Hard money lending drawbacks from lenders perspective

10 Replies

Hard money lending seems to be popular in my area and every lender that does it just raves about it. I would like to know what the drawbacks are and things to look out for from the lenders perspective? Aside from having trust and knowledge of the house flipper, being in first lien position, making sure you know the market/ARV of the property, and using a qualified attorney, what are some of the numerous other things to look out for? Would love to hear any and all stories/experiences good or bad from hard money lenders that lend money to house flippers?

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1. If the borrower doesn't maintain hazard insurance the house could burn down and you lose a very healthy part of your equity cushion, if not all of it.

2. Assuming you even get a title policy, there could be a title flaw and the title company refuses to pay a claim ... ever hear of an insurance company finding an exemption in those impossible to read policies?

3. The market could turn and your collateral value goes down by half ... ever hear of the great recession?

4.  If it's a flipper loan you could end up owning a property that is only partially rehabbed leaving you with a big mess to clean up.

5.  You could originate what you thought was a business purpose loan that turns out to be a consumer loan, thus leaving you with multiple state and federal regulatory violations ... ever hear of a flipper that underestimates the resale value and moves into and lives in the house?

6.  You could be improperly licensed and violate state lending laws.

7.  You could wire funds to a scam title or escrow company bank account ... I get notice from every escrow officer I make a loan on in big bold letters to call the office prior to wiring funds, scams are rampant.

8. The borrower could be a pita and although you get your money in the end you have to take Ambien every night for two years to sleep, not to mention the 376 new gray hairs you acquire.

9.  Your spouse could leave you because you made a bad loan and (s)he thinks you are a dope.

10.  It could be one family member lending to another and things go bad and now everybody hates everybody forever.

11.  You could lend your last dime and not have reserves to fight a Bk or go through a foreclosure.

12.  I could go on but I have a cast on one hand and I'm getting tired of writing.

Another major risk is the borrower declaring bankruptcy. You'd be a secured creditor, but it would still be a major PITI.

For flipper loans you're probably dealing with borrowers with many contingent liabilities that are likely to impact their creditworthiness if anything else in their portfolio blows up for whatever reason.  

there are 50 ways to leave your lover.. same with hard money lending there are 50 ways to lose your money.  but if you use a little bit of smarts you can limit that to maybe 3 or 4 ways.

And if you really know how to do things you can mitigate that even more.

First, I agree, @Andrew Hooyman , with everyone you met that raves about lending.

Adding to Account Closed's excellent list of pitfalls, with maybe a bit of overlap:

  • You could take bad lending advice from a lousy attorney and not know it. (Not that that's ever happened to us).
  • You could start out undercapitalized and initially get into low value loans such as dangerous 2nds or into low-cost out-of-state areas you know nothing about to borrowers you’ve never met against properties you've never seen.
  • Similarly, you could advertise online (Craigslist, LinkedIn, and yes, BP) and take an ill-advised chance on strangers.
  • You could break the law by advertising in states that require a license to simply call yourself a lender.
  • Not understanding licensing requirements in the state you're lending.
  • Lending to anyone who is inexperienced. I could leave it at that, but especially if you are also inexperienced. This is not a business where the blind should lead the blind.
  • Not knowing the difference between a consumer purpose and business purpose loan. (I'll add that 95% of all the lenders on BP, some very experienced, don't know the difference. @Account Closed , excluded.)
  • Not understanding the definition of a prohibited transaction when lending through your retirement plan.
  • Making the perfect loan to a perfect borrower on a historic home, without knowing that there are three historic committees that must all agree on the repairs but never meet at the same time. (Guilty -- on a three-year HML, and counting.)
  • Not having a clue about how to read a preliminary title report or how to specify lender title requirements when requesting one.
  • Not understanding all the documents you need in the state you are lending, including all the required disclosures.
  • Finding your lending documents online, asking for them on BP, or posting some here and asking for legal advice. Truly, this never ceases to amaze me.
  • Not knowing how to do due diligence on a pre-brokered loan. Becoming a lender by buying pre-originated loans thru a broker you have no idea knows the first thing about originating a loan in their state. Perhaps they are prolific and write well here on this board? Is that good criteria?
  • Poor understanding of foreclosure and deed-in-lieu requirements. For example, asking a borrower to sign a DIL at closing.
  • You do know how to qualify a borrower and the property? Yes?
  • Lending is not tax efficient. Interest income is taxed at the same rate as ordinary income. You don't get the benefit of depreciation or any of the other tax advantages as real property. On the other hand, it's very time efficient, and there are no tenants. Retirement plans are best suited for lending.
  • On a positive note, it's not a difficult business to learn and earn double digit returns with very little risk, if you're careful.

