What is a Hard Money Loan?
Hard Money Loan is a type of loan where the borrower uses real estate as collateral. Hard Money Loans can be both for the purchase of real estate and/or to refinance existing debt against real estate. A borrower & lender will create a promissory note denoting the interest rate, term and monthly payments on the loan . A lender will also create a mortgage whereby if the borrower defaults on the loan, a lender can take possession of the property through foreclosure – i.e. sell the property through judicial process to obtain the proceeds from the sale. Hard Money Loans are generally considered short term loans and in most cases require that principal be paid on or before maturity date.
Core Elements of a Hard Money Lending Agreement
A hard money lending agreement is a binding contract between a borrower and a lender specifying the terms under which a property can be used as collateral for a loan. Home buyers often use hard money lending to finance a home purchase quickly and easily when conventional lenders are unable to provide financing. In a hard money lending agreement, the lender creates a promissory note to create a lien against the property. All hard money lending agreements should contain certain key components, including:
- Loan Terms – A hard money lender provides a certain amount of money to a buyer or a property owner. The loan terms are the corollary to the agreement that speaks to the exchange of money, namely how much money will be provided under the agreement and what other conditions are agreed upon by the borrower and lender.
- Interest Rates – Because hard money lenders provide what is considered high-risk loans, the interest rates attached to these loans are typically much higher than what is considered "normal" for a traditional loan through a bank or mortgage company. Hard money lenders are in the business of financing real estate deals, so it’s important to do your homework and understand the risk you’re entering into with the loan’s interest rates.
- Repayment Plans – A repayment plan refers to the repayment schedule put in place by both the lender and the borrower. It outlines the terms of exactly when payments. Hard money lenders are typically most interested in the liquidation of the collateral if defaults occur, so there may be less flexibility if you run into financial difficulties.
There are several additional elements considering placing into your hard money lending agreement, including security interests, events of default, late fees, maintenance, repairs, insurance, and property taxes.
Hard money lending can be a great way to finance the purchase or development of real estate, particularly if you lack credit history or experience. But it’s vital that you fully understand the implications of committing to a high-risk lender before signing a hard money lending agreement.
Advantages of Hard Money Lending Agreements
When speed and efficiency are the two primary concerns, hard money loans offer what so far have been unattainable for a long time: an ability to access capital without having to wait for an approval process that could take weeks or even months. Tight lending regulations and economic downturns have resulted in hard times for real estate investors who need fast access to funds to make profitable purchases. Today’s lending environment has revived hard money lenders’ status as being ideal for real estate investors who want to lift their selves above the limits imposed by traditional bank lenders and the borrower-unfriendly government-mandated qualified mortgage rules.
Traditional lenders generally require borrowers to have a credit score of 640 or more. If a borrower has a credit score below that threshold, hard money loans provide an alternative. There are no credit score requirements for a hard money loan, yet borrowers must sign a personal guarantee to repay their loan. Moreover, hard money lenders are not bound by Dodd-Frank and are not required to determine whether a loan is suitable for a borrower; a lender can lend to whosoever it chooses.
Hard money loans are created quickly, and once the loan closes, funds are usually immediately available. A hard money lender can create a purchase agreement for the investor along with loan documents and close within a week at the latest. Once the agreement and all docs including any reusable templates have been created, the process can be done even more quickly in the future. Since the loan will be a short-term loan, the lender and investor will begin weighing terms for a refinance from the outset. Unlike traditional loans that are associated with several unknowns and potential delays, hard money loans are dramatically easier and faster to obtain. Often, the stipulated interest rate is the only factor to nail down before the loan closes. A fundamental use of hard money loans is to re-invest the funds in the property while waiting for more long-term financing. Purchasing and flipping distressed properties that are in need to repairs or major improvements often presents a problem with traditional lending mechanisms. With hard money loans, you take control of the renovation timeline, not the lender. After initially funding 100% of the purchase price and renovation costs, the lender will make further payouts at set intervals after the contracting work for that renovation phase is complete and properly documented.
Risks and Caveats
While hard money lending can be a great option for some, it also comes with potential risks and challenges that need to be considered before proceeding. Here are some of the most critical factors to consider before signing a hard money lending contract:
High Interest Rates: The most significant disadvantage associated with hard money loans is the elevated interest rate. While recent years’ loans have tended to hover around 12-13 percent, this is still between two and three times the market average.
Variable Rates: Many hard money lenders offer variable rates that fluctuate according to the market. Such terms are not favorable for the borrower, who risks getting stuck with increased payments over the course of the loan.
Shorter Terms: Most hard money loans last no more than three years, while other traditional loans often offer a seven to 10-year term. This means a hard money borrower could be forced to refinance multiple times if they want to keep the property long term.
Property Clauses: Lenders offering hard money contracts often include clauses that hand over the property to them if the borrower does not immediately repay the entire loan or cannot secure permanent financing after the short-term term is complete.
Higher Closing Costs: Closing costs on hard money contracts are generally higher at the outset than on traditional mortgages.
Low Amounts: For many hard money lenders, the payments required for payoff are so high that they’re often no more than $100,000. Many banks won’t lend so little, so this means the buyer will have to look for a second lender.
