Choosing the right form of financing for your commercial real estate investing is very important, both in the short run and in the long run. With tens of options to choose from, it might get very difficult to sift the right form of financing from the not-so-right ones.
However, regardless of what kind of loan you choose to finance your commercial real estate property, you should first decide whether you want to work with commercial real estate hard money lenders or with conventional lenders.
Understanding the difference between Hard money loans and traditional loans thus becomes very important to make the right call and choose the best form of financing for your property.
This blog is an overview of the major differences between hard money loans and traditional loans. Read on to understand the difference so you are more informed to make the right decision about your financing.
What are Hard Money Loans or Private Lending?
Hard Money Loans are loans that are provided by commercial real estate hard money lenders or otherwise called private money lenders. Hard money loans or private loans are short-term loans issued by private lenders. The loan term is generally short ranging from 6 months and can go up to 5 years, unlike the conventional mortgages which can extend up to 30 years.
Hard money lenders do not have stringent loan qualifications and that is one of the reasons why borrowers prefer working with commercial real estate hard money lenders instead of conventional mortgages. These loans generally have a solid exit strategy where the borrowers can pay back the loan – usually after the remodeling of the property and selling it.
Thus, private money lenders can be seen focusing more on the before and after the value of the property, making these lenders the best go-to options when you have a solid plan for applying for the loan and getting good returns on your real estate property investment.
Hard money lenders generally lay more emphasis on the project plan of your property and if this plan can convince a lender that the project will be completed on time, in the budget, can be sold easily later and that the loan will be paid back, there are good chances that your loan will be approved by your private lender.
One advantage of working with hard money lenders is the flexibility and the convenient periods that they offer.
What are Traditional loans or Conventional Mortgages?
Traditional loans or conventional mortgages are long term loans that are provided by banks or credit unions to finance property purchases. These are generally very long term loans ranging between 5 years to 30 years with strict credit and income requirements.
You can typically get a traditional mortgage at both fixed rates or flexible rates but they’ll need you to put down at least 20% of the property value as a down payment.
If your project plan can convince your traditional loan lender about approving your loan, they might agree to find you a loan at 5% down payment but in this case, you will be asked to pay up some percentage of loan amount every month as part of mortgage insurance premium until your equity in the property goes up to 20%.
For most commercial real estate borrowers, this is a huge unnecessary expense and since it is a regular monthly payment that needs to be done until the equity goes till 20% or more, it can be a major additional expense that might end up costing you more in the long run.
Conventional mortgages are best suited for long term requirements where the borrower has considerable equity in the property and generally suits best for property owners that own single-family or multi-family properties.
In other words, conventional mortgages are the best go-to options when the property owner uses the property for residential purposes or for multi-family housing whose nature also comes under residential purposes. In other cases, where owners are interested in fix-and-flip deals with properties, conventional mortgages often end up being a wrong choice both in terms of time and money.
Major differences between Hard Money Loans and Traditional Loans
Now that we’ve talked about the meaning and nature of Hard Money Loans and Traditional Loans, let us look at the major differences between the two forms of financing:
#1 – Time frame
Timing is one of the most crucial aspects of commercial real estate investing. You just cannot afford to make mistakes when it comes to timing. It is said that timing can make or break your commercial real investment success. Not being able to encash upon a great investment opportunity because you fell short of finances is probably the worst nightmare for a savvy commercial real estate investor.
When it comes to hard money lending, the time frame needed to close the loan request and approve it revolves anywhere between 3 days to 2 weeks. On the other hand, conventional mortgages take a much longer time with an approximate period of 4 weeks to even a few months to just process your loan application. It takes a long time for conventional mortgage lenders to even say a NO to your loan application.
Thus, if time is of the essence for you in your nature of commercial real estate lending, going ahead with private money lending has the upper hand over its conventional loan mortgage counterpart.
The best part is that once you’ve started working with a private money lender for some time and have built a solid good relationship, it becomes even easier for you to get your loan requests approved at lightning speeds and make your investments on time, every time. Whereas with conventional Mortgage, you should go through the whole documentation process all over again every time you wish to apply for a loan.
#2 – Loan qualification requirements
One of the major differences between hard money lending and conventional lending is the qualification requirements that are expected to be met by the borrower. Conventional lending involves a big list of loan qualification requirements and the conventional lenders are extremely critical of a borrower’s financial profile.
The process of loan approval by a traditional lending institution like a bank or a credit union is not only a lengthy one but also tedious as it requires a lot of documentation, great credit scores, and an income verification proof that you can pay off the monthly loan liabilities on time, additionally to paying up the 20% down payment costs and other upfront costs and legal fees associated with getting your loan request approved.
Private money lenders, on the other hand, are less concerned about your credit scores and are more interested in the property value and are more than willing to approve loan requests that propose a solid project plan.
Bottom line: If you have poor credit scores and not enough capital that can convince any lender that you will pay off your loan liabilities on time, a conventional mortgage becomes too far fetched for you and an easier alternative for you would be commercial real estate private money, lenders. On the other hand, if you have solid credit scores and a good financial profile and are on a lookout for a long term loan, conventional mortgages would do justice for you at much lesser rates than the hard money loans.
#3 – Nature of the property
The next thing that sets conventional mortgages apart from private money lending is the nature and type of the property. Traditional mortgages are generally approved for properties that are either single-family or multi-family properties where the borrower is the owner and he intends to use the property for residential purposes.
On the other hand, private money lending supports commercial properties that are not intended to be used for residential purposes by the owner and generally involve properties that are most likely fix-and-flip properties.
Hard money loan lenders also provide funding to owners who want loans for their residential properties but that is not their specialty and in most cases, a homeowner who wants to live in the home he’s buying does not generally choose to work with private money lenders due to the high rates of interest and the short term within which the loan must be paid off.
In a nutshell, hard money loans are the best for non-owner occupied properties or commercial properties whereas traditional mortgages are the best for owner-occupied properties.
#4 – Rates of the loan
Hard money loans generally carry higher rates of interest as compared to their conventional mortgage counterparts. The major reason behind this would be that private loans are short term and do not extend over a long period, say 20 to 30 years like conventional mortgages.
Besides, private money loans are typically provided on distressed properties that require fix-and-flip, thus making them a riskier venture calling for higher rates of interest.
If you can put down a down payment of at least 20% of the property value and want a long term period of the loan, the best form of financing will be to go ahead with conventional mortgages as you can save up largely on the interest costs. However, as we mention earlier, if you suffer from a poor credit score and it’s next to impossible for you to find a conventional mortgage, you have to choose to work with private money lenders.