Hard money loans and conventional loans share several similarities. Both loans are secured and used to buy property, and you need to apply and be approved. Once the loans are funded, both need to be repaid with interest over a set time period.
However, that’s about where the similarities end.
From their purpose, their approval process, and even to who lenders are, hard money loans are vastly different from conventional loans.
In short, if you need “hard” money fast and for a short time period, hard money loans are the way to go. If you’re looking for something long-term, a conventional loan is probably your best bet.
In this post, I will discuss:
Let’s get started with this post.
What Is A Hard Money Loan?
Hard money loans are short-term loans (usually between 3 - 36 months) you receive from individual or private lenders. Hard money lenders accept tangible assets as collateral for the loan you need, and if you’re unable to repay, lenders can take ownership of those assets.
Hard money loans were originally thought of as a loan of “last-resort.” Commonly, borrowers will consider a hard money loan as an option if their mortgage application gets denied, or if they want to avoid the lengthy approval process for traditional loans. Traditional mortgages can take a month or even longer sometimes to get approved, while a hard money loan can take just a few days.Since their inception, some homeowners and real estate experts have discovered that hard money loans come with other great benefits: they’re perfect for house flipping, rental properties, and commercial properties - but more on that later.
What Is A Conventional Loan?
A conventional loan, also known as non-conforming or traditional loan, is a loan that follows the guidelines set by two government-sponsored enterprises: Fannie Mae and Freddie Mac. They’re the ones that purchase lenders' real estate notes, and conventional banks' loans always follow their guidelines.
Traditional lenders can’t sell the notes without adhering to their guidelines. However, they can enjoy the benefits. By following their guidelines, traditional lenders are protected, as are any financial institutions that buy your note later on.
Also, there are several types of conventional loans, and each of them comes with different requirements. Some require higher down payments, while others have raised credit score minimums to qualify.
Conventional loans are much more common, especially for first-time home buyers or anyone else looking to take out a long-term loan. Often, borrowers apply for loans for 15, 20, or 30 years and enjoy lower interest rates compared to hard money loans.
Since there are more regulations for conventional loans, they usually take longer than hard money loans. Increased regulations can be annoying, but they also provide better protection from predatory lender practices, to which hard money borrowers fall victim.
Should You Get A Hard Money Loan Or A Conventional Loan?
There’s a time and place for both hard money loans and conventional mortgages. However, there is a common distinction between the two:
When To Apply For A Hard Money Loan
As I mentioned earlier, hard money loans are more commonly meant for house flippers and people buying a commercial or investment property. If you have poor credit history or are denied conventional financing, a hard money loan may be your only option (besides taking the time to boost your credit).
Let’s take a deeper dive into each of these scenarios.
If you’re an experienced real estate investor and/or have the skills to buy a fixer-upper, renovate it, and resell it, then short-term financing is probably all you need. Conventional bank loans are for 15, 20, and 30-year loans. As a house flipper, you probably only need someone to lend money for a few months.
You won’t mind paying the high hard money interest rates, because you won’t be paying them for long. If you know what you’re doing, the profit you’ll enjoy should more than make up for it.
For instance, let’s say you buy a property for $100,000. Your down payment is $25,000, and you take out a hard money loan for the rest ($75,000) with a 12% interest rate. Then, you spend $20,000 on renovations over 4 months and resell it for $175,000:
How much you spend
Hard money interest
($75,000 x 12%) = $9,000
$9,000 / 3 (4 months is ⅓ a year) = $3,000
Profit - Expenses
Amount from resale
Original purchase price
Your expenses - your down payment
($48,000 - $25,000)
(not including resell fees or capital gains tax)
Not bad for 4 months!
Commercial And Investment Properties
Sometimes the amount you need is more than what a traditional lender can provide. After all, conventional lenders have limits on the amounts they can loan to people. If you need a lot of capital and know that you can make it up quickly, then a hard money loan could be your best option.You could also look into jumbo loans, but you need a minimum credit score of 700, and even then they’re not ideal for all situations.
You’re Denied Conventional Financing
Traditional mortgages have stricter criteria. If you don’t have great credit, or if your debt-to-income (DTI) ratio is too high, or if you fail to meet one of a conventional lender’s other requirements, your loan will be denied.
Hard money lenders have fewer requirements. Sometimes they don’t even look at your credit history! We’ll talk more about lender requirements a little later.
When To Apply For A Conventional Loan
If you’re looking for a long-term loan, going with a traditional mortgage is your best bet. Because these loans are paid off during long periods, conventional loans offer significantly lower interest rates. Also, the regulations required of them help protect you from predatory lending practices.
Approval for conventional loans takes longer. However, if you’re planning on owning the property for longer than a year or two, it’s well worth the wait.
Requirements Of Hard Money Lenders And Conventional Lenders
Hard money lenders and conventional lenders may both look at your credit history, the property purchase price, and recent appraisal and inspection information (emphasis on “may”). Beyond that, they’re interested in different things.
Hard Money Lenders Are Interested In Value
Hard money lenders want to make a quick return on their investment. To make a quick return, they need to know that you know what you’re doing, and that the value of the real estate investment can cover the loan. In other words, they’re interested in the loan-to-value (LTV) ratio.
The LTV ratio is pretty straightforward. You’re simply dividing the loan amount by the after-repair value (ARV) of your property or other asset. Let’s return to the house flipping scenario from earlier. In order to buy the $100,000 property, you needed a $75,000 loan. After renovations, the property’s ARV was $175,000. Therefore, your LTV ratio is $75,000/$175,000, or roughly 43%.
