What’s a Hard Money Loan?
A hard money loan is defined as a loan which is secured by real property, as opposed to a non-secured personal loan. In a hard money loan transaction, the borrower offers some form of interest in their real property as collateral for the repayment of the loan. Hard money lenders are normally private individuals or companies, rather than banks or credit unions, and their loans are normally executed on a short-term basis, typically within 1 to 3 years.
A hard money loan can be either a first or a second mortgage. A first mortgage is simply the loan that was extended first, while a second mortgage is given on top of the first mortgage. A first mortgage normally has priority over all other mortgages on a piece of real property. A second mortgage will only be enforced after the first mortgage is paid off. The underlying property itself serves as the collateral for the loan, and the lender can take possession of the property if the borrower fails to pay back the loan .
Hard money loans are supposed to be different from regular loans in that they are intended to be transacted quickly and without many of the qualifications necessary to apply for a traditional loan. In this way, they offer a high degree of freedom and flexibility for the borrower. However, they also carry a higher interest rate and more severe penalties for failing to pay. Hard money lenders have more latitude than traditional lenders, which means that they can offer financing to borrowers who have less than stellar credit or multiple previous bankruptcies, but they can also demand much higher returns. Additionally, hard money lenders deal in larger amounts, with most loans ranging from $30,000 to $30 million, although the standard you might see from any individual hard money lender will vary quite a bit. The amount of equity a borrower has in their property is the most important criterion a lender will look at when considering whether or not to extend a hard money loan.
Essential Components of a Hard Money Loan Agreement
Like any loan, the written hard money loan agreements are binding. In that document, the borrower agrees to repay the lender under specific terms. A typical hard money loan agreement contains many of the same components as other types of loans. Important elements include:
Interest rates – Interest rates for a hard money loan vary from those offered by banks and mortgage lenders. The rates may be higher than other types of loans with comparable risks and restrictions. For example, if the bank offers a 5 percent interest rate but the hard money lender charges 9 percent, the borrower typically will choose the bank rather than the hard money lender even if the terms of the bank loan are less favorable overall.
Loan term – The length of the loan term can vary from one lender to another. As with interest rates, the term may be longer or shorter than that of other loans. The terms can vary depending on the amount of the collateral, the value of the assets pledged for the loan and regulatory issues, among other factors.
Collateral requirements – Like any loan, the borrower must pledge collateral to receive a hard money loan. When the lender uses the underlying real estate as collateral, the lender has the ability to foreclose on the property if the borrower defaults on the loan (for example, if the borrower stops making payments).
Lender credibility – The borrower assembles a hard money loan agreement from a private lender in a much different way than he or she would with a bank or other lender. The borrower usually has a preexisting relationship with a hard money lender who has proven credibility in the lending process.
Advantages of Hard Money Loans
One of the most sought-after benefits of a hard money loan is the elimination of most of the stringent rules and regulations that smaller real estate investors face when applying for traditional or even some non-traditional bank financing. Many real estate investors actually choose hard money loans over conventional financing because of the flexibility and efficiency of the process, not despite of it.
Flexibility
One of the most notable differences between hard money loans and traditional mortgage loans is the flexibility that hard money provides. Hard money lenders in the private sector are not limited by strict state and federal regulations in their ability to approve a loan application. Instead, a lender is guided by their own underwriting criteria as well as the overall risk versus the potential return on their investment.
The result of this, however, is that hard money lenders have the ability to make quick decisions and adapt their requirements according to the needs of each loan applicant and the overall risk associated with a particular deal.
Speed of approval
Another major benefit of hard money loans is the ability to obtain a loan and final approval in a matter of days, not weeks. Just the sheer fact that a hard money loan is able to close in a matter of days (sometimes even as little as 25 hours), rather than the standard 30 to 60 days that often comes with a traditional mortgage, has attracted a premium following among real estate investors who require speed when seizing on a specific opportunity.
Options for less-than-perfect credit history
Because of the nature of their financing, hard money lenders are able to work with individuals with less-than-perfect credit histories. A bad credit score is an indication of risk, but hard money loans are based on risk to return. Thus, if there is value in the underlying property, it is much more likely, almost guaranteed, that hard money lenders will approve the loan application.