Personal Guarantees: In many cases, the lender requires the borrower to provide a guarantee of payment in the event of a default. Depending on how much equity is in the project, borrowers may even need to show proof of assets outside of the property itself.
Legal Considerations and Regulations
In the realm of hard-money lending, a number of legal obligations are imposed on lenders and borrowers. For example, when entering into a hard-money loan agreement, lenders should be aware of a host of state and federal laws and regulations with which they must comply. On the federal side, lenders should be familiar with the Real Estate Settlement Procedures Act, the Truth in Lending Act, and the Dodd-Frank Wall Street Reform and Consumer Protection Act, among other things. On the state level, those catering to individual borrowers need to be wary of licensing and usury laws, which vary from state to state. For instance , New York has been known to impose criminal penalties on unlicensed money lenders. There has been little jurisprudential development on this issue, and so lenders and borrowers remain in a legal haze over which transactions do, and do not, require a license. It goes without saying that transactions contemplated outside of New York need to be evaluated in their own particular context. Beyond state and federal law, there could be restrictions on who the lenders and borrowers could be. In some transactions, syndicates may be prohibited from investing through hard money agreements, and so on. The point is, lenders should always be cognizant of the relationships they enter into through these agreements.
Negotiating Terms of Your Hard Money Loan
When entering into negotiations for a hard money loan, whether as the lender or borrower, it is important to understand the leverage that you have in the transaction. Lenders are generally in a stronger negotiating position and have the opportunity to take full advantage of their leverage by either proposing a term sheet or a loan commitment letter that favors their interests. When doing so, however, lenders should always remember that there are practical implications of having an unhappy borrower. Borrowers who perceive themselves to have gotten a bad deal or having paid too much by way of interest and fees for a hard money loan will hold a grudge and have no problem letting the world know.
Thus, at the outset, whether you are the lender or the borrower, make clear to the other side what is most important to you. For lenders, especially, it is important to know what the borrower’s plans for the property are. After all, the lender may very well be the investor’s best partner or worst enemy. If the lender knows that the property is going to be held for the long term, that may change his or her willingness to accept a lower rate of interest.
Borrowers, on the other hand, should try to balance their economic interests up front with a desire not to give away the store just to get a lower rate of interest. Arguably, the biggest benefit is the timing. Borrowers should accept the lender’s unsupported argument that they are only going to hold the property for less than a year at the greater risk to themselves. If the lender wants to lend for that short period of time at a high rate of interest, say that he is being unreasonable and agree to repay the loan in 18 months even if you have to pay a higher rate of interest to another lender in the interim.
If the issue of getting the investor their money back more quickly is focused on by the lender, then have your counsel include a pre-payment language that caps the maximum penalty at the full amount of the period of the loan. In the above example, if the lender agrees to a loan for 12 month and is going to charge $100,000 in fees and interest, borrower would pay all of that even if he (or she) pays off the loan after 9 months.
Things can get a bit awkward when you consider whether to pay a yield maintenance penalty. It may seem only fair to pay the lender the penalty for paying the loan off early if the point is to get the money back more quickly. In that case, the borrower should pay the lesser of the yield maintenance penalty and the outstanding balance on the loan. Once the lender has gotten what he or she wanted and more, it is time to rethink any prepayment premium and return to normal market terms.
Common Mistakes to Avoid
There are several common problems associated with such real estate transactions, which generally can be avoided by borrowers. The most frequent problem lies in the mortgage documents that are recorded and filed with the county clerk’s office. Many times the borrower assumes that the lender has recorded the necessary documents, but in fact, there are many instances where the documents remain unrecorded; thus, leaving the borrower vulnerable to losing the property and the funds that had been paid (in fees, etc.) for those transactions. This is especially true in circumstances where a borrower must deal with a fraudulent hard money loan. While a borrower may have made all the payments properly and in a timely fashion, due to the fraud the lender could foreclose because the loan had not been recorded.
A common piece of advice to all borrowers is to review all of the financial documents with which you are presented carefully. It is imperative to have your attorney review all documents that need to be signed, and be mindful of exactly why you are signing those documents. Even after the documents are signed, review your statements carefully so that you are fully aware of your outstanding balance. When you find that you have a delinquent balance, do not ignore it; rather, immediately contact your lender to discuss the problem and how it may be resolved. Failure to promptly do so can end up costing you even more in foreclosure fees.
How to Locate a Trustworthy Hard Money Lender
First, look at the lender’s website and online reviews. Make sure they have an established online presence since fake lenders will spend little time on something that can be found through a simple online search. Check out their reviews. Make sure their past customers are satisfied with the service they received. Don’t forget to check out the details. Are the reviews about loans for single-family residences or are they about more expensive investment properties like apartment buildings? Also, check out if the lender has a blog. If they are updating their blog regularly, it could be a sign that the lender is reliable and maintains an active internet presence .
Second, check out forums and peer discussions to see if your contacts have anything to say about the lender’s service or reputation. Ask friends within your local real estate investor community to see if they have any feedback about a lender you want to know more about. Try to ask someone who currently has a loan with them.
Finally, if you can, try to meet with the lender in person. Take the time to find out who they are. This meeting will help you determine if they are the right lender for you and if you can build a positive working relationship with your lender.