Certain types of borrowers who either cannot get traditional financing or are not interested in it turn to hard money instead. Hard money loans are the domain of private lenders, like Salt Lake City’s Actium Partners. And just like traditional financial institutions, they charge interest.
Interest in a hard money scenario is very similar to interest in traditional financing. But there are some differences borrowers should know about. Hard money lending is governed by different rules, so to speak, so borrowers really need to know what they are getting into before signing on the dotted line.
1. Interest Rates Are Higher
Even if you have no experience with hard money, you are probably aware that interest rates on such loans are higher compared to traditional bank loans. How much higher depends on the individual hard money lender. Several percentage points is certainly not out of the question.
Interest rates are higher because hard money lenders assume a greater risk. The types of projects they fund are considered high-risk projects by traditional financial institutions. That’s why banks don’t want to fund them. At any rate, higher interest rates are one way that lenders can offset some of the risk.
2. Lenders Set Their Own Rates
Hard money lenders are free to set their own interest rates. The general rule is to establish a standard interest rate as a baseline. It can be adjusted up or down depending on circumstances.
Just as with traditional financing, more risky ventures tend to incur higher interest rates. Borrowers with questionable financial histories also tend to pay higher rates than those with stellar track records. In that sense, credit score and history do matter to hard money lending.
3. Interest Payments Are Amortized
Like traditional lending, hard money lending takes advantage of amortization. Interest is calculated on a monthly basis by taking the amount owed, multiplying it by the annual interest rate, and then dividing it by 12. Traditional lenders follow the same formula. The difference is how interest and principal are paid.
4. Making Interest-Only Payments
On a standard bank loan, a portion of the borrower’s monthly payment goes toward interest. The remainder is applied to the principal. Because the amortization schedule determines interest on a monthly basis, every payment reduces the outstanding principal. This reduces interest payments and shifts more money to principal payments.
Hard money loans are structured differently. They are interest-only loans, meaning monthly payments cover only the interest charges. The principal is never reduced by monthly payments, meaning interest stays the same throughout the entire term. Structuring loans this way creates additional protection for the lender.
5. Down Payment Can Affect Interest Rates
Hard money lenders require down payments just like their institutional counterparts. In fact, their down payment requirements tend to be stiffer. This is to say they require higher amounts than banks. The higher, the better – at least for the lender.
Lenders may encourage higher down payments by offsetting them with lower interest rates. It is a way to entice borrowers while simultaneously reducing the risk.
When borrowers are real estate investors, their actual experience as investors can also influence interest rates. More experience means less risk for lenders. So just as with down payments, experience is rewarded with lower rates.
There is no getting around interest when you want to borrow. Interest is part of the game. In a hard money scenario, interest is one of the primary means through which lenders protect themselves against loss. That’s why hard money rates tend to be higher than bank rates. It is also why loans are structured as interest-only loans with short terms.