Investing in real estate can be a lucrative avenue for building wealth, and it’s an effective way to diversity your portfolio. Reeal estate investment trusts (REITs) and real estate crowdfunding allow you to invest passively, but some investors may prefer to own property directly.

If you’re not comfortable parting with a substantial amount of cash up front to purchase real estate, a hard money loan may be the answer. While this type of loan has advantages over traditional financing, it does have potential downsides.

How Hard Money Loans Work

Hard money loans, sometimes referred to as bridge loans, are short-term lending instruments that real estate investors can use to finance an investment project. This type of loan is often a tool for house flippers or real estate developers whose goal is to renovate or develop a property, then sell it for a profit. Hard money loans are issued by private lenders rather than mainstream financial institutions such as banks.

Unlike traditional bank loans, the ability to obtain hard money financing isn’t determined by the borrower's creditworthiness. Instead, hard money lenders use the value of the property itself in determining whether to make the loan. Specifically, lenders focus on the “after repair value,” or ARV, which is an estimate of what the property will be worth once the renovation or development phase is complete. (See also: How to Value a Real Estate Investment Property.)

The Cons

Hard money loans aren’t a perfect financing solution. There are two primary drawbacks to consider:

  • Cost Hard money loans are convenient, but investors pay a price for borrowing this way. The rate can be up to 10 percentage points higher than for a conventional loan. Origination fees, loan-servicing fees, and closing costs are also likely to cost investors more. (See also: The Complete Guide to Financing an Investment Property.)
  • Shorter repayment period The purpose of a hard money loan is to allow an investor to get a property ready to go on the market as quickly as possible. As a result, these loans feature much shorter repayment terms than traditional mortgage loans. When choosing a hard money lender, it’s important to have a clear idea of how soon the property will become profitable to ensure that you’ll be able to repay the loan in a timely manner. (See also: How to Calculate ROI for Real Estate Investments.)

The Pros

There are several good reasons to consider getting a hard money loan instead of a conventional mortgage from a bank. Here are the main benefits this lending option offers to investors:

  • Convenience Applying for a mortgage is time-consuming, particularly thanks to new regulations on mortgage lending implemented as part of the Dodd-Frank Act. It can take months to close on a loan, which puts investors at risk of losing out on a particular investment property. With a hard money loan, it’s possible to get funding in a matter of weeks. That’s important if you’re funding a large-scale development project and can’t afford deviations from the timeline to completion.
  • Flexible terms Because hard money loans are offered by private lenders, it’s possible for investors to have more room for negotiation of the loan terms. You may be able to tailor the repayment schedule to your needs or get certain fees, such as the origination fee, reduced or eliminated during the underwriting process.
  • Collateral With a hard money loan, the property itself usually serves as collateral for the loan. But again, lenders may allow investors a bit of leeway here. Some lenders, for instance, may allow you to secure the loan using personal assets, such as a retirement account or a residential property you own.

The Bottom Line

Hard money loans are a good fit for wealthy investors who need to get funding for an investment property quickly, without any of the red tape that goes along with bank financing. When evaluating hard money lenders, pay close attention to the fees, interest rates and loan terms. If you end up paying too much for a hard money loan or cut the repayment period too short, that can influence how profitable your real estate venture is in the long run.

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