When people want to borrow money in an easy, simplified way, then they may want to consider getting a loan from a hard money lender. People are starting to see the benefits of private loans, particularly with how quickly they can be arranged. Nevertheless, some skepticism is also in order.
Hard money loans can be quite risky. They are very different from bank loans, not in the least because they do not follow the Banking Regulation 2017.
Over the past several years, many regulatory initiatives in the United States derived from the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), which was enacted in 2010 in response to the financial crisis of 2007-2009. Many provisions of the Dodd-Frank Act focus on the largest financial institutions due to their perceived role in causing the financial crisis and the perception of such institutions as ‘too-big-to-fail’. The new Trump Administration is expected to seek to modify or repeal certain aspects of the framework implemented under the Dodd-Frank Act.
That said, while it is certainly true that hard money lenders don’t have a standardized process and that they charge high interest rates, they also have some key advantages. This is why it is important for people to be aware of the myths and facts surrounding hard money loans, thereby providing them with an opportunity to make an informed decision.
MYTH: A Hard Money Loan Costs a Lot of Money
FACT: It is certainly true that a hard money loan comes with a hefty price tag. However, it also offers a fantastic opportunity for a high return on investment. Usually, banks and other financial institutions will only provide people with a very low loan-to-cost ratio.
The loan-to-cost (LTC) ratio is a metric used in commercial real estate construction used to compare the financing of a project as offered by a loan to the cost of building the project. The LTC ratio allows commercial real estate lenders to determine the risk of offering a construction loan. Similar to the LTC ratio, the loan-to-value (LTV) ratio compares the construction loan amount to the fair-market value of the project.
Indeed, the LTC is usually between 50% and 65% of the cost of the project. In other words, a developer has to be able to find between 35% and 50% of the funds required somewhere else. In commercial real estate in particular, this could mean millions of dollars.
In contrast, a hard money lender can offer an LTC of between 80% and 90%. This means that there is a far smaller gap to cover. It is true that the interest rates on a hard money loan are a lot more expensive. However, it is also a short term loan, which means that it is easier to obtain a quick return on investment.
Borrowing money is about doing the math. Borrowers must calculate the cost of the loan, which includes the total interest they will pay and the equity they must somehow raise themselves, potentially incurring more interest, and deduct this from the money they will eventually make when their development project is over. Because of the short time frame of a hard money loan and the fact that so much less equity will have to be raised, it is very common to see a hard money loan cost less overall than a traditional loan.
MYTH: You Lose a Lot of Control when You Take out a Hard Money Loan
FACT: It is common for those who want to take out a traditional loan to have to work together with partners in order to raise the additional equity required for the project. What this means is that the lender no longer invests in a piece of property, but rather in an LLC.
Simply put, an LLC is the least complex business structure. Unlike an s corp or c corp, the structure of an LLC is flexible. Starting an LLC also gives you the perk of pass-through taxes, limited liability (obviously), and legal protection for your personal assets.
However, bringing in a partner and forming an LLC often means having to give up partial or even full ownership to the partner.
A hard money lender invests not in an LLC but rather in a property. This means that the borrower remains as a complete owner.
MYTH: It Is Much Easier to Work with a Bank than with a Private Lender
FACT: Just because traditional lenders like banks have a standardized process, they are not necessarily easier to work with. In fact, hard money lenders are often far more flexible and their process is usually highly streamlined as well. If the project is a new development, then hard money loans are generally far more effective. This is because federal regulations make it difficult for traditional lenders to invest in construction.
The commercial real estate market continues to be highly volatile, which means higher reserves have to be held against a project. Additionally, banks must follow the rules and regulations set by the Federal Deposit Insurance Corp..
The Federal Deposit Insurance Corporation (FDIC) preserves and promotes public confidence in the U.S. financial system by insuring deposits in banks and thrift institutions for at least $250,000; by identifying, monitoring and addressing risks to the deposit insurance funds; and by limiting the effect on the economy and the financial system when a bank or thrift institution fails.
What this means is that the vast majority of construction investors will not have the 1099 income or consistent tax returns they need to qualify. If a loan application is approved, it will be highly conservative. Large banks are concerned about exposure and avoid construction loans as much as possible, preferring to work with customers they already have ties with.
A hard money loan, by contrast, doesn’t have to follow these regulations. While they can also be conservative, their processes are usually much easier to follow and their criteria easier to meet. Indeed, a hard money loan can close in as little as 30 days. Some hard money lenders have such a streamlined process, in fact, that they can have the funds available within 48 hours of receiving a complete application package.