Do you know the difference between hard money loans and purchase money? Elizabeth Weintraub, a home-buying expert, explains the difference between hard money loans and purchase money as revolving around the word, “purchase.” Purchase money is money loaned to you that you use to buy a piece of property, such as a residential home. A hard money loan, by contrast, is a loan that is NOT purchase money.
“In some ways, it is easier to describe what a purchase money loan is not,” explains Weintraub. “It is not a loan that is taken out after you buy a home such as a home equity line of credit or a home equity loan. It is not a refinance mortgage. A purchase money loan is evidenced by the trust deed or mortgage a home buyer signs at the time the home buyer purchases the home. A purchase money loan is the money a home buyer borrows to buy a home. …Purchase money makes up part of the purchase price. The loan is secured by the property, meaning if the buyer stops making the payments, the lender may have the right to seize the home and sell that home to get its money back. A hard money loan secured to real estate is a loan that is not purchase money. It is money loaned to a borrower, which is not used to buy a home. You can get a hard money loan without owning a home at all — without any security for that loan — providing the lender feels you are a good credit risk. [But] most hard money lenders prefer securitizing collateral to make a loan. That collateral, such as a home, reverts to the hard money lender if the borrower defaults and the home eventually goes to foreclosure. Real estate is an excellent vehicle to secure a hard money loan, providing the property in question has equity.”
In other words, someone who cannot qualify for a traditional mortgage or home equity loan, someone who cannot obtain a conventional loan, can still obtain a hard-money loan if they have an asset with which to back the loan. The loan they then receive is money they can choose to spend however they wish, rather than for the specific purchase of a specific piece of property (as in the case of purchase money). Hard money loans are loans that are usually issued by a private firm, and the interest rates may be higher than those for residential loans or more conventional commercial loans specifically because of the greater risk and the borrower’s credit status. This understanding is shared by both parties.
But how does this compare to purchase money loans? K.C. Hernandez, writing in SFGate, explains the advantages of a Purchase-Money mortgage as an alternative to conventional mortgages, especially when there is a great deal of competition in the market. “One way to make a home more attractive to buyers is by offering a purchase-money mortgage, also known as seller financing, seller carry-back or owner financing,” Hernandez writes. “A purchase-money mortgage is advantageous when it is difficult to sell a home. By offering a purchase-money mortgage, a seller sets his home apart from the rest and increases the number of buyer candidates. When purchasing real estate, a buyer typically uses commercial mortgage financing from a bank or mortgage lender, as well as cash. He contributes cash for the down payment and finances the rest of the sales price with a lending institution. When offering a purchase-money mortgage, the seller offers to be the bank, financing all or a portion of the cost to purchase his home. The advantage to a buyer is that he obtains more financing than a lender might provide. The seller benefits because he sells his home or obtains partial payment of the sales price with the promise of repayment for the purchase-money mortgage.”
Hernandez goes on to explain that in buyer’s’ markets, when there are more houses for sale than there is demand for them, unconventional financing can help the seller get the best selling price possible by opening up the number of people who can purchase. “A buyer [who] does not qualify for sufficient financing because of income or credit restrictions may need help from the seller to make the purchase. Reasons a seller may need to sell under unfavorable market conditions include financial need, divorce, job relocation or the need for a different property type. The seller of the home holds — or carries back — a note for all or part of the sale price and secures it as a lien against the property. The advantage of holding the note is that it helps ensure repayment. In the presence of an institutional mortgage, the purchase-money mortgage is the second mortgage, also known as a subordinate or junior lien. Its secondary position means the first lender’s mortgage must be paid off before the purchase-money loan can be liquidated. Purchase-money mortgages have disadvantages as well as advantages. Both parties must proceed with caution and protect their own interests by clearly outlining the repayment and sales terms in writing. Because the seller holds a note on the property, he needs to ensure the home is insured properly and its condition remains good enough to be marketable in case he needs to repossess the home for lack of payment. A buyer runs the risk of losing the home if he fails to keep up the payments with either the first mortgage lender or the seller.”
So how does that compare to hard money loans? Hard money loans, as we’ve already said, could be used for a number of different things. If the loan is for a specific project, such as construction, that project’s duration is probably anywhere from a few months to a few years. A hard money loan might be an asset-secured loan (and it may have a relatively high interest rate based on risk), which is one of the reasons hard money loans offer value to customers who cannot secure more traditional means of financing for a project or purchase. A hard money loan could also be one that involves a foreclosure, or a situation in which a mortgage is in arrears.
