There is a unique form of lending most consumers do not know about because it is primarily the domain of real estate investors. It is known as hard money lending. Hard money can be a valuable resource to investors looking to move quickly on property deals. Hard money is also easier to come by. But it has its own strings. For example, most hard money loans are structured as interest-only loans.
You might be familiar with the interest-only concept if you purchased a home in the late 1990s or early 2000s. Back then, interest-only mortgages were pretty common. They were known as balloon mortgages in those days.
The mortgages were considered subprime and risky. And in fact, the overuse of interest-only mortgages was a big contributor to the 2007-2008 housing crash. They proved so disastrous the banks no longer offer them on residential purchases. However, hard money lenders still deal in interest-only loans.
The Basic Principle
The basic principle of an interest-only loan is this: a borrower makes monthly payments that cover interest alone. Taxes and insurance are also covered if they are paid via an escrow account. The principal – which is the original amount borrowed – is paid as a single, lump sum on the due date of the final payment.
The name ‘balloon mortgage’ was born out of this practice. That final payment was known as a ‘balloon payment’ because it was so much larger than an interest-only payment and it was paid in one fell swoop rather than gradually.
Actium Partners, a Utah hard money lender based in Salt Lake City, says that hard money loans arranged as interest-only loans work the exact same way. A borrower makes monthly interest payments for the entire term. With the last payment, he also pays the entire principal amount.
One Major Difference
Actium says there is one big difference between a hard money loan and a balloon mortgage: term length. The balloon mortgages of the 1990s and 2000s were generally structured as 10–15-year loans. Terms on hard money loans are much shorter. How short?
Most hard money lenders will not exceed 36 months. Actium rarely goes beyond 24 months. Better yet, they prefer to keep terms at 6-12 months whenever possible. Why does this matter? Because shorter terms give borrowers less time to come up with the principal. This is where hard money borrowers need to be incredibly careful.
Trust Deed Arrangements
While there are exceptions to the rule, most hard money loans are facilitated through trust deed arrangements. A trust deed arrangement involves a third party, usually a title company or attorney.
At the time of sale, the property’s deed is transferred to the third-party who acts as a trustee. That party maintains custody over the property even though the buyer maintains day-to-day control. Only when the loan is fully paid off is the deed transferred from the third-party to the owner.
This arrangement makes it a lot easier for a lender to move when a borrower defaults. A trust deed typically includes a right to sale clause, a clause that gives either the lender or trustee the ability to immediately sell the property in the event of default. A sale can be initiated without any court intervention.
What does this all mean? It means that hard money borrowers need to be sure they can pay up on the maturity date before applying for a hard money loan. Otherwise, failing to make that balloon payment could ultimately result in the loss of the property and any money the investor has already put into it.
