Are you looking to diversify your real estate investments? Do you have some extra cash from profitable rentals that you are looking to put to good use? Have you thought about becoming a hard money lender but feel it’s too complicated?
I know exactly how you feel! I’ve been a landlord for nearly 10 years now and I’ve built up a sizable pool of equity. Instead of buying another rental when prices are high, I’ve been looking into hard money lending as a way to invest those funds for higher returns.
But I was a little intimidated by the whole process. It seemed like it was too complicated and too risky. Instead of giving up and accepting a measly rate of return from my savings account, I decided to learn more about hard money lending.
In reality, becoming a hard money lender is not very complicated. With a little knowledge and some tips, you can easily earn 8% to 12% return or more on your cash without virtually any risk to you.
In this article I will explain what hard money lending is, its advantages, how hard money lending works and what mistakes to avoid.
What Is A Hard Money Lender?
A hard money lender is any individual or group of individuals that loan their own money privately on a short-term basis and secure their investment with real property. Let’s break this down a bit further:
- It can be a person or company making the loan
- They use their own funds, not deposited funds like a bank
- Typical loan term is short, often a year or less
- The loan is collateralized by a mortgage – an interest in the real property
The term Hard Money Lender is often used synonymously with Private Money Lender but there is one vital difference. If you are loaning money on the basis of someone’s credit worthiness without an asset to collateralize the note, then you are simply a private money lender.
By contrast, a Hard Money Lender secures their investment with a lien on real property and doesn’t rely entirely on the credit of the borrower to repay the loan.
Advantages Of Being A Hard Money Lender
You are probably already familiar with some of the advantages of becoming a hard money lender if you are seriously considering becoming one. But if you are just getting started, here’s a list of the key advantages of becoming a hard money lender.
The biggest advantage of becoming a hard money lender is the fact that you will be able to realize higher returns on your invested capital versus a savings account. Typical loans yield between 8% and 12%, often higher.
Expanding into paper investments is a great way to boost returns on your real estate business without buying more property.
Notes are investments that can be sold more easily than the underlying property. However, you should expect to receive less than your full principal depending on the going rate of return and the underlying characteristics of your note.
Becoming a hard money lender allows you to invest in real estate deals on a short-term basis when you don’t have a deal to invest in yourself.
Low Hassle Cash Flow
Hard money loans provide for a steady cash flow without the usual hassle of managing a tenant or property manager.
How Does The Hard Money Lending Process Work?
Finding A Borrower
Unless you are an established Hard Money Lender or advertising as such, you will need to reach out to your network of investors to see who’s got a deal you can fund.
The best place to do this is at your local Real Estate Investment Club. Here is a great directory of local clubs in case you don’t know of any in your area. Reach out to the club manager and ask if the members typically use Hard Money Loans and if it’s ok to attend the next meeting.
Size Up The Deal
Once you’ve found a local investor who needs a hard money loan it’s time to size up the deal to see if it makes sense for you to invest in.
How much equity does the borrower have in the property? As a Hard Money Lender you should be looking for at least 30% equity. This means that the borrower is borrowing no more than 70% of the After Repair Value of the property. For example:
$85,000 purchase price,
$15,000 in repairs,
$150,000 After Repair Value
Loan for $100,000 = LTV of 67%
Assess The Borrower
Do they have a local reputation for making great deals? Have they gone through bankruptcy? Are they new to the business? Is this their first deal? Do they have an excellent track record of timely payments? You are not necessarily concerned with their personal credit history because your loan will be secured by the property. Instead, you are concerned with their reputation as an investor.
Negotiate The Terms
Ask the borrower what terms they are expecting. Hard Money Loans are typically short-term, 6 months to 1 year. Some borrowers are looking for a multi-year loan, up to 5 years but they will likely refinance and pay off your note early.
Interest rates can vary widely depending on the local market, the risks involved, the length of the loan, etc. Be sure to know the going rate in your market. You may need to offer a slight discount until you establish yourself as a reliable lender who can close quickly.
Kick The Tires
Now it’s time for due diligence.
- Ask the borrower for their list of comparables. How do they stack up to your list?
- Obtain a list of repairs needed and an inspection report which should include a termite and oil tank inspection (if prevalent in your area)
- Have an After Repair Value appraisal prepared by a professional appraiser
- Inspect the property to verify the repairs needed and value if possible
- Obtain Repair bids
- Insist the borrower obtain title and home insurance naming you specifically
Close The Deal
Review the loan documents and wire the funds to the escrow agent. Be sure to use an experienced lawyer, especially if this is your first transaction.
Service The Loan
A simple interest-only loan with a balloon payment can be managed directly by you. However, if your loan is more complicated, you may want to turn the loan over to a servicing agent who prepares amortization tables, monthly statements and collects the payments.
PRO TIP – Be sure to set a minimum period of at least 2 -3 months to make the loan worth your efforts.
3 Hard Money Lender Mistakes To Avoid (That I almost Made)
1 – Not Being Secured In The Deal
This is the biggest mistake you can make. And I almost made it on my first deal!