Unlike more traditional means of funding, while hard money loans may incorporate an examination of the income and credit score of the loan applicant, the primary reason hard money loans are approved has to do with the value of the asset that is put up as collateral to secure the loan. That is why this type of loan is referred to as an asset-backed loan, because the asset is offered up as collateral and can be forfeit if the borrower ends up in default. The collateral therefore reduces risk for the lender and, the greater the collateral, the more likely the lender is to be able to approve the loan. (If the borrower defaults, the lender is typically the first creditor to receive remuneration, such as in the case of a bankruptcy trustee paying out collected funds to those owed money.
Some investors decry hard money, going so far as to characterize hard money lenders as “loan sharks.” A blogger identifying himself only as Brandon, writing for Real Estate In Your Twenties, went so far as to call hard money “ridiculously expensive.” He writes, “Imagine a world where you have all the money you need, all the credit you could get, and banks pounding down your door to give you large sums of money for low interest. Nice isn’t it? However, the real world is a much darker place. In reality, trying to get financing from a bank is often like trying to shave Chuck Norris’ beard while he sleeps. It’s just not possible. As they say, necessity is the mother of invention and Hard Money is the invention birthed by the need for financing.” Ironically, in saying so, Brandon is actually making the case for hard money. Yet he goes on to say, “It may be an expensive way to do business, but if those costs are factored into the equation, it just might work for some people. When investors cannot obtain normal bank financing, we will often use hard money as a ‘bridge’ between purchasing and the resale or refinance. Often times, house ‘flippers’ will use hard money (as I have) to buy a property, fix it up, and sell it again. When it works, it works well. The lender may charge 4 points (4% of the loan) and a 12% interest rate, but if those costs are figured into the cost of the project this number is inconsequential.”
Given all this, Brandon is still making the case for the option of hard money, even when he concludes, “I have used Hard Money on a number of occasions, but I try to steer clear whenever possible. I am a strong believer in security and in the ‘buy and hold’ method of investing. Hard Money – with its short term lengths – do not fit well with my investing strategies. I like to think in terms of ‘worst case scenarios’. If I try to ‘flip’ a house using Hard Money, and am unable to sell that house before my term is up, I am in danger of losing the house to the lender. I only use hard money when I have a clear exit strategy on a flip and secondary funding available as a backup. Hard Money can be a great way to get into the ‘flipping’ business, if that is the business model you are looking to get into. However, you must weigh the risks with the reward to decide if this is a path you want to go down.”
Ken Corsini, writing for the online real estate magazine Biggerpockets, explains that “hard money” has a bad reputation, but shouldn’t. “While not all hard money lenders are ideal business resources,” he writes, “most are knowledgeable, professional, and can be used to great advantage… One of the biggest advantages of hard money is the ability to borrow funds for renovation expenses. Most investment properties have some equity potential, but the average home buyer is often discouraged by the less-than-attractive condition of the property. As investors we create margin by having the ability to find, acquire and renovate these properties. The ability to finance the purchase and repairs is key to this equation, and hard money is one tool that allows us to do just that. …Once the property is acquired and renovated using hard money, the investor can then employ a conventional lender for the permanent financing. Since the renovations presumably have increased the value of the property, the refinancing lender can use the new appraised value in determining the investor’s maximum allowable loan amount. Typically, a conventional lender will allow financing up to 75% of this appraised value. Best case, the appraisal will be high enough so that the investor can refinance the balance of the hard money loan as well as closing costs without any additional money…”
Corsini does caution that just because you a borrower is approved today doesn’t mean he or she can still be approved months from now. Guidelines are always changing, and the securing asset used to obtain the hard money loan is something that could itself be fluctuating in value. It’s also the case that borrowers sometimes endanger their borrowing status through their own behaviors, such as running up an existing line of credit and thus altering their credit position or debt to asset ratio. Comparable sales located near the asset property or near the prospective purchase, if that purchase is some form of real estate, may also be a relevant factor. “No matter your investing goals, hard money financing can be a highly effective tool,” Corsini concludes. “Even with the upcoming guideline changes, using hard money to leverage your investment can be a great strategy to acquire, renovate and maintain investment property.” Given all this, hard money loans may indeed be the best option for you.