Hard Money Business Loans: What Are They & Should You Get One?
Is a poor credit rating preventing you from accessing the immediate cash you need for your business? If so, and if you have available collateral to back up a small business loan, a hard money business loan might be a good solution.
What is a hard money business loan?
Hard money business loans are collateral-backed loans that can give entrepreneurs easier access to capital — regardless of their creditworthiness or time in business. These loans are similar to bridge loans and are usually secured by real estate, such as a commercial property, residential property or land. Business owners who have less-than-stellar credit, just opened their doors or need cash in a relatively short period of time might be great candidates for a hard money business loan.
The catch is that these loans often come with higher interest rates and a quick repayment schedule — this makes them very risky and often difficult for borrowers to pay back. Traditional lenders don’t offer hard money loans, but nontraditional lenders, such as private individuals and private funding groups, do. In most cases, private lenders use their own money to finance these secured loans.
“They offer an execution that’s fast and predictable and they don’t have as many regulations to deal with as commercial banks do,” explained Terrence Young, director of commercial banking at Urban Partnership Bank in Chicago. Traditional banking institutions must adhere to state and federal regulations, but if it’s private money, they can choose whatever rules and regulations they want to follow.
Young said he’s noticed a “rapid growth” in hard money lending following the 2008 financial crisis, attributing some of the increase to the banking industry tightening requirements for small business loans.
“I won’t say that’s the case with every bank, but with some banks in the banking industry, it could be tough for small business owners to qualify for a standard loan,” he said.
Hard money lenders have more lenient policies and control their own rates and criteria, which includes quicker approval and funding times. These loans often carry double-digit interest rates that surpass subprime rates. These lenders might not have to follow the same guidelines as conventional banks, but they do have “traditional underwriting criteria” they follow that protects them and their borrowers, Young explained.
Young also noted that hard money loans offer a quid pro quo scenario between lenders with money who want to make a profit and entrepreneurs in need of funding, but with limited options.
“There were some smart [investors] with money who said, ‘Hey, maybe if we offer a slightly different execution, we can make some money in the process and help those people reach their goals and achieve their dreams at the same time,’” Young said.
Who should consider a collateral-backed loan?
Hard money loans are risky in nature. Lenders mitigate those risks by requiring borrowers to secure the loan with hard collateral that could be easily liquidated in the event of default. Entrepreneurs who own real estate, such as residential, commercial, industrial or land properties, have a better chance of getting approved for a hard money loan. For this reason, hard money loans are very popular in the real estate industry, because the apartment building you want to invest in could be used as collateral.
“The lender’s going to want to have access to that collateral just in case something goes wrong. If you forfeit or you don’t pay them back, they take your collateral and then they sell that collateral to try to get repaid,” Young said.
Hard money lenders aren’t going to give you dollar-for-dollar on your land or buildings. Instead, these lenders offer a lower loan-to-value ratio that’s usually 50 percent to 80 percent of your collateral value, he explained. If your collateral is a $100,000 property, a hard money lender will likely lend you $50,000 to $80,000. This provides a cushion for the lender in case the collateral value is misestimated or something happens in the marketplace.
“Another reason why they do it, too, is because there’s a general feeling among credit people that borrowers need to have some skin in the game. That skin is that money you put in the deal,” Young said.
Lenders might be willing to accept a marketable security such as stocks and bonds as collateral. They might even accept a precious metal or art collection as collateral if they feel it could be liquidated.
Even though hard money lenders will consider funding a startup business, business owners who’ve been operating longer might be better suited for this type of loan because they’re more established and will likely have steady cash flow that will enable them to meet the terms of the loan.
The risk, however, isn’t just with the lenders. Borrowers who are unable to repay the loan according to the terms risk losing their collateral.
“You can lose your collateral … but you can do that with a bank, too. It’s just that with a hard money lender you can probably lose it faster or it’ll cost you more to redeem it,” Young said.
Hard money business loan advantages
One of the most attractive features of a hard money loan is that as long as you can back the loan with a liquefiable asset, approval should be quick and easy.
“I’m a banker and from what I’ve seen, they can be very fast and a little more flexible because they don’t have the same federal regulations to follow,” Young said.
Aside from offering speedier approval and closing processes, these lenders evaluate each applicant on a case-by-case basis, have more leeway with the underwriting process and could adjust the repayment schedule. All of this provides a level of flexibility that isn’t available with conventional banking.
“The pros of it is if you only need it for a short period of time and you need it quickly, they can be a better option for some investors and for some companies,” Young said.
These lenders prioritize valuable collateral over creditworthiness, making it an appealing option for those with poor and fair credit. And, depending on how the loan terms are structured, hard money lenders have to follow the same legal process for repossessing your collateral that a bank does if your loan defaults, Young explained.
“I think a lot of those hard money shops are entrepreneurial people themselves and perhaps there are some situations where they may better identify with their customer base than perhaps a bank might,” Young said.
Hard money business loan disadvantages
Although some private lenders might identify with the entrepreneurial spirit of small business owners, their priority is to make money.
“Most hard money lenders are more focused on their money than they are trying to help the little man,” Young said.
One of the drawbacks of hard money business loans is that they’re expensive. The fees and interest rates are higher than what conventional banks offer and could be more costly than even subprime loans.
The unregulated nature of these loans allows lenders to have more lenient rules that cater to borrowers with bad credit and those who need cash fast. Being unregulated, however, also allows these lenders to set terms that might be prohibitive. If a traditional bank offers a loan with a 5 percent interest rate, the private lender’s product will likely double it.
“And if the bank is charging a 1 percent fee, that hard money lender is probably going to charge you anywhere from a 5 to 10 percent fee. So, it’s expensive,” Young said.
Another concern is that these loans have shorter repayment plans that are typically no more than a year in length. So, you’re looking at repaying a loan with higher interest rates and fees in a relatively short period of time. And you could lose your asset if the loan defaults.
When it makes sense to get a hard money business loan
Each entrepreneur must evaluate his or her needs to decide if committing to a hard money business loan makes sense. Asking yourself honest questions could help prevent a lot of financial trouble down the road.
Young described the ideal hard money borrower as an entrepreneur who has successfully operated his or her business for at least three years, has lots of experience and owns sufficient collateral. These individuals have to be confident that they can repay the loan within the agreed upon terms. Many hard money loan borrowers are real estate investors because real property serves as good collateral.
The amount of experience the borrower has is also important because a business’s first five years of a business are the riskiest and many don’t survive beyond that. A more experienced business owner may be better equipped to navigate any challenges that could arise during the repayment schedule, explained Young. This isn’t to say that startups shouldn’t consider hard money loans, but they do need to do their due diligence beforehand.
“I won’t say stay away from it because that money could be the key to their success, their survival. But they need to be very careful,” Young warned. “They need to have a very well-thought-out business plan and maybe even a Plan B.”
The backup plan would include cost-effective methods to pay off the loan within the agreed terms. It’s also important to read the fine print and familiarize yourself with the jargon that’s commonly used in the industry.
Debt is one of the worst things that a small business operator could take on, and in many instances, finding an equity partner or angel investor is the better option.
“You don’t want to go into a situation, perhaps, without your lawyer, accountant or your team in place. Because, at the end of the day, that institution that you’re borrowing from is going to look out for their interest first,” Young said.