It is not strictly necessary to obtain a mortgage through a bank or credit union. With a private money, or hard money loan, the money is not borrowed from a bank, but rather another person or business.
A private mortgage is a legal agreement between two individuals, or an individual and business. While there are several potential risks to a private money loan, most can be avoided through clear planning and documentation.
Private money loans are often used by borrowers who have been turned down by financial institutions. Many borrowers over the last few years have found themselves unable to obtain a mortgage due to strict lending requirements imposed by major lenders. While hard money loans have typically been used by home investors to secure real estate, more homeowners are now turning to private lenders.
Advantages of Private Mortgage Loans
- Easier to qualify. Private money loans can be a good option for homebuyers who are unable to qualify for a traditional mortgage, due to bad credit or substantial debt, as well as self-employed individuals who have difficulty proving steady income. Underwriting for hard money loans tends to be more focused on the property, not the individual borrower, so even buyers with poor credit can obtain a private mortgage if the project seems profitable.
- Geared toward fixer uppers. Homes that need extensive renovations and repairs do not qualify for a conventional mortgage, even if the borrower has excellent credit. In these situations, private money loans may be a good option.
- Short approval process and funding. The approval process for most private loans takes just a few weeks, compared to 30-45 days for a conventional mortgage. Some borrowers feel this is a fair tradeoff for higher interest rates.
- Good option for home flippers. While hard money loans usually have a shorter repayment term, this may be an advantage to home flippers who plan to sell the property within a short period of time, or investors who plan to qualify for a conventional mortgage within a few months.
Downsides of a Private Mortgage
Private mortgages almost always have much higher interest rates than conventional mortgages. The rates are sometimes more than double the average 30-year mortgage rate, (generally between 10 and 20%). This is because private lenders do not require excellent credit.
Private money loans also require a higher down payment, as private lenders lend at significantly lower loan-to-value (LTV) ratios, (usually, just 65% compared to 80-90% with an institutional lender). This means borrowers must put down at least 25-35% to purchase a home with a private loan.
Private loans are usually not paid back over 15 or 30 years like a traditional mortgage. Most private money lenders expect the loan to be repaid in six to twelve months, occasionally going as long as two years. For this reason alone, most homebuyers should look elsewhere for a home loan. However, this does not pose a problem for most home flippers, who often turn to hard money loans while flipping property.
Borrowers will also be unlikely to receive tax benefits, such as mortgage interest deductions, that are received with a traditional loan.