Hard money loans allow you to become a banker or lender for other people who are in need of money, but can’t access traditional capital markets. At the same time, you don’t actually have to become a bank or start a new business. Here’s how they work and how you can benefit from them.
What Are Hard Money Loans?
When a borrower needs money, but can’t get it from a bank, he or she may pursue “hard money.” Despite its name, hard money is actually easier to get than a traditional bank loan. Lenders do not assess the borrower’s credit or, if they do, the consideration is secondary to the collateral being put up by the borrower.
Not all borrowers who want a hard money loan are in financial trouble, and not all of them have bad credit. Sometimes, banks stop lending money because a borrower has extended himself beyond the typical 40 percent debt-t-income ratio required by most lenders.
Sometimes, the borrower wants to borrow a sum of money that’s less than what a traditional lender would lend. Still other times a borrower wants to buy a rehab property, but banks generally do not approve loans for homes or properties without plumbing, electrical, or other major issues.
This is where you come in. As an investor, you help those in need, and make a nice profit for yourself.
Advantages Of Hard Money Loans
Hard money loans pay a higher rate of return than most other types of loans because the lender (the company issuing the loan) and you (the investor) accept a higher risk of default on the loan. In some cases, the risk is low, but you’re investing money usually without fully knowing the credit risk of the borrower.
However, you have incredible security because you trade default risk for collateral. If the borrower does default on the loan, you obtain property that is worth at least as much as the loan amount. In some cases, it’s worth three times what you’ve invested.
This can create a situation where, regardless of what happens, you win.
Because you’re investing in loans where people typically have no other options, you have more control in the deal-making. Terms can be more generous for you than the borrower. That doesn’t mean you’re taking advantage of him or her. It just means that you have more power to negotiate higher interest rates and other favorable repayment terms.
It’s not unusual for hard money loans to pay in excess of 10 percent APR, making them an attractive way to boost the returns in your portfolio.
Disadvantages Of Hard Money Loans
Even though there are numerous advantages to hard money loans, it’s not all sunshine and rainbows. Hard money has some important disadvantages. First, when investing in these types of loans, you’re taking on a risk of default that’s higher than what a traditional lender would accept.
You do receive collateral, but that collateral is in the form of real property. In other words, you may end up becoming a de facto real estate investor. If this isn’t something you want, or you’re unprepared for it, it can cause you a lot of stress.
For example, if you’ve invested in a property that needs to be rehabilitated, it may take time to sell off that property if the loan against it defaults before the project is completed. You may have to invest more time and money hiring a contractor, and a real estate agent, to help you get out from under the property.
If you’re investing with a company that manages hard money loans, they may be able to take care of the “cleanup” for you, but it may decrease your rate of return on your investment.
How To Invest In Hard Money Loans
Start by carefully evaluating options for loans in the marketplace. You want to fully understand the collateral that’s backing the loan. Is it a rehab home? Is it a rental property? Is it a residence? What will you be receiving and how difficult will it be to get rid of it?
The ideal property is one that is in a competitive market where transaction volume is high (property moves fast) and where property values are trending up, creating a highly liquid real estate market.
Hire a lawyer to help you go over loan terms, even if you’re investing with a professional management or investment company. Require some type of personal guarantee directly from the borrower.
Even when you invest with companies that invest in hard money loans, it may be difficult to recover your full investment without a personal guarantee. Review all of the title endorsements, don’t invest with just one company or firm, and never assume that anyone can or will service your loan investment for you.
Due diligence is probably the most difficult aspect of investing in hard money, but it’s also the most important. You will likely need a lawyer, a real estate professional to act as counsel when you’re first starting out, a lender or banker (also for counsel), and an excellent investment firm that has extensive experience investing in these types of loans.