In the world of real estate finance, there are two well-known ways for buyers to fund acquisitions:

1) Traditional Bank Loans

2) Hard Money Loans

Hard money loans are made primarily by private lending companies and individuals to real estate investors.

The term “hard money” refers to the fact that these loans are made based on the value of the property used as collateral rather than the creditworthiness of the borrower.

Various factors, such as market conditions, the financial strength of the borrower, and the condition of the property, will dictate which type of loan is most advantageous for your deal.

When to Use a Traditional Bank Loan

When is it advisable for a buyer to finance an acquisition using a conventional bank loan?

First, let’s consider the tone of the real estate market:

• Is the market overheated?
• Are sellers receiving multiple offers at or above their asking prices?
• Is there a scarcity of inventory?

If none of the above conditions exist, then the most sensible course of action is to secure financing from a bank.

Keep in mind, banks take substantially longer to approve and fund a loan than a typical hard money lender.

If market conditions are such that the speed of a transaction is not a concern, then using a commercial bank makes sense.

Using a traditional bank makes for a successful transaction, provided the borrower can satisfy the bank’s rigorous lending standards. The credit score of an ideal borrower is important, as is the type of real estate project and the borrower’s debt-to-income ratio.

It is advisable to use a bank with which the borrower has an existing relationship. If the bank knows the borrower and the borrower knows the bank, the chances of having a successful transaction are high.

When to Use a Hard Money Loan

If the real estate market is overheated and buyers outnumber sellers by a wide margin, a real estate investor could consider using hard money instead.

A hard money loan can free up the investor to make an all-cash offer and could be the difference between completing a transaction and losing out to another buyer.

1- Speed of Funding

With a traditional bank loan, the process from start to finish usually takes several weeks or even months.

In contrast, a hard money loan can be funded in less than a week because there is less reliance on the borrower’s financial history.

This ability to fund quickly is the principal advantage of a hard money loan.

2 – Distressed Property Acquisition

The second advantage of a hard money loan arises when the borrower is purchasing a distressed property.

If the property is in poor condition and requires a major rehab, it might not qualify for a conventional loan. 

In that case, the borrower can still obtain financing via a hard money loan.

Once the property has been renovated, the borrower refinances out of the hard money loan and into a traditional bank loan.

3 – Fix-N-Flip Projects

The third advantage of using a hard money loan is when the transaction is a fix-and-flip project.

Such projects are of short duration, ranging from several weeks to a few months. There is a timeline, a clear estimate of the cost of the project, and a realistic plan to market and sell the property.

To qualify for a fix-n-flip loan, most hard money lenders will require the borrower to have experience in this field. Getting funding for your first fix-and-flip project will be challenging if you do not have experience or a partner with a successful track record.

4 – Customizable Terms

Last but not least, the terms of a hard money loan are often tailored to the specific needs of the borrower.

The loans can be interest-only, have flexible payment schedules, and have lower loan-to-value ratios. For many fix-and-flip projects, cash flow is a primary concern, and having flexibility with respect to terms is important.

For more background on hard money, check out the complete guide.

What to Watch Out for With Hard Money

What should a buyer be aware of when deciding whether or not to obtain a hard money loan?

1 – Higher Costs

First and foremost are the higher costs associated with hard money loans.

The interest rate on a typical hard money loan can be three or four percentage points higher than on a traditional bank loan.

2 – Clear Exit-Strategy

Second, the buyer must have a clear and viable exit strategy that is realistic and accounts for possible changes in market conditions, such as an increase in interest rates causing demand to plummet or an influx of new construction in the proximity of the property.

3 – Avoid Being Over-leveraged

Third, the borrower must avoid being debt-heavy.

Investors must not be over-leveraged. Being over-leveraged could lead to a default and the loss of whatever equity the borrower contributed to the project.

4 – Scammers

Working with a bank also allows the borrower to avoid various pitfalls inherent in the practices of some hard money lenders.

A few hard money lenders offer terms that are so favorable they outshine all other lenders (including banks) by a considerable margin.

In this case, you can be almost certain the deal is most likely a scam.

Watch out for terms that include an interest rate that is below market rates or for lenders who ask for fees to be paid before borrowers receive funding.

If the lender does not require collateral and is willing to lend an amount equal to one hundred percent of the value of the property, back away and move on.

No successful hard money lender with their salt will ever offer a 100% loan-to-value ratio.

Also, watch out for lenders who try to change the terms of a loan just prior to closing or after closing.

Perhaps the clearest sign that a scam is in the works is if the hard money lender asks for an upfront fee to get the loan process started.

The fee can be a small amount, such as $4,000 or $5,000. Unfortunately, the loan is never funded and the borrower is out the amount of the fee.

For more background on hard money scams, check out the following guide.

In Conclusion

Choosing between a traditional bank loan and a hard money loan will ultimately depend on your goals, timing, and the particular conditions of the deal.

If time is on your side, you have strong credit, and the property is in good condition, a conventional bank loan will offer lower costs and more favorable terms.

However, when attractive opportunities arise in competitive real estate markets for distressed property acquisitions, or short-term fix-and-flip projects the speed, flexibility, and creative financing features of hard money loans can be an invaluable tool.

The key is understanding when and how to use each option.

Hard money loans reward investors with a clear exit strategy, local knowledge of the housing market, and a conservative approach to taking on leverage.

When used strategically and with proven lenders, hard money loans can capitalize on opportunities that traditional financing simply can’t match.