Let me add one.  It's more of a moral dilemma than something that can go wrong.

I was asked by a newbie flipper for a loan. I did my analysis based on rosie assumptions and determined that if everything goes as expected, and of course it never does, he will make about 1% of ARV as profit. Should I make the loan or not?

Keep in mind that flipper will probably find a loan somewhere else if I don't do it, I will make money no matter what because my LTV is super low, I showed them my analysis and explained that the margins are very thin and probably negative and they want to go ahead anyway, I've seen many successful loans and many unsuccessful loans so I know the difference, I recognize the newbie mindset that leads them into this kind of deal but cannot change it ... so what do you think BP?

No way, Account Closed Since you know the borrower will likely not make money, this could be considered a predatory loan. If he contested a foreclosure or complained to the BRE, your license could be in jeopardy, as well as your cash.

Anyone can make a bad deal and it doesn't matter that he'll find another lender elsewhere. Lot's of new borrowers and lenders don't think the numbers apply to them. I've heard borrowers say they don't mind if they lose money at first. I imagine this lasts until they have to bring a check to escrow on their first sale. Let Darwin take care of this. Not you.

FYI, after we agree to make any loan, we send the borrower our comp comparison to theirs, indicating our agreement with the ARV, our walkthrough summary to confirm the repairs, as well as our spreadsheet evaluation showing why we believe this deal will provide a fair profit to them. IF something goes wrong, and by doing this it rarely does, it can't be because of bad initial intentions.

Why risk the brain damage of a foreclosure, David? Certainly, you can find qualified borrowers with qualified deals?

Interesting take @Jeff S.

Lose money: They are projected to make money, not much but it should be positive, assuming their assumptions about ARV, rehab costs and holding time are correct. I say they could lose money because I know these assumptions are just that, often way off and the margin is small. What has always amused me about projections is that rehabbers are willing to work on a 10% profit when the input variables like ARV can EASILY be more than 10% off thereby driving their profit negative or >=20% in the blink of an eye. Any projection is very squishy at best, even mine They do have a line item bid from a contractor so I know rehab costs are not a wag. I use 6 mo for holding time.

Comps: They have comps from a local realtor who has listings in the area, they seem a little sunny day to me but they aren't too bad. I'm not that familiar with the area so I'm going with the realtor comps. If the LTV was higher I would probably demand an appraisal which I have done many times in the past. I really have a hard time demanding the borrower pay for an appraisal when my exposure is so low and they will just ignore it anyway.

Predatory loan:  That term applies in the consumer arena for sure,  I'm not so sure it applies in the B2B arena.  Do you know anything specific about this?

Don't mind if they lose money: I've heard that too, that's when I'm sure I'm dealing with a newbie. They won't however be bringing a check to escrow in this case, the check they receive from escrow at closing will simply be less than the sum of their downpayment+rehab+holding+sales costs ... they will walk away with a good size check no matter what. They would have to be off on the ARV by more than 40% before they would have to bring money to closing ... ain't going to happen.

Foreclosure: There won't be any foreclosure, the LTV is too low. IF it becomes a negative profit scenario either they will lower the price and sell now, or hubris will kick in and they will keep the price too high until they get sick of losing money then lower the price for a quick sale.

I looked back at my projection, the potential profit is 4%, not 1% like I said earlier, borrower is projecting higher than that.  Personally I wouldn't do the deal as a rehabber, not even at a 10% projected profit, but I'm a very conservative guy.  Just because I wouldn't do the deal as a rehabber does that then mean I shouldn't do it as a lender?