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A hard money lender is an investor who makes loans secured by real estate, typically charging higher rates than banks but also making loans that banks would not make, funding more quickly than banks and/or requiring less documentation than banks.
Hard money lenders differ from bank lenders in that they often fund more quickly, with fewer requirements. Hard money lenders are sometimes called “asset-based lenders” because they focus mostly on the collateral for the loan, whereas banks require both strong collateral and usually excellent credit and cash flow from the borrower.
Hard money lenders are willing to foreclose on and “take back” the underlying property if necessary, to satisfy the loan. Bank lenders typically look at the borrower to be able to pay back the underlying loan from the borrower’s income, whereas hard money lenders are comfortable looking to a sale or refinance of the property as the method of repayment.
Hard money lenders exist because many real estate investors need a quick response and quick funding to secure a deal when looking for a real estate loan. Banks and other institutional lenders that offer the lowest interest rates don’t provide the same combination of speed and transparency in their decision making process, along with quick access to capital.
In our experience, even investors/developers with strong financial statements and access to bank credit frequently choose to use private money loans (also called “hard money loans”). Situations where private money loans make the most sense include those where the borrower:
Requires a quick closing and banks cannot meet the deadline;
- Has more good opportunities than cash;
- Wants to avoid spending too much time raising equity or debt from many different smaller investors, but prefers to instead focus on finding new opportunities;
- Lacks the patience or time to deal with¬†the bureaucracy¬†of securing a loan from a bank;
- Has an excellent investment opportunity, but does not have sufficient financial strength to get a bank loan, and/or;
- Has a bank line of credit but needs a larger loan than is allowed under the existing bank line.
The common theme is that there is an opportunity for the borrower to generate substantial profit (or savings) quickly, and the cost of interest and origination fees is small relative to the anticipated profit, even given the higher interest rates charged by private lenders versus banks.
Hard money loans are also sometimes referred to by the following terms: (1) private money loans; (2) bridge loans; (3) short-term loans; (4) transitional loans; (5) asset-based loans; (6) rescue loans.
DOCUMENTATION AND TERMS & CONDITIONS
Typical loan documents required for a hard money loan include a Note and a Deed of Trust; other documentation requirements do vary but may include a personal guarantee from borrower (sometimes non-recourse loans are issued without a personal guarantee); personal financial statements such as past tax returns and proof of income; and assurance that the borrower has access to sufficient cash to perform any and all proposed property renovations.
The purpose of a Letter of Intent (LOI) for a hard money loan is to provide a quick means to be sure that both the prospective borrower and lender are on the same page. Although this document is not legally binding on either party, it serves to put the prospective deal “in writing” and helps to avoid any miscommunication or misunderstandings.
Title insurance helps protect someone who has purchased real estate against another party making a claim challenging the ownership of the property and the seller’s right to enter into a transaction. Well known title insurance companies include Fidelity National, First American Title, and Chicago Title. The title insurance company will handle any issues that arise during the property sale, and if a competing claim of ownership is deemed legitimate, the title insurance company is responsible for payment of any fees to the claimant. The reason why hard money lenders insist on being covered under title insurance is to enjoy the same protection as the borrower.
A Mechanics Lien is used in the construction trade when a property owner either fails to pay a general contractor for services rendered, or the general contractor fails to pay sub-contractors according to the terms of their agreements. Since title insurance does not provide any protection against this, hard money lenders will protect against possible Mechanics Liens by making sure that if a loan includes a renovation budget, that all sub-contractor and general contractor releases are properly executed before disbursing funds to a borrower.
Hard money lenders typically will charge interest rates in the high single digits to low double digits, with a range of 7.5 percent to 12 percent being considered standard. Additionally, origination fees can range from 1-3 points, with any additional points above this range usually signaling that there are numerous brokers involved in the transaction. It should be noted that points paid on a longer-term loan may be beneficial if the borrower needs capital for a longer period of time, as it is not uncommon for many hard money lenders to include pre-payment penalties which guarantee the lender a minimum number of months of interest on the loan principal.
Borrowers should also be aware that extension options are possible on hard money loans and are a matter of negotiation with a lender.
THE DIFFERENCE BETWEEN HARD MONEY LENDERS AND BANKS
Hard money lenders are typically regulated at the state level via the Department of Real Estate, as at least one person associated with hard money lending must have a valid Real Estate Broker License. Additional licensing requirements may be required on a state-by-state basis.
Cross-state transactions fall under the jurisdiction of both states involved and are subject to each state’s respective requirements.¬† Securities licenses are usually not required for hard money lending unless a loan is classified as a securities offering due to the loan being syndicated to multiple investors
Hard money lenders are licensed differently with less regulatory scrutiny than traditional banks and can look at the merits of a loan more so than a bank, which must meet certain non-negotiable criteria to issue a loan.
It is essential for borrowers to ascertain whether a lender is reputable, to avoid disappointments, wasted time, and lost opportunities. A borrower can research a prospective lender using the following techniques:
- Ask for references from clients/borrowers and mortgage brokers; talk to the references.
