Introducing Private Money [Hard Money] Lending – Part 2: How Hard Money Works
As we discussed in Part 1 of our series, banks are not the only entities to provide real estate secured financing. Private money (or hard money) lenders offer an important alternative to institutional and conventional lenders for many who own, buy, and invest in property and provide a valuable option for many types of real estate transactions. Let’s continue by taking a look at how hard money lending works.
Simple in Concept, Complex in Practice
Private money lending is a simple concept characterized by the arranging of a real estate secured loan transaction to a borrower (individuals and businesses) who execute a Promissory Note and Deed of Trust (Trust Deed) secured (recorded against) the real property. The Promissory Note is the borrowers promise to repay the loan, and the Deed of Trust is a security instrument (lien) recorded against the borrower’s real estate. Private individuals who have money to invest do so with the desire to receive a fair return on their investment that is commensurate with the risk they take in making the loan.
Private money lending is complex in practice; Core competencies are derived from the school of hard knocks, where knowledge and technical expertise is developed one transaction at a time and seasoned veterans are born from field experience.
Market Participants
- There are various “origination channels” in the private money mortgage business. Understanding them is the first step to engaging this source of financing and can expedite the loan request while saving considerable time, frustration and heartache.
- Investor lender. Hard Money “funds” primarily consist of money derived from “private” sources such as: Individuals, Trusts, Partnerships, Real Estate Investment Groups, and Retirement Funds. These “private” sources are commonly referred to as “Investors” or lenders. Most investors transact through an intermediary such as a TDIC (described below), while a few interact with the consumer direct.
- A Trust Deed Investment Company (TDIC) a.k.a. (Hard-money broker), serves as both an aggregator of investors and an intermediary between the investor and borrower, generally performing the due diligence process {processing, underwriting, packaging, funding, closing and servicing}, on behalf of the Investor. TDIC’s represent the largest slice of the origination channel pie.
- Direct hard-money lender. Some variations on the traditional hard-money broker’s role have emerged in the last few years as a number fund their own loans, becoming direct lenders. They may access funds from their own capital, a mortgage pool sourced from other investors, a line of credit or a loan. A few fund with the explicit intention of selling off every single loan, either immediately or a few months down the line, but are increasingly funding in their own name, while concurrently selling the new loan to another party in a process known as “table funding.”
- Conventional Mortgage Broker. A broker is not lending his own money, but is being paid instead to put the loan application together and submit it to the appropriate Trust Deed Investment Company or Direct hard money lenders to arrange hard money loans for approval. Once funded, the broker is effectively out of the picture and future activity related to the loan must be addressed by the lender.
- Professional and ethical originators know how to make a good match. The originator usually understands the market for each deal and connects the borrower to the appropriate money source for their needs making for a smooth transaction to the benefit of lenders, investors, borrowers and brokers alike.
Shopping a Hard Money or Private Money Loan
The process of shopping (searching, comparing, securing) a hard money loan is in no way shape or form comparable to shopping a conventional loan. There are no rate sheets or pricing matrices. Pricing and loan type varies with each lending situation. Loans are tailored to meet the needs of the request and quotes are deal specific.
Before pursuing the private money avenue, it is important to exhaust institutional and conventional lending options first. If unable to qualify, then approach hard money lenders and let them know what the traditional lenders objection(s) were – why the loan was declined.
Finding a Lender
Hard money sources are scarce, low profile and primarily referral based. They are not in the phonebook and do not advertise. Many are concentrated in certain geographic areas [California, Texas, Florida, Arizona, Nevada, Oregon, New York, New Jersey] and typically will not lend outside of their area. Because private money sources are not mainstream, they are more difficult to locate.
The best way to locate a hard money lender is to talk to a mortgage company or broker. The recent emergence of mortgage brokers into the hard money space has proved to be a viable origination channel for the lender. You may want to consider contacting industry related service providers such as an escrow company, settlement/closing attorney, a title company or a real estate agency. You can also call other professionals such as attorneys, accountants, insurance agents, etc., a small business banker at a local bank branch, real estate investing club or network with any other real estate professional group you know. Another way is to search online for hard money lenders or the newspaper for a classified ad in the real estate or business sections.
Caveat Emptor
Be careful of Broker Chains – multiple referral partners layering the participants between the lender and the principal; that is, when one mortgage broker contacts another mortgage broker, who contacts a third mortgage broker trying to find a lender. Make sure you are working with an intermediary that is dealing directly with the funding source as most private money lenders will not work with a broker who isn’t representing the borrower directly.
