What are the costs of a Hard Money Loan?
A Hard Money loan is a short-term, collateral based loan most commonly made by Private Lenders. Private lenders are either individuals or groups of individuals who are lending their own money. Because they are lending their own funds, they can make their own decisions on the types of loans they want to make and they type of deals they feel comfortable with. The downside is that Private Lenders are people like you. They have a limited source of capital which they have earned, paid taxes on and saved. Combined with the added risk inherent in a collateral based loan which typically has minimal underwriting and low or no credit requirements. Some Hard Money Lenders to speed up the loan process will also waive the need for appraisal or home inspections. For these reasons this type of loan is generally considered to have more risk. Hard Money Lenders will also loan out money for shorter durations. If someone is going to borrow money for 3 to 6 months, it would make sense that they would need to pay more than if they were going to pay interest for 15 or 30 years. The combination of higher risk, limited funds, and shorter loan durations drives the higher interest rate that borrowers will pay when they take on a Hard Money loan.
In contrast, banks and credit unions are institutional lenders. They borrow money from groups of people “their depositors”. This capital source is plentiful and relatively inexpensive. They also deal in loan types that are insured or backed by the government which offers them no risk or much lower risk if the loan were to default. Conventional lenders also sell their loan to the secondary market which also reduces their risk and gives them almost limitless low-cost capital. The tradeoff is that they are highly regulated and have limitations of the types of loans they are willing or able to make. They also lose money on loans that last less then 2-years, so don’t expect them to jump at the opportunity to fund your next flip.
These factors play into the cost of the loan and the interest rate which each type of lender can fund loans profitably. Institution lending is greatly affected by the Federal Reserve’s Interest rate since the bank’s profit is made in the difference in what they can borrow the money for and what they can lend it out at. Bank lending rates can change daily or even hourly. A Private Lender’s rate of interest can also vary, but it is more tied to the type of the loan, the associated risk, and how much money they have left to lend out.
For these reasons you can expect to pay more for a Private money loan or hard money loan. The cost of the loan will vary from lender to lender. Some lenders reduce their rate based the amount of loans you have made with them, the amount borrowed or the loan size in comparison to the value of the property LTV. Others have a fixed rate.
Whether you borrow from a Private Lender or Bank you can expect to pay for closing costs. Closing costs are the cost of all the people and services needed to create a loan. The biggest difference with a Private Lender or a Hard Money loan is the larger upfront fee to make the loan. This is commonly called an Origination fee and is commonly a percentage of the amount borrowed.
This cost represents what it costs the lender to make the loan. The reason a Hard Money loan costs more than a conventional loan is largely based on the length of the loan or the loan duration. If you have a loan for 30-years the lender has more time to recoup the cost to make the loan. A Hard money loan is generally less than 2-years and sometimes as short as a few days…so there just is not the time to cover all the costs. Like banks, a Private Lender is in the business of making loans and it cost them money to make a loan. They too have buildings, employees, insurance, licensing and systems that all cost money. It is not uncommon for a Hard Money Lender to charge between 1% and 5% of the amount borrowed as an origination fee.
As with any loan there is a cost to prepare the loan and legal documents that will secure the lenders interest in the property. These documents are usually drawn up by a legal firm or attorney and the cost can generally range from $500 to $5000 and will depend on the complexity of the loan.
As with any loan, the lender will want to make sure that there is sufficient insurance bound to the property to secure against fire, damage or injury. This cost will be paid to the borrower’s insurance agent or company of their choice and will vary based on the type of project, the usage of the property, location, and property value.
Almost all lenders require a 3rd party Title and/or escrow company manage and insure the transaction. Title insurance is different than property insurance as the title company is responsible for documenting all liens on the property as well as judgments against the borrower. The title insurance ensures that there are no other liens on the property (other than what the lender allows) after the transaction is complete. This fee varies based on the loan amount and is paid to the Title and Escrow company directly.
In addition to the closing costs which pay for the creation of the loan, the loan itself has interest that is due. Hard Money Interest rates can vary but are generally in the range of 8% to 18% per year.
Long-term loans are almost always amortized which means that you will pay both the interest and principal. Hard Money Loans have shorter term loan durations and the payments are commonly interest only. Meaning you are just paying the monthly interest due and your loan balance will remain the same.
Most Hard money Lenders want their money back quickly and will set a timeline for when the loan needs to be paid back. The expectation is that you will pay off the loan in full on or before this time. Most lenders will charge you an extension fee to extend the loan past the due date and it can range from a 1/4 % per month up to 1% to month. Some lenders don’t charge extension fees…definitely check and understand what would happen if you need to keep your loan longer than expected.
One of the ways Hard Money lenders reduce their origination fees is to include a Pre-payment penalty. This means that you have to have the loan for a minimum set time or pay a minimum amount of interest, even if you pay off the loan early. Not all lenders charge these, so be aware if your lender does.