- Consider working with a local mortgage broker who has done transactions with that lender;
- Confirm that the lender has a valid Real Estate Broker License;
- Determine whether any complaints have been filed against the Real Estate Broker License;
- Consider checking with the Better Business Bureau (BBB);
- Find out what industry events the lender attends and ask people at the event about the lender’s reputation.
It generally will take a hard money lender 30 days or less to fund a loan, although some are equipped to do this in two weeks or less.
It is possible for borrowers who start with a hard money lender to transition to working with a bank later in the process. This may happen if the borrower has a recent credit issue (such as a past foreclosure or bankruptcy) and the hard money lender is used to “age out” that credit issue until the borrower qualifies with the bank. A borrower may also choose to enter into a hard money loan prior to seeking a traditional bank loan in order to demonstrate performance and credit worthiness.
Borrowing from a hard money lender can act as a bridge to receiving future credit in that it builds a track record and can also enhance the borrower’s financial strength, assuming the underlying investment for which the loan is used proves successful.
Banks can offer lower interest rates than hard money lenders because banks can fund loans via retail deposits on which they pay minimal interest rates. Hard money lenders fund loans via private capital which has higher expectations. For example, in 2022, most bank depositors earn 1% or less on their deposits while most investors in private money loans expect 6-7% or more, to compensate for the greater risk of loss of principal.
COMPETITION AMONG HARD MONEY LENDERS
Hard money lenders will compete on fees, interest rates, their reputation, and quality of service, which includes the ability to fund a deal quickly and being more accessible to the borrower during the term of the loan and/or flexibility in case of unforeseen events and how the lender responds to special borrower requests that may arise.
Hard money lenders differ from one another in a number of ways, including their lending criteria such as loan-to-cost and loan-to value guidelines; the type of real estate on which they lend; minimum and maximum loan size; the geographic region they serve; their industry reputation; and level of service which is provided.
Hard money lenders will compete on price, but the reputable firms tend to be close to each other in pricing due to the competitive nature of the market. Service is typically the greatest differentiator, along with the lender’s relationships, dependability, and ability to perform once a loan is agreed to.
WHAT IS TRUST DEED INVESTING AND HOW IS IT RELATED
Trust deed investing is simply investing in loans secured by real estate. Most trust deed investments are relatively short term loans (maturity under five years, with many loans two years or less) made to professional real estate investors. In the current economic climate professional real estate investors are buying properties needing¬† a substantial renovation, fixing-up these properties, and reselling them for a profit. Banks are reluctant to lend to this market not because the loans are particularly risky, but because banks have taken write-offs on real estate loans and are still wary of originating new real estate loans, other than the most “plain vanilla” loans
Trust deed investing and hard money lending are closely related. Trust deed investors are one of the sources of capital for the private money loans made by hard money lenders. Brokers work with trust deed investors to fund hard money loans for borrowers. In the case of funds that make private money loans, the funds can be said to be making trust deed investments when they fund a loan. For more information about trust deed investing, please see our Trust Deed Investing FAQ.
MORE ABOUT THE HARD MONEY LENDING INDUSTRY
Hard money lenders use private capital to fund loans secured by real property. The business model is fairly straightforward; there are one or more investors on one side of the deal and a borrower on the other; the entity issuing or brokering the loan must charge the borrower enough to pay the investor(s) the return they are seeking and retain enough to cover their own overhead and desired profit margin.
In order to understand how a hard money lender makes money, it is necessary to distinguish between those who are brokers only serving as a matching service between borrowers and trust deed investors, and “balance sheet lenders” which originate loans and then hold those loans in a portfolio until maturity. In the latter case, the lender suffers directly if the loan goes bad, but for brokers, the risk is primarily to their reputation since they are paid “up front” and typically do not invest in the loans which they broker.
A prospective borrower can find hard money lenders through the following means:
- Attend real estate events held in your local area;
- Ask other real estate investors;
- Search online;
- Through industry publications;
- Ask mortgage brokers to refer a lender;
- Seek referrals from real estate brokers and attorney specializing in real estate transactions.
Hard money lenders make lending decisions based on either a Loan-to-Cost (LTC) ratio or Loan-to-Value (LTV) ratio. These ratios measure the risk of the loan by comparing the loan amount to the cost and value of the underlying real estate, respectively.
Prospective borrowers can learn about hard money lenders by attending real estate events sponsored by various parties; by making inquiries at local business schools about real estate-related events; through real estate industry publications; and via various professionals including title insurance representatives, mortgage brokers and real estate investment brokers. In Los Angeles, UCLA has the Ziman Center for Real Estate and USC has the Lusk Center, both of which are focused on real estate-related research, education and fostering productive relations between academia and the real estate industry.
HOW TO INVEST IN HARD MONEY LENDING
Private individuals with disposable income can invest in hard money loans through a process known as Trust Deed Investing. Such investors may invest in individual loans or in a fund that manages a portfolio of loans to mitigate the risk associated with any single loan going into default.
Advantages of investing in hard money loans include reliable cash flow (quarterly or even monthly distributions of interest) and risk mitigation, assuming deals are structured and underwritten conservatively.
Disadvantages can include a lack of liquidity and if the investor is unfamiliar with real estate investment and operations, loss of principal and/or the need for active management of non-performing loans.