Financing 101: How do Hard Money Loans Work?
Did you know that 70% of small businesses have outstanding debt?
Without the financing necessary to keep the engine running, your business has a higher chance of crashing. For many entrepreneurs who get rejected by traditional lenders, alternative lenders have become lifelines, including hard money lenders.
But how does a hard money loan work, and are there any benefits to taking out this type of a loan? Keep reading to find out.
What are Hard Money Loans?
A hard money loan is a type of short term bridge loan you get against collateral you own. These loans are common in real estate transactions where private investors and companies, rather than banks, are the lenders.
How Does a Hard Money Loan Work?
Most hard money leaders are either private investors or companies. You’ll rarely find a bank dealing in hard money loans.
When you approach a hard money lender, they will take a close look at the collateral you have to offer. In most cases, it is going to be real estate assets that is used to secure the loan.
Since the lender is more concerned with your assets’ value, your credit score and financial history aren’t a big part of hard money loan requirements. If you fail to pay back the loan, the lender will liquidate the collateral to recover their money.
You should know that hard money loans carry a higher interest rate than traditional loans. On average, the interest rates for a hard money loan range between 7% to 15%. That’s nearly double or triple that of a bank loan.
As such, due to the high interest rates, you should not make the mistake of using the loan for long term purposes, such as funding for a startup.
You can get a hard money loan for a term of between one to five years. Ideally, though, you should structure your loan for six months. Since the interest rate is higher, the shorter your loan term, the more affordable the loan.
Hard Money Loan Points
With every loan proposal, hard money lenders try to limit their risk by using points. A point is an origination fee the lender uses to cover costs associated with administering the loan.
These points are valued as a percentage basis, with one point equating to 1% of the total loan amount. Depending on your situation, the points you’ll can pay range from 2% to 10%.
For example, if a borrower pledges collateral that will take longer to sell, the risk factor rises. To mitigate this, the lender will charge more points. A borrower pledging collateral that can be liquidated quickly will be charged fewer points.
Once the loan application has been approved, you will pay these points as part of the closing costs. Points are a reason why you should know how hard money loans work before you actually apply for the loan.
Why You Should Apply for a Hard Money Loan
In contrast to other traditional loan types like asset-based lending, several advantages make a hard money loan attractive. They include:
One of the challenges that make traditional bank loans slow to get approval for is the “know your customer” process. Traditional lenders need to take time and investigate your sources of income, financial history, and your creditworthiness.
Hard money lenders, on the other hand, do not need such lengthy processes. Their primary focus lies in the value of the collateral you bring to the table. As long as they can recoup their funds by selling the collateral, they are good to go.
For example, let’s say you face foreclosure when applying for a traditional loan. That fact alone makes a successful application incredibly hard. A hard money lender will focus more on your collateral without letting the foreclosure slow down the application process.
Hard money lenders don’t use a generalized approach to approving loans. Instead, they approach each applicant on a case-by-case basis. What that does is offer you the flexibility that can help you access the funds when you need them.
If, for example, you’ve been in business for less than six months, it will be difficult to get a traditional bank loan. However, a hard money lender can look at your collateral and determine a repayment schedule that enables you to tap into the credit facility.
Easy to Qualify
Hard money lenders take the risk based on the assets being pledged by the borrower. As such, that neutralizes other potential lending risks, and enables much-needed financing to more people.
Do you have poor or bad credit but high-quality assets? You’ll likely be approved for a hard money loan. The easy application process gives you a lifeline to turn to even during times when finding funding is hard to come by.
The Drawbacks of Hard Money Loans
As with almost anything else in life, hard money loans have a few cons you should think about prior to submitting an application. These include:
High Interest Rates
Hard money loans attract higher interest rates than traditional credit facilities. Hard money lenders assume significantly more risk than banks, and the high interest rate helps cover their risk and overall exposure.
That doesn’t mean this type of a loan can’t work for you. It just means you must be wise in how you use this type of financing. Conventional wisdom dictates that hard money loans work best over shorter periods of time. Less than a year would be best.
For business owners, that means avoiding the classic business funding mistake of taking out a high interest loan for an extended period of time such as a few years.
Your Collateral is at Risk
The instant you use your assets as collateral to secure the loan, you agree to the lender seizing them if you default. Thus, if the assets you put up are critical to operating your business, you place the future of your business at risk.
Of course, you must put this in context as you think through your decisions. Any loan you take out will always have a level of risk attached to it. Even unsecured loans come with risk should you fail to pay them when due.
As long as you’re using the hard money loan proceeds wisely, your assets face a calculated risk.
Hard Money Loans Can Save Your Business
Without proper funding, many businesses fail, and that’s typically due to the constricting nature of traditional lending. A hard money loan can be a financing alternative that helps your business thrive. Make a point of answering the question, “How does a hard money loan work?” to help you pick the right financial solution.
Your FundingTree is a marketplace matching borrowers with the most suitable lenders for their business. Apply today to secure a loan that attracts a lower interest rate, and that comes with exceptional customer service.