Hard money lenders provide borrowers with loans that are backed by some form of real estate. Here, the borrower may put up their property interest in a home or commercial property as collateral for the loan. These loans are often called “bridge loans.”
Loans obtained from a hard money lender often have the following characteristics:
• They may be easier to obtain, as the hard money lender often does not follow traditional credit check and loan approval guidelines.
• The loan may be subject to higher interest rates, since borrower approval is somewhat “loose”, and there is often the risk of borrower default. To counteract this, hard money lenders often lend at higher interest rates.
• The loan term is typically shorter than a traditional loan, often less than 10 years. This means higher monthly payments in some cases.
While hard money lenders may not always require an exhaustive check for approval, they are required by law to verify “ability to repay.” That is, they will usually be required to verify income documentation from the borrower.
Hard money lending can often be associated with specific legal issues. These include:
• Licensing: Hard money lenders need to obtain the proper licenses and certification in order to lend the money. For instance, they will need special licensing if the property to be used as collateral is residential property. Without proper licensing, the loan will not be considered valid.
• Fraud: Some hard money loans may be subject to various loan fraud and misrepresentation issues on both the lender and the borrower’s side.
• Pre-paid interest: Lenders generally cannot require more than two months of pre-paid interest for loans backed by residential property. This may be different for loans backed by commercial property.
Legal disputes over a hard money lending contract can often require a lawsuit. These may be remedied through a damages award that will help the non-breaching party be compensated for losses. In some serious cases, criminal charges may sometimes be involved, especially for cases involving fraud, deception of a government official, or other criminal issues. Hard money loans can often help a person obtain funds in a short amount of time, with less verification requirements. However, they are also associated with certain risks and penalties. You may need to hire a qualified bankruptcy attorney if you need help with a hard money loan. Your lawyer can help you research your financing options, and can also represent you if you need to file a lawsuit with the court. When it comes to private loans or hard money loans, it’s essential to involve an attorney for the borrower’s protection. Private loans are very individualized and complicated, so a lawyer is needed to review all aspects of the contract. It’s necessary to work with an attorney that has experience with hard money loans, not just a general counsel. Many real estate attorneys have past experience dealing with private loans and can save the borrower money as they understand the typical issues that come up. The private money lender (PML) may be able to recommend an attorney that their clients use.
The lawyer should have a working knowledge of the state’s usury caps. Usury laws are regulations on the maximum interest rate that can be charged on a loan. Most often, loans will be set with an average interest rate, with a clause that if the borrower defaults, the interest rate can increase. A real estate attorney should review the usury caps to ensure they are fair and in your favor as much as possible.
Upfront fees should be a clear and open discussion between the private money lender and the borrower. A specialized attorney can review the contract to ensure the upfront fees are aligned with what was agreed on, and advise if the upfront fees are standard for the typical loan of the borrower’s size. This is yet another reason an experienced lawyer is essential. They will be able to identify if any of the fees associated with the loan seem significantly higher than ones they have come across in the past.
Repayment Term of the Loan
An attorney should review the repayment term of the loan, including the penalty fees. As a borrower, it’s essential to understand when penalty fees may occur, so they can be avoided as much as possible.
Default, Foreclosure, and Bankruptcy
Depending on the state the loan is being acquired, the private money lender may or may not have to adhere to banking laws. For example, private money lenders in the state of Texas must adhere to banking laws and regulations.
Ultimately, this can make a significant difference in how a default or foreclosure is handled by the lender. A specialized attorney can review the contract to understand and explain when the lender would be allowed to begin the foreclosure process. Ensure that the agreements outlined for default and foreclosure are fair, and seem within reasonable limits, so this situation is avoided at all costs. The hard money lending business is a hard asset (real estate) based business. You will need to consider several factors while structuring your company. One factor is whether you will be using your money or seeking investors. A second factor is whether you will be making loans locally, nationally or internationally. Third, you will need to determine what you are investing in real estate, start-up companies or early stage businesses. The fourth factor is the type of businesses that you will lend money to, such as technology, real estate development, and construction, residential or commercial.
Use Your Money
1. Start by naming your company and obtaining a corporate address, phone and fax number. These are essential regardless of how you legally structure your business because your legal documents will need a corporate address. Contact the secretary of state’s office, on your state’s website, to reserve your company name.
2. Meet with a lawyer to determine the legal structure of you hard money lending business. The most likely legal structure will be a limited liability company. Your attorney needs to be an expert in business and real estate. Discuss with your attorney the appropriate state of incorporation, tax issues, licensing and the different legal issues concerning residential and commercial lending. Have your attorney set up your employer identification number with the IRS.
3. Research your particular investment focus. Perhaps you have an expertise in small apartment buildings or tech companies. You will want to focus on what you know and learn what the markets are doing in your space. For instance, if you are investing in apartment buildings, you need to know the rents in the area, property values, comps (values of similar properties nearby), business environment and other factors that affect the current and future value of the property and the ability of the borrower to repay.
4. Purchase business planning software and draft your business plan and underwriting criteria based on the types of loans you will be making. Develop such items as your loan to value parameters, minimum and maximum investment amounts, interest rates charged property types such as manufacturing plants, office buildings, strip malls or apartment buildings, and payback periods. Think of your business plan as your road map that keeps you on track.
5. Put together your financial projections. Regardless of the fact that you are investing your own money, you need to know the break-even points, projected monthly and annual income based on various interest rates charged, monthly expenses, legal costs and other expenses. You will need to develop a balance sheet, income and cash flow statements, and a profit and loss statement.
6. Buy your domain name, set up your website and launch your business. Have the website professionally done and put an intake form on the site so you can pre-qualify projects online. Make certain to request information such as project type, loan requested, length of loan, value of property, location, and other important factors based on your lending criteria.
