The Pros and Cons of Becoming a Hard Money Lender
When most people think of real estate investing, they tend to think of direct investing: buying property to fix and flip or hold for long-term rentals. While these are the most popular ways of participating in the real estate investment market, there are other options.
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If direct investment isn't for you or if you are already an investor but want to add some diversity and expand your reach, one option is to look at getting in on the other side of the real estate investment equationâas a hard money lender.
Overview of Hard Money Lending
In case you are new to this term, a hard money lender, also known as private money lender, is a non-institutional (non-bank) individual or company that provides Âloans to real estate investors (borrowers) for the purchase or construction of properties.
The term "hard money" is used because the lender focuses more on "hard" assets (the real estate) when evaluating a deal versus the borrower's ability to pay as indicated by income or credit score. The loan is generally secured by a note and deed of trust.
What Is a Hard Money Loan
Loans available from a hard money lender are known as hard money loans, private money loans, rehab loans, or bridge loans. The borrower's objective is usually to purchase and then Âfix and flip or, in the case of new construction, build the property and sell. In both cases, time is critical.
Borrowers want to complete the project as quickly as possible, so they can repay the loan and turn their project into proÂfit. There are many varieties when it comes to hard money loans, but most have the following characteristics:
- Usually short term (6 to 12 months)
- Commonly used for fix and flips but can also be used to build new properties or purchase and hold
- Most often used for residential properties but can also be used for commercial real estate
Considering Becoming a Hard Money Lender?
Here are a few pros and cons to consider:
- You can expect a relatively high return on your investment as compared to bank investments or bonds.
- The actual work of rehabbing and building is someone else’s problem. Some people are better suited to be financial managers/lenders than they are to do the actual work on the property.
- There is a margin of safety as hard money lenders typically lend 65% to 70% LTV (but see point below about less risk equating to less reward).
- Hard money lending is relatively secure since you can hold the borrower’s assets as collateral. If the borrower defaults, you can move in to secure the collateral through foreclosure.
- Becoming a hard money lender requires a lot of capital. You actually have to have money to lend. And you need to make sure that you can cover the expenses required in case the borrower defaults and you need to go to court to recover your cash. (IRA money can actually be used for this purpose, but to make this work, you must set up a self-directed IRA.)
- While returns can be attractive, lending money for a project will typically result in a lower return than if you were to take on the project yourself. In exchange for taking less risk, lenders are limited to making money on the interest. If a project is super profitable, all of the upside goes to the borrower who took the equity risk.
- Hard money lending lacks standardization (this is both a pro and a con). There are fewer requirements, less paperwork, and limited red tape. But with a lack of standardization comes a real risk of borrower default.
- Federal regulators, including the Consumer Financial Protection Bureau, routinely update the rules in ways that could affect hard money lending. It is important to be aware of and stay on top of federal and state regulations.
- There may be additional licensing requirements depending on the state in which you will lend.
Just like any venture, becoming a hard money lender has its pros and cons. Before jumping in to the business of hard money lending, it is important to do your homework. Make sure you have clearly defined goals and objectives, know your strengths, and identify where you'll need help.
In my case, it made sense to expand my real estate investment business by adding hard money lending to the equation. I had the industry knowledge to evaluate the deals, could assess properties well, and knew when to walk away.
I also had a network established, a way to raise the capital, and a business objective to expand without being hands on. Review your objectives and strengths to make sure it is the right option for you.
Have you considered getting into hard money lending? Do you have any questions for me?
Ask away in the comment section!