Hard Money pts considered part of closing costs or separate?

Question

Hi folks,

Hopefully a simple question.

I talked to a private lender recently and asked what typical closing costs were.   I was told $5-6k, which didn't shock me too much.

Later in the conversation I asked what the points on the loan were, and were told 4.   So the loan is 15% at 4 pts.

What I forgot to ask is if the points are considered part of the closing costs, or if they are on TOP of the closing costs.   I do have a message in to the lender to clarify, but in the meantime, I wanted to ask those of you who deal with hard money how it normally works in your experience?

Thanks,
Bryan

Dion DePaoli · Answer

"Closing Costs" are a generic term that carries a variety of meanings depending on who you speak to.  They incorporate the different cost segments to the transaction such as lending costs, legal costs, title costs, etc.  That is aside from the "Cost to Close", which usually describes the amount of money needed from a borrower at the closing table.  If you ask a Realtor about closing costs, they will infer one idea, a mortgage lender or broker another idea and a title agent likely a third.  Where all of the ideas have commonality but at the same time some distinctions and perhaps exclusions.

It is because of this terminology manipulation, if you will, that there are requirements to expose or show the borrower what the costs involved in the loan are.  In residential loans, regardless of the lender (HML or conventional) the TILA (Truth In Lending Act) applies.  Typically in commercial, line items are present on a term sheet but not a TILA.  Commercial loans are less regulated than residential loans and can be more complex so TILA is not always used, but some lenders do use them.  There is no duty to apply TILA to commercial transactions, but instead, it is generally the practice of a prudish investor to get to the bottom of what number is for what.  Commercial borrower are expected to be of a more sophisticated level than that of a the residential or consumer level borrower.  That is why the rules a little different (ok, a lot different)

I would side with Bill in his reference to what the "points" are.  A point by any other name is still a point.  Call it broker fee, call it origination fee, call it rate buy down, etc.  They are all points.  Those points are considered an expense and are factored into the cost of the loan and amortized over the term of the loan since that is how the loan is to be paid back.  Again, go check out TILA text.  TILA allows a borrower to compare two different loans by way of apple to apple.  Prior to the implementation and updates to TILA loans had hidden fees and interest rates alone are not a good indication of a good deal.  As an exercise, go pull out your Note and look at the interest rate, then go look at your TILA and look at the APR.  (they are not the same number)  TILA will be more than the note rate as there are fees, which are not borrowed but are still considered 'financed'.

And there in lies the next distinction.  In a loan, there is "Principal" and "Interest".  So, again, Bill's is correct, those points regardless of who receives them (broker, lender, employee, Johnny down the street) are considered "prepaid interest".  It falls to that category, since in order to get 'that' loan, those fees, paid by the borrower, are present.  So in this case, in order to get the OP's loan of 15%, it includes 4%.  The purpose of the 4% or points, whether it is used to pay a broker or it is used to buy down the rate or pay the lender has no affinity to what they are, which is prepaid interest.  It is the cost of the loan.

Interest is simply defined as the fee paid by a borrower for the use of principal.  Paying those points at closing is considered "prepaying".  That is opposed to paying along the way or paying at the end.  Again, the loan is originated, the principal is not given to the borrower to be used without the points.  Cost of the loan.

For the record, these are also all the items that go into the calculation for high cost loans or usury.  A loan proposed in a state where 12% is usury with 9.0% interest plus 4% in fees, 2% to a broker and 2% to a lender over 12 months is usury and the rate is considered 13% not 11% since that is all that goes to the lender.  The broker is part of the cost to the loan, just like an employee, etc, etc.

Now, all that said, just like "closing costs"; "Points" take on many different meanings depending on who is speaking.  So as a prudent borrower, always get loan terms in writing.  When closing, always have a settlement statement that has line items of fees and costs, etc.

Account Closed · Answer

Thanks for the replies, everyone.

