What is hard money lending? How it works, costs and risks

A hard money loan is a short-term loan that is backed by property, usually land or a building, and approved mainly on what that property is worth. The borrower's income, credit score and paperwork matter less than they would at a bank. The lender is asking one question first: if this loan is not repaid, can I recover my money by selling the property?

The name comes from the United States, where "hard" refers to the hard asset behind the loan. In other countries the same kind of lending goes by other names: bridge loans, asset-based loans, private loans against property. The idea is the same everywhere.

How a hard money loan works

• The borrower owns, or is buying, a property and needs money quickly.
• The lender values the property and offers a loan that is a share of that value. That share is the LTV, loan-to-value.
• The borrower signs a loan agreement and gives the lender a legal claim over the property, such as a mortgage or a charge.
• The borrower pays interest, often only interest, for a short term. The whole amount is due at the end.
• The loan is repaid by selling the property, by refinancing with a cheaper lender, or from other money the borrower expects.

Why borrowers use it, and why it costs more

Banks take weeks and want a clean file. A hard money lender can often decide in days, because the decision rests on the property. That speed suits a buyer who must close before a deadline, an investor renovating a building to resell it, or an owner who needs a bridge until a sale or a bank loan comes through.

The borrower pays for that speed and flexibility. Rates are usually well above bank rates, and lenders often add an upfront fee, commonly called points, where one point is 1 percent of the loan. The higher price covers the shorter term, the weaker borrower files and the work of recovering the property if something goes wrong.

Typical terms

Terms vary by lender, country and property, so treat these as the ranges you will commonly see quoted, not as a rule.

A worked example

An investor is buying a building valued at 200,000. A hard money lender offers a loan at 65 percent LTV, which is 130,000, for 12 months, interest only, at 12 percent a year, with a fee of 2 points.

• Interest for the year: 130,000 x 12 percent = 15,600, or 1,300 a month.
• Upfront fee: 2 percent of 130,000 = 2,600.
• Total cost of borrowing over the year: 15,600 + 2,600 = 18,200.
• At the end of the year the borrower repays the 130,000 in one payment, by selling the building or refinancing.

Spread over the year, the 18,200 is a cost of about 14 percent of the loan, more than the 12 percent rate on its face. That gap is why borrowers should always compare the total cost, not just the rate.

For the lender, the building is worth 200,000 against a loan of 130,000. Its value could fall by about a third before the loan is bigger than the property. That cushion has to cover a falling market, a forced sale at a lower price, and the cost and time of recovering the property.

The risks for the lender

• The value is wrong. A generous valuation, or a market that turns, shrinks the cushion. Use an independent valuation where you can.
• The title is not clean. If someone else has a claim on the property, or the seller does not really own it, your security may be worth little. Check ownership and existing claims before you lend.
• There is no way out for the borrower. Because most of the money comes back in one payment, a borrower who cannot sell or refinance cannot repay. Ask how they will repay, and have a second answer.
• Recovery is slow and costly. Taking and selling a property usually goes through a legal process, and that takes time and money.
• The rules apply to you. Lending against property for a fee can be regulated, and some places require a licence. Check what applies where you lend.

The risks for the borrower

• The cost is high, and fees add to it. Work out the total, not just the rate.
• One large payment is due at the end. If the sale or the refinance is late, the borrower may face extension fees or default.
• The property is at stake. Default can mean losing it.
• Terms that look small can matter. Ask about extension fees, prepayment charges and what counts as default before signing.

Keeping a hard money book in order

These loans are few in number but large in size, so each one deserves a complete file. Record the property, its valuation and who did it, the LTV on the day you lent, the claim you hold over it and the date it was created, the interest and fees charged, the end date, and how the borrower plans to repay. Put the date the loan ends in front of you well ahead of time, because that date is when the risk peaks.