare land into buildable lots or the construction of new homes.  If an investor purchases a property and is able to build a home in six months, he or she can sell the home for much more than the original purchase price.

However, it’s vital to exercise caution when using hard money for property development and construction, as construction timelines can be unpredictable. If you take on a major development and the timeline is extended by several months in the midst of the project, you may exceed your loan term before the property is completed and can bring in a profit.

1031 or reverse 1031 exchange

Real Estate that is not sold but rented requires no tax be paid on the equity now built into the property.  That profit can now grow tax deferred until the final sale of that property.  A 1031 exchange is a tax advantage given to investors who sell an investment property and use the funds to purchase another investment property of greater value.  If the sale and purchase is completed within a short window it can be done so tax free.  If a property cannot be found and purchased inside that window the taxes on the profit from the sale will be due.  It is common for investors who are coming to the end of that window to use a Hard Money loan to purchase the new property quickly and will then refinance the loan when they have more time to get a conventional loan.

Repayment of borrowed money

Hard Money loans can also be used to pay off another loan.  While expensive Hard Money Loans collateralized by real estate are tax deductible and the interest is generally less than the below examples:

  • Repayment of retirement advancement
    • A retirement account is a great way to save money tax deferred. Some plans allow you to borrow money from that account for a short period of time.  If the money is not paid back within that time frame the taxes on that money will come due and with penalties can exceed 50%.  While a Hard Money loan is costly it is significantly less costly than paying the taxes if they were to become due.
  • Repayment of a loan that has become due
    • Most loans have durations in which they must be paid back. If a loan cannot be paid back in the specified time, there are commonly large fees and increased interest.  Personal loans can charge in the range of 18% to 30%…sometimes more.
  • Purchase and Sales contract
    • If a property is purchased on contract it means that the seller is carrying the loan for a period of time. At the end of that period the contract is not paid back in full, the seller get the property back.  If in that time the property the value goes up significantly, it is not uncommon for the seller to wish they had not sold the property and be waiting for the contract to expire.  A Hard Money Loan, might be costly, but if it is less than the increased equity in the property, it can make sense.
  • Refinance of business / personal loans
    • Short-term business loans or short-term personal loans can range between 0% and 30%. It is not uncommon to pay off these loans through the refinance of an investment property at a lower rate and which the interest is tax deductible.

Alternative Lending

Getting a loan on an investment property from an institutional source requires good credit history and a low debt to income ratio.  Foreclosures, late payments, defaults, and bankruptcies remain on your credit report for years, and can keep you from getting a conventional loan for a period of time.  If your financial situation has changed either from a new job or inheritance, you still may be denied from traditional banks.  If a bank denies your mortgage application, a private lender may be your only choice for financing.  If you choose to get a Hard Money loan for a period of time, the goal should always be to refinance that loan down the road for a lower interest rate.

In the end, the primary value of a Hard Money loan is the speed and ease in which you can have access to capital.  If having quick access to capital allows the real estate investor to make a profitable investment, then Hard money can absolutely be a great resource.  An investor’s exit strategy, (how the investor is going to pay off the loan) be a key factor in considering this loan type.  In most cases, the sale of the property once a profit has been made or the refinance of the property with a conventional loan are the most common exit strategies for real-estate investor.

Northwest Private Lending Inc NMLS # 1522364 // ML # 5496 is based in Portland, Oregon. NW Private Lending is an Equal Opportunity Hard Money Lender. We provide quick acess to capital for borrowers, real estate agents and mortgage brokers in Oregon and Washington. NW Private Lending is a collateral based lender focusing on bridge loans, fix and flip or rehab loans, commercial loans and non-owner occupied real estate investment properties.

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