The term “hard money” in hard money lending originated from the nature of the collateral involved in the lending process. In hard money lending, the loan is secured by a tangible asset, typically real estate property, which serves as the collateral. The term “hard” refers to the tangible and physical nature of the asset, in contrast to “soft” assets such as stocks or bonds.
Hard money lenders primarily focus on the value and liquidity of the collateral rather than the borrower’s creditworthiness or financial history. If the borrower defaults on the loan, the lender has the option to seize and sell the property to recover their investment. The use of physical assets as collateral provides a “hard” guarantee to the lender, making it a secured form of lending.
Here are 5 reasons to LOVE it:
- A win for the lender, a win for the borrower, and a win for the community.
- The lender is able to place investment funds at anywhere from 8-15% yield which kicks the pants off Wall Street. This is my favorite kind of “mailbox money”. If you invest in income properties, cash flow can be smoothed out with hard money lending.
- Borrowers with poor credit history or unique financial circumstances can still obtain funding as long as they have valuable collateral. This feature is especially advantageous for real estate investors who need immediate financing for property acquisitions or renovations.
- The community where you lend (I like lending local) is a huge benefactor. Borrowers are improving the real estate on “Main Street” and getting paid well for their efforts.
- Speed, Flexibility, and Security: Hard money loans offer a faster approval process, making them suitable for time-sensitive transactions such as real estate auctions or investment opportunities. Lenders focus primarily on the collateral’s value, allowing for more flexibility in terms of borrower qualifications. I am evaluating the collateral first and foremost. My risk as a lender is defined by the Loan-To-Value (LTV), and the quality of the collateral (real estate). I might be open to a higher LTV on a better quality piece of real estate because if I need to foreclose due to a default by the borrower, I have more options. A traditional “soft lender” must evaluate the credit worthiness of the borrower, which does factor into my evaluation but matters less. Personally, I would rather evaluate a static tangible thing like real estate than a dynamic fluctuating emotional organism like us human beings!
- Opportunity for Higher Loan Amounts: Hard money lenders may be more willing to lend larger amounts compared to traditional lenders, as they primarily assess the property’s value rather than relying solely on the borrower’s financial history.
- Mailbox Money: In the lender role, this is true mailbox money. I conduct my investment due diligence (dd) up front. I look at the collateral. The question to ask yourself is “Am I happy if I get paid, AND am I happy if I don’t get paid? If the loan goes well I get paid 12% on my money, and if I’m really smart I lend money from a self-directed retirement account and I pay no taxes on the interest income. If the loan goes bad, and you lend money on quality real estate at 50-65% LTV, and the the borrower defaults on the loan, after some legal work, I take the collateral back with a steep discount to the market value. Of course I need to understand what to do with the collateral, but that’s a great scenario to play out should the investment “go bad”.
- Passive Income, Compounding of Capital, and Investment Term: For easy math, if you’re lending at 12% inside of a self-directed ROTH, you are doubling your money every 6 years. This is rocket fuel for retirement accounts! If you outsource the loan origination and loan servicing, there isn’t a more passive investment in real estate that I’m aware of. Most of the loans I’m involved in turn-over every 3-6 months, so you will receive your principle back often to re-evaluate market conditions and determine if there is a better opportunity to compound your money.
Risks and Considerations:
- Borrowers are usually betting on a profit after they turn a property from an ugly duckling to a beautiful masterpiece. It is possible that a borrower’s exit plan fails, or they get caught on the wrong side of market conditions, or miscalculate the funds needed to rehab the property. These are all possibilities and must be evaluated by the lender and borrower, and there should be a clear business plan established at the beginning of the deal which lays out everything.
- The more skin in the game the borrower has, the less likely they are to walk away from the deal leaving you to pick up the pieces. It is better for a lender’s security to have the borrower use a portion of their own money for closing; maybe 10-20% or more. Withhold construction funds and allow the borrower to withdraw funds as they complete the rehab on a schedule of milestones. You or your representative can do the inspections to make certain the rehab is a certain percentage complete before releasing more funds to the borrower.
- Have a plan B. If I lend on a property, I always evaluate holding the property if it comes back to me in default. What can I get for long term/short term rent on the property? If I hold it for 5 years to let the market come back and ultimately sell it, what is my ROI as a rental? Is it acceptable?
Growing Significance:
We are currently in a market where bank loans are becoming more conservative and harder to get. I expect the trend to continue. As the financial landscape continues to evolve, hard money lending is likely to remain a significant component of the lending ecosystem. Its ability to bridge gaps in traditional financing, coupled with its adaptability to various market conditions, positions it as a valuable tool for borrowers seeking timely and flexible funding options and lenders seeking stellar returns.
Please smash the “like button” or leave me a comment if you found this information useful.
Best,
Derek
Derek Petersen
Chief Compounding Officer
Aviara Capital Investments
www.AviaraCapitalInvestments.com
www.linkedin.com/in/derekpetersen
Disclaimer: I am a financial independence guy and a financial freedom hack. I am not a financial advisor, a CPA, or a broker of anything. I recommend discussing financial decisions and/or planning with the professionals.