One of the critical decisions for borrowers is choosing between private money loans and bank loans. Private money loans, also known as hard money loans or bridge loans, are provided by private investors or non-institutional lenders. These lenders assess the loan application based on the potential profitability of the property and the borrower's real estate strategy. Private money lending is often favored by real estate investors who require quick financing or have complex financial profiles that do not meet the strict requirements of traditional lenders.
On the other hand, traditional mortgages are issued by financial institutions such as banks or credit unions. These loans follow a rigorous approval process that examines the borrower's credit history, employment status, debt-to-income ratio, and financial stability. Traditional lenders often offer longer loan terms and lower interest rates, making their loans more appealing to homeowners and real estate investors looking to hold onto properties for longer periods.
The borrower can be professional entities, private companies, or individuals. Unlike traditional lenders, private lenders focus more on the value and potential profitability of the property, allowing borrowers to seize timely investment opportunities. Private money loans are commonly used for short-term financing.
Private money loans offer several advantages and disadvantages for borrowers in real estate projects.
One of the significant advantages of alternative lending is the speed of funding. Private lenders can often close a deal in less than two weeks, providing quick financing solutions for borrowers who need funds urgently, such as real estate investors in competitive markets. The streamlined approval process and minimal documentation requirements contribute to the faster funding timeline offered by private lenders.
In contrast, the approval time for a bank mortgage can be lengthy, often taking a couple of months. Banks follow a more detailed underwriting process, which includes verifying the borrower's credit history, employment status, income, and debt-to-income ratio. The slower application process can be a deterrent for borrowers looking for fast funding.
Private loans generally carry higher interest rates and fees compared to bank mortgages. This higher cost of borrowing is due to the increased risk associated with alternative lending, as lenders often provide financing to borrowers with less than perfect credit history or to properties in transition.
Bank mortgages, on the other hand, offer lower interest rates and fees, making them more appealing to borrowers with good credit and verifiable income. The lower cost of borrowing with bank mortgages is a result of the rigorous underwriting process and the lower perceived risk associated with traditional lending institutions.
The interest rates for both types of loans can vary depending on factors such as the borrower's creditworthiness, the term of the loan, and the overall market conditions. Here is a comparison of interest rates for alternative lending and bank loans based on a hypothetical scenario at the time of this writing:
|
Loan Type |
Interest Rate Range |
|
Private Loan |
10% - 12% |
|
Bank Loan |
5% - 8% |
It is important to note that these interest rates are for illustrative purposes only and may not reflect actual market rates.
Common fees associated with private loans may include origination fees, processing fees, closing costs and prepayment penalties. These fees contribute to the overall cost of borrowing and should be carefully considered when evaluating loan options. It is essential to review the fee structures of both alternative lenders and banks to determine the most cost-effective commercial real estate loan for your next project.
As one example, commercial banks usually require appraisals for commercial properties be done by appraisers with “MAI” designations. These appraisals are often more expensive and take longer than those often required by private lenders.
Loan terms play a crucial role in the impact on investors when choosing between alternative lending and bank loans. The term length and repayment flexibility can significantly affect the feasibility and profitability of the investment.
Hard money lenders typically offer shorter terms compared to bank mortgages. The shorter-term length of alternative lending can be advantageous for real estate investors who plan to sell or refinance the property within a shorter period.
Bank mortgages, on the other hand, offer longer repayment terms, typically 15 or 30 years for residential loans and usually 3, 5, 7 or 10 years for commercial loans. Longer loan terms provide greater stability for long-term real estate ownership. However, the longer loan term can also result in higher overall interest payments.
With things like leases, estoppels, income/expense history and the like, commercial real estate loans are more difficult and time-consuming to underwrite. Given that, commercial lenders often have “prepayment penalties” associated with these kinds of loans. The penalties are often expensive relative to the loan amount, particularly if prepaid within a brief period after the loan closes. For example, a 5-year term loan on a commercial property might have a prepayment penalty as high as “5,4,3,2,1”. This indicates that if paid off during the first year, the borrower would have to pay 5% of the outstanding loan amount when they pay off the loan.
Most private loans – even those on commercial property – usually have a relatively weak prepayment penalty, such as an “interest guarantee” of a certain number of months.
Given that, particularly if the borrower is looking for a relatively short-term loan, it could be that the cost of the private loan may even be less than the cost of the commercial bank loan, depending on how long the borrower keeps the loan.
When it comes to repayment flexibility, hard money loans offer more options compared to bank mortgages. Alternative lenders often allow borrowers to customize the repayment terms based on their unique financial situation and investment strategy.
Private lenders commonly offer interest-only payments, allowing borrowers to focus on cash flow during the loan term. They may also provide more flexibility in prepayment penalties, allowing borrowers to pay off the loan early without incurring excessive fees.
On the other hand, bank mortgages typically have more rigid repayment structures. They often require full principal and interest payments throughout the loan term. While some banks offer options for bi-weekly payments or early repayment, these options may come with restrictions or additional fees.
As an example, an investor plans to purchase a non-performing commercial property that she plans to sell (or refinance) shortly after repairing and re-tenanting the property. The investor needs to close quickly due to multiple offers and a competitive market.
Should she borrow money from a private lender or from a commercial bank?
For this purpose, it could be a great idea for the borrower to get a short-term interest only private money loan may be beneficial due to the quick underwriting and approval and weak prepayment penalty. The investor can renovate the property, fill the vacancies with quality tenants and move on to their next investment opportunity or refinance this one.
Both private lenders and banks provide commercial real estate loans. As is the case with all real estate loans, the loan amount is backed by the property, meaning that if the borrower fails to make the monthly payments, both types of lenders have the right to seize and sell the property to recover their funds.
Loan-to-Value (LTV) ratios play a crucial role in determining the amount of financing provided by lenders. In some cases, private lenders may offer higher LTV ratios compared to commercial banks, allowing borrowers to access more funds for their real estate projects. This is often particularly true for value-add rehab projects, particularly for smaller investment properties.
Private lenders such as Red Tower Capital considers factors such as the location of the property, market conditions, rental income potential, and the borrower's experience and track record in real estate. They also evaluate the property's condition and any existing leases or tenants. By assessing the security of the investment property, lenders can determine the level of risk involved and make informed decisions about providing financing.
The LTV ratio determines the maximum loan amount that a bank is willing to provide. For example, if a property is appraised for $1 million and the bank has an LTV ratio requirement of 65%, the maximum loan amount would be $650,000. Banks set LTV ratios based on property type and their risk assessment and the potential for the property to maintain its value over time.
Borrowers who do not meet the strict criteria of bank loans may find it difficult to secure financing for their commercial real estate projects. Furthermore, there are restrictions on property types and loan purposes with bank loans. These projects include non-warrantable condos, vacant lots and land, and properties in need of major repairs. In such cases, hard money loans can be a viable alternative.
Private money loans offer distinct advantages over traditional bank loans in the realm of real estate. While hard money loans provide faster funding, more flexibility in terms and often weak prepayment penalties, they may come with higher interest rates and upfront fees. Whether opting for speed and adaptability with private money loans or stability and lower costs with bank loans, choosing the right financing approach is critical in achieving success in your real estate ventures. Contact us to get more information and discuss your real estate financing needs.