How to avoid trouble with hard money lenders
Know the details of today’s hard money loans
- Hard money loans offer short-term financing at higher interest rates.
- These are asset-based loans that close quickly and focus less on the borrower.
- Investors commonly utilize hard money for construction or renovation projects.
- When issues arise, talk to your lender as soon as possible.
There are many reasons why a real estate investor would turn to a hard money loan for financing. Compared to banks, hard money lenders offer greater speed and certainty of execution, and they are less concerned with a borrower’s financial details than the quality of the asset that’s being purchased.
If you’re planning to invest in residential properties of one to four units, today’s hard money lenders offer the flexibility and personal attention you might not find at a traditional bank. You’ll likely need to bring more equity to the table and you’ll pay for the borrowing privilege through a higher interest rate, however. And because hard money has a short-term nature — terms of three months to three years are common — you’ll want to have an exit strategy prior to signing a loan agreement.
Whether you’re a fix-and-flipper who plans to remodel and sell the property for a profit, or you’re a landlord looking to secure tenants for a long-term rental, you should communicate with your lender if your business plan isn’t going smoothly. They may offer options to help you avoid loan default and foreclosure.
“Talk to us early and often,” said Michael Miller, chief marketing officer at 5 Arch Funding Corp. in Irvine, California. “Tell us where things are going. Tell us what’s happening. Don’t wait until the 11th hour so you’re now in the bind and there’s a lot of calls that need to be made very quickly to help you out.”
Why hard money?
Speed is a common reason why an investor would choose a hard money loan over conventional bank financing. Banks require more documentation and may take several weeks to approve a loan request, but the typical hard money lender can complete the task in 10 days or less.
Alexa Mizrahi, director of loan origination at Lone Oak Fund in Los Angeles, said most of her company’s loans close within a week. She commonly sees financing scenarios such as 1031 tax exchanges, foreign-national borrowers and fix-and-flip investors.
“Flippers usually don’t want a bank loan for a long term,” Mizrahi said. “Their whole business plan is to get in and out of the property maybe in six months or less. And they don’t want a prepayment penalty, meaning that as soon as the property is sold, they don’t want to incur any additional costs that they would if they had a bank loan that they were paying off quickly.”
Miller said there are many lenders that operate in the “soft-money” space between banks and true hard money financing. They often look for semi-experienced borrowers who may have successfully completed a few fix-and-flip projects. The borrowers, in turn, may be looking to avoid the slow turnaround times of community banks and the double-digit interest rates of hard money.
“They have very good credit. They have demonstrated veracity and experience. They are creditworthy of getting a loan that (has) a lower interest rate,” Miller said of the ideal soft-money borrowers.
Historically, Mizrahi said, hard money has referred to “troublesome loans or troublesome borrowers, low FICO scores, previous bankruptcies, some sort of issue that is barring a borrower from going to a bank.” In the years following the Great Recession, however, the private-money space that encapsulates hard money has transformed and now caters to sophisticated borrowers with significant capital who could obtain a bank loan but choose a more flexible route, she said.
“In general, the hard money, private-money, bridge-lending space has become much more institutionalized and has definitely been used as a tool this (real estate) cycle, not as a last resort,” Mizrahi said.
Hard money can be used for construction of new housing units. Peter Meiusi, a loan originator at Pyatt Broadmark Management in Seattle, said his company has a maximum loan-to-value (LTV) ratio of 65 percent but no constraints on loan-to-cost (LTC) ratios. This allows borrowers to finance 90 percent or more of the construction costs, in some cases.
“We’re able to finance the majority of the costs and even in some instances, give credit back,” Meiusi said. “Let’s say they paid for permits and then when we close on a deal, we can reimburse them for some of the costs they have already incurred to date.”
For borrowers who plan to become landlords on their one- to four-unit investments, refinancing into another loan is a necessary part of their business strategy. This may involve a traditional bank loan with a 15- to 30-year term. But it’s not the only way for borrowers to refinance a hard money loan.
If a 12-month loan is in place, for example, and the borrower needs more time to sell the property or complete renovations, the lender may extend the term, as long as the payments are current, Mizrahi said.
“Sometimes, people will use us to close a purchase,” she said. “They might be buying a residential property that a lot of buyers are looking at and so they put in an all-cash offer with a five-day escrow (period), and then they use us to beat out all that competition.
“But then they might go from our loan to another private-money lender who provides higher leverage or provides funds toward the renovation. So, some borrowers do private money to private money. … It doesn’t always have to go to a bank after us.”
Construction lenders may have a network of builders, architects, developers and attorneys that can help identify potential solutions when a project isn’t going as planned, Meiusi said.
“Maybe we can sell it off to another builder,” he said. “That way, the existing borrower can exit cleanly and the project still can be finished out.”
With renovation projects, Miller said, it’s not uncommon for a borrower to request an extension or refinance. Often, it’s due to things beyond their control, such as delayed approval for building permits or land entitlement. Meiusi agreed, citing a real-world example in which a builder was struggling to obtain a permit to install fire sprinklers. The lender extended the loan period for an additional six months, including 60 days to sell the units.
“The interest rate stays the same,” Meiusi said. “Everything maintains the same and that’s just one way that we partner with our builders to help them be successful.”
Miller’s advice is to immediately approach your lender if you think you won’t be able to repay a loan on time. Balance-sheet lenders make decisions in-house and aren’t interested in owning real estate, he added, so foreclosure is generally a last resort.
“When a borrower has three months left and things are getting a little bit tight … having an open and honest conversation with us will lead to a very strong outcome for them,” Miller said.