If you’re considering a hard money loan, figuring out why the interest rates are set the way they are can help you make informed decisions. Interest rates aren’t just random numbers; they’re well-thought-out figures lenders use depending on the loan’s risk.
Do you want to understand how they work before you invest in real estate? What determines the interest rate of a hard money loan? This guide takes you through the factors that affect the overall cost of your loan. In addition, we’ll discuss the annual percentage rate and differentiate between a hard money loan and a traditional bank loan.
Table of Contents
Understanding Annual Percentage Rate (APR)
Annual Percentage Rate, alternatively called APR, is the total cost of borrowing expressed as a percentage. It is the interest rate, fees, and other charges you might pay to get the loan, like application and origination fees. That’s why one of the essential questions to ask a hard money lender is, “What are your additional charges?”
The APR is an essential metric for landlords because it gives you a more comprehensive view of what a loan will cost annually. It’s a helpful tool when comparing loans because it considers both the interest and additional expenses. In other words, it is a more holistic metric for borrowers.
However, remember that the lower the APR, the less expensive the loan is overall, and vice versa. So, when navigating loans, focusing on APR provides a clearer picture of the actual cost and helps you make informed financial decisions.
Factors that Affect Interest Rates
Leverage
A property’s value can significantly affect interest rates through what experts call leverage. For example, a three-bedroom SFU is more expensive than a single apartment in the same unit. In other words, the former has more leverage than the latter.
Thus, the first investor would require a bigger loan to refurbish the three-bedroom effectively. That means the lender would have to take on more risk. Hard money lenders in Baltimore can help leverage and process funds for a rehab project while keeping interest rates at a minimum.
Loan Term
Besides leverage, the duration of the loan matters. Shorter terms may have lower rates but higher monthly payments. In contrast, longer terms mean lower monthly payments but higher overall interest costs. Thus, opt for a duration that allows you to meet your monthly repayments comfortably.
Property Type
Property type can play a pivotal role in determining interest rates. Due to varying risk profiles, residential properties may have different rates than commercial ones. Although commercial properties often have higher interest rates, they vary depending on the property’s state, neighborhood, and size.
Creditworthiness
Another crucial factor that can affect interest rates is creditworthiness. A borrower’s credit history and financial health significantly affect interest rates. Better credit often translates to lower rates, especially with conventional mortgages. Conversely, poorer credit reflects a higher risk for lenders and, consequently, higher interest rates.
Market Conditions
Market conditions affect interest rates on a broader financial landscape. During a recession, interest rates tend to decline as the government tries to encourage investments. However, during periods of growth, central bank policies can hike interest rates as competition grows.
How Do Hard Money Loans Differ from Traditional Bank Loans?
Although different factors affect interest rates similarly, hard money and traditional bank loans differ significantly. Here’s how:
1. Approval Speed
Quick approval is a hallmark of hard money loans and one of the reasons investors often opt for it. Due to its focus being less on a borrower’s credit history and more on the value of the collateral, the approval process is greatly expedited. On the other hand, traditional bank loans require more bureaucracy. Detailed credit checks, income verification, and detailed financial assessments extend the process.
2. Risk Tolerance
Hard money loans cater to higher-risk scenarios. Thus, they’re more suitable for house flippers or those needing quick, short-term financing. As a result, it’s a more common financing option for investment properties or renovations.
In comparison, traditional bank loans are popular for lower-risk situations. They’re a better option for personal and long-term financing needs. They’re commonly used for personal mortgages, business loans, or long-term financing needs.
3. Interest Rates
On average, hard money loans tend to have higher interest rates. Considering they come with increased risk, lenders are more likely to hike their fees as compensation.
Meanwhile, traditional bank loans with lower risk tolerance are on par with their lower interest rates, especially for borrowers with good credit.
Conclusion
Understanding what determines the interest rate of a hard money loan is crucial for borrowers. From leverage and creditworthiness affecting the lender’s risk, various factors can weigh in on your annual percentage rate. The loan term, property type, and market conditions can contribute to a higher or lower interest rate.
Yet, despite these factors affecting interest rates across the board, distinct differences still exist between hard money and traditional bank loans. With their swift approval, collateral-centric focus, and higher risk tolerance, hard money loans cater to niche scenarios like real estate investments. In contrast, traditional bank loans, emphasizing creditworthiness, lower risk, and diverse purposes, remain a staple for personal and long-term financial needs. Understanding these distinctions helps borrowers choose financing options that align with their specific needs and circumstances.