Launching a Hard Money Lending Business Using Investors
Complete all the above steps, coupled with a discussion with legal on the documents required to raise capital for your business. You need to determine in what states you will be seeking investors. Your attorney will need to be versed in “blue sky law,” which are state laws to protect investors from fraud. Direct your attorney to draft the stock subscription, stock purchase and shareholder rights agreements.
1. Hire an experienced management team. You will need a team that has been successful in the past and knows the real estate and banking sector. Team experience adds credibility and makes raising investment capital easier.
2. Draft a two-page executive summary and 20-page investor focused PowerPoint presentation. The executive summary needs to make clear the amount of capital you are seeking and clearly captures the essence of the business model. The PowerPoint needs to include use of funds and the returns that investors can expect. Edit and review your PowerPoint at least five times.
3. Develop your risk management and underwriting program. This protects you and your investors. You have a responsibility to investors to manage risk appropriately in order to protect them and to protect you from litigation should loans go bad or the business fails.
4. Begin raising money and looking for projects to fund. Having a network of commercial real estate brokers will bring you a great deal of business. By having projects that are undergoing the pre-funding due diligence process, while seeking capital, provides you a portfolio of projects that will attract investors.
Pros and Cons of Bridge Loans
Bridge loans are short-term loans in which a property owner borrowers against the equity in their existing real estate. The intention is that the borrower will purchase new real estate. After the new real estate has been secured, the previous property will be sold in order to pay off the bridge loan. Bridge loans are useful financing tools for homeowners and real estate investors with sufficient equity within their property. Prior to applying for bridge loans, it is necessary to understand the pros and cons of bridge loans.
Bridge Loan Pros
• Avoid Moving Twice: If the homeowner obtained a residential bridge loan they would only need to move one time. Once the bridge loan is funded, the homeowner would have the needed funds to purchase the new home. After the new home is purchased, the homeowner moves and sells their previous home. If the homeowner decides to first sell their current home to access the equity in the property there would be additional steps. The homeowner must move somewhere temporarily and sell their home. When their home sells, they would use the proceeds to purchase their new home. Once they have completed the purchase of new home the homeowner would then move from the temporary housing to the new home.
• Access equity quickly without selling: The purpose of a bridge loan is to borrow against the equity in an existing property in order to purchase a new property. Hard money bridge loans can be approved and funded very quickly. Bridge loans for investment property can be funded in as few as 3-5 days if needed. Owner-occupied bridge loans take 2-3 weeks as there are additional federal regulations that all lenders must follow. Hard money bridge loan lenders typically provide approval and funding much faster than conventional lenders who offer bridge loan financing.
• Present a stronger purchase offer: Homebuyers will occasionally present a purchase offer that is contingent on their current residence selling before closing the new home. Buyers must submit this type of offer when they don’t have cash on hand for a sufficient down payment or all-cash offer and need the equity in their current home to complete the purchase of the new home. This type of offer may work in some situations, but from the seller’s point of view this type of offer is weak due to the inherent risk. There is no guarantee the buyer’s property will sell quickly and at the estimated price. Any other comparable offer without a contingency to sell an existing property would likely be accepted instead. During a rising real estate market, purchase offers with contingencies to sell are not likely to be accepted or even responded to. A buyer who chooses to obtain a bridge loan against their current home and present an offer with an all-cash offer or sizable down payment has a much better chance of their offer being accepted. Bridge loans can help a buyer completely change their situation and take a purchase offer from very weak (contingent on sale of current home) to very strong (all-cash offer).
• Receive bridge loan approval after being denied by banks: Hard money bridge loan lenders are asset-based lenders and are most concerned with the value of the real estate as well as the equity the borrower has in the property. Hard money bridge lenders are able to lend to borrowers with bad credit and issues including foreclosures, discharged bankruptcies, loan modifications and short sales if the borrower has significant equity within their real estate. Institutional lenders like banks are much more concerned with a borrower’s income history and credit scores. Banks will see any issues on a borrower’s record as a red flag and probably deny the bridge loan request.
• Attain a bridge loan against currently listed real estate: Hard money bridge loan lenders are in the business of providing short-term loans and will provide bridge loan mortgages for real estate that is currently listed for sale. Most institutional lenders will not consider a loan against a property that is currently listed for sale. These types of lenders do not want to go through the process of approving, underwriting and funding a loan only to have the loan be paid off within 2-3 months.
• Income documentation not required: The current federal regulations require the borrower to provide income documentation for owner-occupied loan. The lender is required to calculate the borrower’s debt to income ratio and make sure it remains in a reasonable range. Borrowers without sufficient income documentation cannot qualify for an owner-occupied loan because of the Ability to Repay Rule. Both conventional lenders such as banks and credit unions and private hard money lenders must comply with this rule. The Ability to Repay Rule does not apply to bridge loans as there is special exception. The sale of the existing property that will be sold once the new property acquired serves as the repayment for the loan. Bridge loans may be the only type of owner-occupied financing available for self-employed individuals, seniors, retirees, and those without income (but have equity in their home).
Cons of Bridge Loans
• Higher interest rates: Hard money bridge loan lenders have higher interest rates than conventional lenders. The fast approvals and funding provided by a hard money bridge loan lender generally justify the higher rates for the borrower. Hard money bridge loan rates are higher compared with conventional loans, but the borrower will only have the bridge loan for a very short term (12 months or less). The borrower may only make a few monthly payments before the bridge loan is paid off. The overall interest paid on the bridge loan is not likely to be substantial.
• Higher transaction costs: Origination fees for hard money bridge loans are typically in the form of points, which are likely to be in the range of 1.5-3 depending on the lender and other factors of the loan scenario. Borrowers also will have to pay for standard real estate transaction fees including title insurance, escrow, notary and recording fees.
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