Beware of companies who offer to arrange loans, but request a fee in advance. Advance fee schemes are characterized by the charging of a prospective borrower an upfront “commitment” fee, but then not delivering on the financing. Upfront fees for loans could be sign of fraud or scam, but are common among commercial loan applicants for both conventional and private funding. They are typically described as a “processing fee” or “due diligence fee” and are legitimate costs to the lender for third party reports — appraisal, environmental review, survey, etc., as well as to cover other due diligence costs and range from $2,500 to $10,000. Generally, an upfront or commitment fee should only be paid after receipt of a Letter of Intent to Fund (LOI) and backed up by a guaranty in writing for refund in case of failure to fund due to Company or Lender’s own oversight.
Beware of an “exclusive agency” agreement, whereby the “BORROWER gives to LENDER the exclusive right (typically 30-45 days) to obtain the LOAN for BORROWER”. Some private money companies require loan documents to be signed prior to securing a funding source, although signing loan documents does not guaranty a funding. This is more commonly identified when the note and deed of trust are vested in the name of the private money company, but later assigned to an investor at funding. This occurs because of the elusiveness of funds in private money lending, whereas many times no investor commitment exists at the time of borrowers loan inquiry. As such, originators need time to put a due diligence package together and to float it out to investors. Therefore, it isn’t uncommon for loan documents to be drawn in advance of securing funds.
Seems reasonable, but what may not be reasonable is an agreement inserted into the loan document package (AGREEMENT TO PROCURE A LOAN & LENDER-BORROWER ESCROW INSTRUCTIONS) that specifically creates a DUAL AGENCY relationship.
The downside to this practice is two-fold.
1. First is that the borrower has no guarantee that funds will be available or that the private money company will be able to perform, but is agreeing to terms in advance of a commitment including exclusive representation and may still be subject to various conditions after the fact, such as multiple reports (appraisals, environmental, feasibility etc.), additional documentation, conditions or revised terms requiring a new set of loan documents.
2. Second is the binding nature of the “exclusive agency” agreement – the borrower has granted a de facto exclusive. The borrower is contractually obligated to the private money company. Should the borrower secure financing (within the contract period) elsewhere, the private money company would be legally entitled to its commission.
Essentially, this adds up to a lack of transparency. Albeit one could argue the risk is shared between the borrower and originator as the private money company, based upon a confidence that it can perform, expends its resources; but this would require mutual knowledge – both parties sharing in the fact of this contractual arrangement. The reality is that few if any borrowers realize the binding nature of the exclusive relationship being created.
In the conventional mortgage world, funding is a formality of signed loan documents. Conversely, in the hard money arena, the signing of loan documents (prior to a commitment) is a formality to creating an exclusive agreement (to procure an investor {to fund the loan} while binding the borrower to the originator.
The Terms and Conditions
Private money loans have terms that are different from the terms offered by institutional lenders and vary depending on the investor, borrower qualifications, loan amount and purpose, property type, location, lien position, term, prepay period (if any) and any applicable federal and state-level laws and predatory lending regulations.
Private money loans vary in the following ways:
- The loans tend to be more expensive than institutional loans.
- The loans tend to be of shorter duration (5 years maximum in most cases).
- The lender will loan up to 50% to 65% of the value.
- The interest rate of the loan may be set anywhere between 8.00%* and 18.00%*
- The rate is determined by looking at a combination of factors:
- The lien position.
- The loan to value ratio.
- The strength of borrower.
- The condition and/or desirability of property.
- The actual cash-in or real equity contributed by borrower – Skin in the game.
- Terms vary between 90-days and 30 years, mostly interest-only (some amortizing loans)
- Points: 2 to 10 points charged
- Fees: processing, underwriting, title insurance, escrow, doc prep, recording, wire transfer, title messenger, survey, and other fees also apply when applicable. Appraisal fee, where required, is prepaid by borrower C.O.D. at the time of inspection.
- The lender may require certain insurance policies, like fire insurance, vandalism, to be in place on the property in order to insulate them from a loss.
- Other terms a lender may include: a prepayment penalty, personal guarantee, default interest reserve, interest rate guarantee, and default rate clause.
*Indicates the Note rate, not APR. APR will vary based on total finance charges, term, and state law where applicable.
Documentation requirements also vary and can be categorized into two groups: (1) Borrower and (2) Property. In some cases only minimal documentation is required. In other cases more detailed documentation may be required.
For everyday borrowers, hard money lending holds no additional risks outside of the higher cost of borrowed funds: i.e. higher interest rate, points and fees. In fact disclosures, servicing, collection, foreclosure, and pay-offs are all subject to the same rules and regulations as that of a traditional lender.
The real value in hard money lending lies in its accessibility. Especially at a time when banks aren’t loaning money to even the lowest risk investors, having hard money to access for borrowers who present all levels of risk can be exactly what they need to refinance, buy or invest in real estate.
Before you actually get the okay to move forward with your loan, you need to be underwritten. In part three of our series, we’ll discuss how private money loans are underwritten.
