An Introduction To Hard Money Lending

Last time, I mentioned how I like to receive cash flow from my investments, which is why I am a dividend investor. There is one other type of investment I like and have used for years to generate cash flow and that is hard money lending.

What Is Hard Money Lending?

Hard money lending is the process of making a loan based solely on the value of some item put up as collateral by a borrower. Hard money lenders are usually private investors who lend people money using a piece of real estate as collateral. Most lenders will only loan up to a certain percentage of the value of the property. For example, my partner and I don't loan more than 73% of the value of a property. This is referred to as 73% LTV, or loan to value ratio. So if a property if worth $100,000, we would loan a maximum of $73,000 based on that property. This is because if the borrower defaults and doesn't pay the loan back, we need to foreclose on the property and then sell it to get our money back. That process takes time and costs money, so the 27% cushion in the loan gives us some room to cover those expenses, should they occur.

When investing, my primary concern is that my principal is safe. I don't want to lose money (who does?), but no investment is without risk. So hard money lenders secure their investment by writing a mortgage on the property. This is just like a mortgage a bank would create when you buy a house, only in this case the hard money lender is the bank. The mortgage states how much is borrowed, what property is being used as collateral, and how long the borrower has to pay it back. This is a publicly recorded document and the house cannot be sold until the loan has been paid off. When this happens, another document is recorded stating the loan has been paid off and the hard money lender's claim on the property has been released. If you've ever bought or sold a house or refinanced a mortgage, you've gone through all this paperwork.

Hard money lenders usually charge borrowers higher interest rates than a bank would. This is because the whole process moves much faster, which is advantageous to the borrower. There is no credit check or income verification because the loan is based completely on the value of the property.

Who Uses Hard Money Loans?

So who would use a loan like this? People who need a big chunk of money quickly. The borrowers my partner and I lend to are people who buy houses at foreclosure auctions. When you buy a property this way, the entire purchase price is due in full by the end of the day of the auction. Obviously, there is no time to go through a loan process with a traditional bank. Enter the hard money lender. We loan the borrower money to buy the property. The whole process is handled through an escrow company, just like a regular house purchase. The escrow company handles the paperwork of writing and recording the mortgage and distributing the money to buy the house. The borrower then either keeps the house to rent out as an investment (and does a refinance to a standard bank loan later to pay the hard money lenders off and get a loan with a lower interest rate) or fixes up the property to sell it for a profit. The profits from that sale pay the hard money loan off and the rest goes to the borrower.

Who Are Hard Money Lenders?

I don't have enough money to make hard money loans for houses myself, so I have to pool my money with other people to make loans. This is where my partner comes in. He has several investors whose money he pools and lends out to borrowers. When a loan is made, each investor is listed on the mortgage so we are all fully protected. Altogether, our group of investors has a pool of about $6 million that we loan out.

There's much more to hard money lending than this and, if you are interested, I suggest you read about the 30+ loans I've made and written about on my real estate blog.

Why Do This?

So why switch from dividend stocks to hard money loans? Because I can get a better rate of return. My dividend paying stock is right now returning about 4.5%. With hard money lending, I can make between 7% and 8%. When I started years ago, before interest rates dropped, I was making 12%. Now yes, if the share price of my stock goes up, I could end up with a higher overall rate of return when you factor in stock price increases, but that's not a sure thing. Also, a stock price increase is not money I can spend until I sell the stock. Once again, I like cash flow and asset appreciation isn't cash flow.

There are other options for hard money lending besides real estate. Prosper.com and Lending Tree are large peer-to-peer lending sites that basically allow anyone to become a hard money lender. I lent money through Prosper.com eight years ago and I didn't enjoy the experience. I'm sure much has changed since then, but there is still one basic fact about their business model that I don't like: when you make a loan through them, it is an unsecured loan. If the borrower doesn't pay you back, you have almost no recourse. There is nothing you can sell to get your principal back. Recall when I said my primary concern was the safety of my principal? An unsecured loan is not safe. But if you've got $50 you're willing to gamble with and want to experience what hard money lending is like, go ahead and make a peer-to-peer loan. See if you like it.