I was so eager to close on a lending deal that when I received the documents from the borrower’s lawyer I almost didn’t even realize that I was making a Private Money Loan and not a Hard Money Loan!
As mentioned above, when you have no collateral and you simply rely on the borrower’s promise to pay you back, then you are merely a Private Money Lender. The documents I received didn’t include a Mortgage, just a Promissory Note. Luckily, this turned out to be a miscommunication between the borrower and their lawyer. In the end, I did receive a mortgage in addition to the promissory note.
Another way you can end up unsecured is by not having enough equity in the deal. A general guideline is to never loan more than 70% of the After Repair Value. Another way to think about this is to never loan more than you would actually pay for the property in its current condition. That is essentially what you are doing in some respects.
If the deal goes bad, you have essentially bought the property for the outstanding loan amount. Ask yourself, would I make this purchase normally?
Let’s Make A Deal
Here’s an example of two hard money loans. The first loan is well-secured with a LTV <70%. This was my first hard money loan deal. The second loan is less secured with a LTV >90%.
See what happens when something goes wrong and the borrower defaults:
- Property will appraise for $125,000 After Repairs (ARV)
- All funds loaned are spent and all repairs are made
- Property will sell for 80% of ARV at auction
- I will incur about $10k in holding costs and fees to foreclose
I’ve estimated the various costs of foreclosing on the property (although I’ve never done this before) for illustration purposes. Your situation will vary according to your local market. Note that legal expenses are much higher in judicial foreclosure states.
As you can see, my first deal has about 64% LTV so there is some cushion in case I had to foreclose to collect on the loan. After foreclosure, I estimate that I would come out with an additional $10k.
In contrast, the second deal is highly leveraged and there is not enough equity to cover your losses. You are out -$25k after collecting on the foreclosure.
2 – Decimating Your Wealth
The ancient Romans punished mutinous armies by executing every tenth soldier. They believed this was the best way to punish the defecting army without suffering a catastrophic loss of soldiers.
That’s because they knew that if an army lost more than 10% of its men, then they couldn’t win a battle. The loss would be too devastating to recover from. This is the origin of the word Decimate.
You should think of your savings as soldiers in a battle. You never want your savings to be decimated!
Hard Money Lending should be a way to diversify your investments. You should never be investing all of your liquidity in any one deal. Never loan more than 10% of your net worth. You can recover from a loss of less than 10% of your net worth in your lifetime. Any more than that could be unrecoverable.
I was nowhere near this 10% threshold in my deal but I was stretching what I had available in liquid assets. I was able to work with the borrower to finance a smaller loan that gave them what they really needed and still gave me a cushion in case of emergencies.
3 – Not Insisting On Title Insurance
The only way to ensure the mortgage is worth anything is to be named on the title insurance! Without this, you could find your collateral is not actually yours when it comes time to collect.
Why do you need title insurance?
You get paid by either (1) the borrower paying you back according to the promissory note terms or (2) foreclosing on the mortgage and collecting the funds at auction.
Even though your borrower may have cleared title to the property, you could still be surprised down the road should someone come forward with a claim not previously identified.
If you have to foreclose on the property, you could find that not all liens were discovered and in fact, you do not have good title to the property. You will need to clear the outstanding lien which will take time and money. Title insurance protects you from this scenario.
I have to confess!
I was about to knowingly make this mistake! Because I was working with a very trusted investor who was mentoring me, I considered waiving the normal title insurance requirement. Do not do this yourself!
Always insist the borrower pay for title insurance!
In the end, they agreed to add an endorsement for the mortgage policy and to name me on the title insurance.
PRO TIP – I recommend having an experienced lawyer review the title commitment to ensure you are properly covered. Tracing ownership is a complicated process and mistakes often happen. A good real estate attorney is a small investment for significant peace of mind.
I was actually inspired to look into hard money lending by an interview that Coach Carson had with Dyches Boddiford, an expert in real estate paper and hard money lending. You can read more here or you can hear the full interview with Dyches and Coach Carson on Youtube. Be warned, it’s long and full of awesome tips!
If you are looking for ways to earn excellent returns on your rental profits you might want to consider becoming a hard money lender. Don’t let fear keep you from growing your business. You will see that it’s actually an easy process once you do a deal.
The advantages of hard money lending far outweigh the risks if you know what you are doing. Put your assets to use with a safe, liquid, high-yielding investment without ever having to answer a tenant call!
Understanding the process is the key to successful hard money lending. Don’t make the killer mistakes I almost did.
- Secure your loan with a mortgage or else you are simply a private money lender who relies on the credit worthiness of the borrower to repay the loan.
- Don’t loan more than you would pay for the property yourself. If the borrower defaults, this is essentially what you have done.
- Don’t invest all of your money soldiers at once or in any one loan. You may not be able to recover from a bad investment if you loan more than 10% of your total net worth.
- Insist on title insurance to protect your interest in the property. Without clear title, you may find you do not actually have the collateral you thought you did!
What do you think? Is Hard Money lending a good investment or is it too complicated and risky? Leave a comment and let me know your thoughts.
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