While the percentage varies, many hard money lenders prefer an LTV ratio of 70% or less. If you default on your loan and the lender takes over the property, they’ll need to sell it to make good on their investment. A 70% LTV ratio also ensures you’d be disincentivized to walk away from the project if things get tough.
Traditional Lenders Are Interested In DTI
While a hard money lender is looking to make a quick return, a conventional lender is focused on making a secure one. Since you’re in it for the long haul, banks and other traditional lender sources are more interesting in your ability to pay your loan. Are you making enough money to afford monthly mortgage payments, or are your other debts going to be a problem?
Traditional lenders look at your proof of employment, tax forms, and credit reports to determine your DTI ratio. Like the LTR ratio, your DTI ratio is easy to figure out: you take all your debt and divide it by your monthly gross income.
Let’s say your car payment, student loans, and credit card bills come to $1,500 a month. That’s your debt. Your monthly gross income is $5,000. Therefore, your DTI is $1,500/$5,000, or 30%.
While the amount deviates slightly between lenders, your DTI needs to be less than 43% to get a conventional mortgage. If it isn’t, your conventional lender may not approve the loan because they fear you’ll be unable to repay it.
Hard Money Loans vs Conventional Loans: The Application Process
A hard money lender can approve your application in a matter of days, while getting approval from conventional lenders can take months. The reason why lies in the application processes themselves.
Hard Money Loan Applications
The requirements for hard money lenders vary greatly. Some are merely interested in your assets and LTV ratio. Others are more stringent and have more requirements, such as:
Conventional Loan Applications
Traditional lenders have far more hoops to jump through. They'll research your income and credit history, other assets you have, and DTI ratio. However, that’s just the beginning.
Here’s what the conventional loan process looks like:
Down Payment Requirements
Different loans and homes require different down payment amounts. Unless you qualify for a VA loan or USDA loan (in some cases even then), you'll need to put some money down. If you…
Except on rare occasions (like getting a VA loan), if your down payment is less than 20%, you’ll also be paying private mortgage insurance (PMI). PMI protects your lender if you default on your loan. It usually costs .5% - 1% of the total loan amount, though the amount varies depending on your loan, score credit, down payment size, and if you pay some of it during closing. Once you have 20% equity in your home, your lender can remove PMI. Once you reach 22% equity, it goes away automatically.In addition to having enough money for a down payment, you’ll usually need a credit score of at least 620, and your loan amount must be within the limits of your area. Conventional loans usually cap out at around $647,200. In high-cost locations, the cap is raised to as high as $970,800. If that’s a concern, you can check the Federal Housing Finance Agency website to see what the conventional loan cap is in your area.
Traditional lenders usually require you to get a pre-approval letter. A pre-approval letter shows how much you’re approved to borrow, based on your income, credit history, and savings. This letter is vetted against your W2s, bank statements, credit reports, and more.
The pre-approval amount is an actual offer, not merely an estimate. However, I recommend you only take out a loan for the amount you need, not the total amount you’re approved for.
You need to get this letter before making an offer on a house. Also, just because you’re pre-approved doesn’t mean you have to stick with the lender you get a pre-approval from. If you find someone you like more or can get you a better deal, go for it!
The Mortgage Application
Once you’re pre-approved and have chosen a lender, you’ll need to fill out your mortgage loan application. Much of this application was completed when you got pre-approved, but a few more documents are necessary to get a loan file through underwriting.
During this stage, you’ll typically need recent bank statements, pay stubs, and earnest money. Once it’s completed, you’ll receive a loan estimate within 72 hours, listing the exact terms, rates, and fees of your loan.
The Appraisal Process
While all this is going on, your lender needs to arrange for an appraiser to provide their estimate of the value of the property you’re purchasing. The appraiser’s job is to determine if you’re paying a fair price. Without an appraisal, your loan can’t get approved at its contracted purchase price.
Often, your appraiser will be a third-party company.
Next, hurry up and… wait.
Your loan processor will prepare your file for underwriting, which requires ordering all necessary credit reports, conducting a title search, getting tax information, and more.
You may be required to explain any collections, judgments, late payments, income discrepancies, credit issues, etc. If you’re asked, reply ASAP to ensure this step continues smoothly.
Once the processor verifies and puts everything together, they send it to the underwriter. The underwriter goes over it with a fine-toothed comb to ensure you can pay the loan and that the property you’re buying is sufficient enough collateral for the loan.
They might also have questions. Reply ASAP if they do.
The Closing Process
FINALLY, you get to sign the closing documents. There are many of them. Your wrist will be sore by the end of the signing.
Two documents worth noting at the Loan Estimate and the Closing Disclosure. The Loan Estimate is a document you signed earlier that gave you the estimated costs. The Closing Disclosure confirms these costs. They may not be an exact match, but they should be very close.
And that is the short version of the conventional loan application process. As you can see, there’s a reason it sometimes takes months.
Hard Money Loans Or Conventional Loans: Which Is Better?
In short, that’s for you to decide. If you’re looking for an investment property, then a hard money loan is the way to go. If you’re looking to take out a long-term loan for a primary or secondary residence, you should get a conventional loan.
Are you looking to buy land? Check out our post getting a hard money loan for land.Have you been denied for a conventional loan before because of your low credit score, or recently filed for bankruptcy and know you won’t qualify? Read our post about hard money loans for bad credit.