Potential Downsides of Hard Money Loans
Although hard money loans can be useful and even necessary, there are also risks associated with them. For one, the interest rates on hard money loans are often extremely high, as mentioned above. It takes borrowers longer to repay a hard money loan than it does for a traditional loan. Hard money loans typically require a balloon payment in a relatively short period of time. Furthermore, if you default on a hard money loan, you run the risk of losing your collateral, as well as the future income you hope to generate by using that collateral. If the real estate does not generate the expected income or appreciate, then the investor may end up losing the property as well.
Potential Borrowers of Hard Money Loans
Because a hard money loan is generally used for the purchase or refinance of an investment property that is considered a high risk in traditional financing, the most likely hard money borrower is an investor or someone who needs urgent cash such as a business owner about to lose a property to foreclosure if they can’t come up with some cash quickly. Because a hard money borrower can pull out a 25 year amortization on most hard money loans, they can buy as much time as they need to sell an investment or refinance out of an existing hard money loan.
A real estate investor will purchase a property with the hopes of completing substantial renovations or making little to no improvements at all, renting the property out and then selling it or refinancing it when conditions are favorable for such an action. An investor can buy a property for much less than market value under an mortgage known as a sale-leaseback which allows the investor to pay fair cash for purchasing a property by purchasing the property for a quick cash price and then turning around and leasing the property back to the seller . Through a sale-leaseback, the seller of the property is allowed to lease their home from the investor until they can come up with the necessary funds to redeem their property and generally for a capital gain.
A quick closing is most important if you have a short sale that is likely to expire before your lender can make a decision to approve or deny your loan. An example of this is a person in a liquidation situation which is where a debtor does not have a realistic prospect of repaying their debt. Or, if you have a foreclosure pending of your home and are looking to purchase a new home because there is little or no equity in the home, you may want to buy or invest in another property with an instant equity position. A quick closing will provide you the availability to take advantage of such an opportunity.
Negotiating a Hard Money Loan Agreement
It is often the case that borrowers would like to secure better terms than they are offered on a hard money loan. While the negotiating power of a borrower is almost always weak compared to a lender and the lender’s interests, it is still worth pursuing better terms when possible. This is especially the case where negotiated terms can pay dividends in the future if the borrower is able to return to the same lender for more capital.
First, it is important to know that the lender will likely have its own in-house counsel qualified to review and negotiate the terms of any proposed loan. Further, the lender has already secured an interest in the property as a condition of closing on any loan. The borrower should be aware of three things when entering into negotiations with a hard money lender.
1. Compare Hard Money Lenders
While there are fewer hard money lenders in the market today, fees and rates between lenders can vary considerably. Borrowers may want to ask other lenders about their rates and fees in order to leverage that information in negotiation with another lender.
2. Focus on Fees
A major source of profit for hard money lenders is the fees that they charge to secure a loan. These may be in the form of application fees, property appraisals, administrative fees, processing fees and more. By focusing attention on these fees, a borrower may be able to negotiate the total fee down without requesting a reduction in interest rate. Over the course of a year or more, fees can often add up to more than the cost of a high interest rate.
3. Evaluate the Terms of the Contract
Just because a price or interest rate is set forth in a loan proposal does not mean that it cannot be negotiated. Often the lengthy and complex language of hard money lending contracts can hide obscure fees, even from an experienced borrower. A borrower should be sure to have their attorney review any agreement to spot additional fees that were not specifically pointed out by the lender.
Legal Implications and Regulatory Compliance
Borrowers seeking hard money loans should be aware of the legal implications and requirements that may apply when entering into a hard money loan agreement. An experienced real estate attorney is best suited to understand these issues and will work with the borrower, the lender, the borrower’s other creditors and potential creditors, and the court system in the event of a default.
Most states require that a lender be licensed in order to draw and record a deed of trust or mortgage, and to carry on the business of making loans in a commercial context. A lender operating without the proper license could potentially be later forced to buy back the loan at par, which would be highly detrimental .
Compliance with federal securities regulations should also be considered based upon whether there is more than one lender putting money into the deal. A loan will be considered a "security" under the Securities Act of 1933 when an investment of money is made in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others (Securities and Exchange Commission v. W.J. Howey Co., 328 U.S. 293 (1946)), which is essentially the definition of a Syndication. Legal representation and careful structuring is thus critical for the investor to consider.