As it turns out, this hard money lender does consider the points part of the closing costs.

Until this thread, I had no awareness of the important between discount and origination points and their possible tax/other implications.

As always, thank you for the education!

Bryan

Ann Bellamy · Answer

Steve Babiak, nice reference, thanks.  It defines a distinction between the two.

The concept of buying down the interest rate in a short term (usually 6-12 months) loan doesn't really apply for hard money deals.  It makes sense if the loan is long term:  the borrower pays points in order to obtain a lower rate which will save them very significant dollars over the term of the 15-30 years.

It certainly CAN be prepaid interest in the sense that the lender is looking for a certain return regardless of how quickly the loan is paid off.  If a rehabber pays off the loan in 3 months, the interest return would make it not worth the paperwork, so the points compensate for that.  In that sense, Bill is correct, they are essentially prepaid interest.

However, depending on the structure of the deal, they are frequently origination fees that don't go to the lender.  They can go to the broker or some lenders pay their loan originators with those points.  In those cases they are not pre paid interest.  While they may be considered to be so by an outsider, the reality is they are fees paid to obtain the loan.

And in some cases they can be a combination of the two.  In either case, the borrower should calculate these fees as a total cost of borrowing the money.  Payments are almost always interest only, so are easy to calculate.

In neither case are the points amortized over the life of the hard money loan.  Occasionally they are capitalized into the loan, which is a different calculation.

Thank you, Steve, for pointing out the distinction.

The original poster was simply asking whether the lender was including points when he quoted closing costs, and that lender is really the only one who can answer that.  Hard money rates vary by location, so while 15% and 4 points is high, it is certainly not unheard of.  If closing costs are $5K-6K and DON'T include points, those closing costs are VERY high.

Bill Gulley · Answer

LOL, I guess I do!

Points are pre-paid interest.

Origination fees can be expressed as points but is a fee for origination, same with processing or whatever else a lender can dream up as an expense. You'll find this in FASB and GAAP, if points are simply referred to as "points" and not associated with an expense, they are for the money loaned making it pre-paid interest. :)

Doesn't matter what kind of a loan it is, if points are allowed to be charged. In some areas points may not be charged unless they are a regulated lender.

And, points paid on the money affects the APR calculation and may cause a loan to violate usury laws, if the state has them, as applicable.

Bill Gulley · Answer

Quickly said, if the points increases the yield to the lender, it's interest on the money and interest is amortized. Not all points increase the yield but are loan expenses. As Charles mentioned above, I'd suggest you sort it out with your accountant.

Dion DePaoli · Answer

My sentence dialog is not as good as it could have been.  Clearly, in the 3.0% Points 12.0% Interest points are not amortized into the loan payment schedule, they are paid upfront.  To truly compare the cost, they should be amortized into the loan and that is how residential loans are mandated to be compared.

If the above loan is taken for 12 months.  The cost of the funds is 15%.  If the loan lasts 6 months the cost of the funds is 9.0% (18% annual).  If the loan lasts 1 month, the cost of those funds is 4.0% (48% annual).   If the loan lasts 24 months, the cost of funds is 13.5%.

The points are paid at closing and upfront.  I did not mean to imply that is not true.  The points have to be paid in order to get the loan.  A loan has two components, principal and interest.  The principal is $100k.  The interest is what is paid to use the principal.  So in one full year, the borrower pays $12k+$3k=$15k.  In the 6 months borrower pays $6k+$3k=$9k.  The variable is the interest accrual which is based on the term the principal is outstanding.

The reverse way to look at it is the return to the investor who capitalizes the loan.  Points are a function of the capital stack that makes up the loan.  Weather those points are paid to an originator, who distributes the loan or they are used as hedge on return for the investor.  They are attached to the loan.  The nomenclature of buy-down or broker fee or any other name is sort of meaningless in the sense that the points all serve the same purpose.  The purpose is to get the investor to give the borrower principal to use for a certain time at a certain rate with some perspective on risk and return to the investor.  Whether that risk is default or prepayment does not matter.  Points are used to sure up the return to the investor for that purpose.  The same is true when a point pays an originator, regardless of employment inside or away from the lender.  The point is used to pay the employee to put the investor's money to work.  The originator has to go find borrowers and link them the investor, for that service they get paid from the loan.  Sometimes that payment is points or sometimes that payment is yield spread premium, all of that is interest.  It is all a part of the same thing.  The real end game however, is the investor and the borrower.  The investor has lend and the borrower has to borrow.

So the points are all a part of the same loan.  That is regardless of allocation or disbursement to various parties in the loan chain or system.  The fact that the 3% is collected upfront does not change the fact the 3% is indeed interest.   There is only two components to a loan, principal and interest.  If points are a part of the loan and they are not principal, they must be interest.  In the end, the borrower paid for it all.

Bill Gulley · Answer

There have been several around here who go out 5 years, 3 years is the norm, these are on purchases and are hard money loans. They work with the general public as well as flippers and bridging transactions under a year. While many specialize in different markets, HMLing is a very broad arena, especially in real commercial transactions. And, BTW, they don't charge anywhere near 4 points and 15%, usually about 12%, residential is 10%. Points go to the broker, usually 2 or a flat fee for small loans.... post SAFE Act has made things more complicated, where the HMLs are lending to the broker or buying the note. Different parts of the country too I guess.

Ann Bellamy · Answer

In today's post-SAFE act world, the majority of hard money loans are one year or less, mostly about 6 months.  In the hard money world, 2 years is long term.

If a borrower needs to stay in hard money for more than a year, the project is even riskier than normal because hard money is designed as a short term bridge loan, and the cost of hard money for more than 1 year will often kill the project.  The borrower needs to be able to secure conventional funding within a year in order to make the bridge loan feasible.

Bill Gulley · Answer

Ann, that is the proper accounting, however you have now made the loan for less than one year or less than one tax period and in that case there would be no amortization, except on the books of the borrower for 6 months and then fully expensed for that tax report then due. But it is different if the loan is say 2, years or longer.

If I have to pay 3K out of pocket to get the loan it is the same thing as receiving 97K without me having to pay, the allocation is, as required for the APR computations, that the borrower received 97K as Dion explained.  You may not be computing an APR if you are only doing commercial loans, while institutional lenders will generally provide it anyway. A commercial loan is not required to be on a HUD-1 but can be on any closing statement that showes the expenses and cash flow of the transaction. A HML can loan on residential properties and be required to provide the APR and utilize the HUD-1. No distinction was made by the OP.    :)

Ann Bellamy · Answer

"They are all points. Those points are considered an expense and are factored into the cost of the loan and amortized over the term of the loan since that is how the loan is to be paid back. "

I can certainly see not distinguishing between the different types of points and calling them all pre paid interest.  I don't concur, but I can see the perspective.  I must respectfully still disagree that points are always amortized into the loan.  Take the following case:

Borrower pays 3 points and 12% annual simple interest on a hard money loan of $100K for 6 months.

Points are paid at close, and $100K goes toward the purchase of a property.  You can debate whether the borrower only receives 97,000 or whether he pre pays the points, but the borrower comes to the closing with the $3000, and $100K goes to the seller.

For 6 months, the borrower makes interest only payments of $1000 per month.   There is no amortization of the points.  At the end of the 6 months, the property is sold and the borrower pays off the $100K.  again, no back end points, no amortization schedule of the points.

There may be a an amortization of the points for tax purposes, if it was a refinance, but in a short term interest only loan, the points are not amortized into the loan.  This is a very common hard money scenario.

If one of you can tell me how the above scenario describes the amortization you have referenced, I'll be happy to learn something new, but so far, I don't see it.

Hard Money pts considered part of closing costs or separate?

Most Popular Reply