Hard money lending is a funding tool from the borrower’s perspective and an investment from the lenders. In both cases, each party has an obligation to risk management. Sound risk management practices are crucial to avoid the most serious pitfalls of this sort of lending.
Whether you are a borrower or lender, it is assumed that you know the fundamentals of risk management. But if you are new to the game, your knowledge might be lacking. Below are the most important things you need to know, complements of Salt Lake City’s Actium Lending. Actium makes hard money and bridge loans in Utah, Colorado, and Idaho.
Risk Management for the Borrower
A smart borrower will do his due diligence before he takes out a loan of any kind. Due diligence is especially important in hard money due to the nature of how it works. It includes evaluating lenders, learning how to negotiate favorable terms, and understanding how repayment works. Borrowers should also thoroughly understand:
1. Rates and Terms
Rates and terms on hard money loans can differ drastically from their traditional counterparts. Interest rates tend to be several percentage points higher due to the risky nature of hard money lending. As for terms, they are comparatively short. Most hard money loans do not exceed terms of 24 months.
2. Exit Strategies
Hard money lenders require a sound exit strategy prior to approval. An exit strategy is a reasonable plan for repaying a hard money loan at maturity.
3. Trust Deed Transactions
Hard money deals designed to support real estate transactions are almost always conducted as trust deed transactions. Borrowers need to know how such transactions work, because the trust deed model has significant implications for deed possession and loan default.
Risk Management for the Lender
Hard money is inherently more risky for the lender compared to the borrower. So due diligence is just as important. Lenders need to be absolutely sure that borrowers do not pose undue risk. They must be sure about collateral value and the borrower’s experience with asset-based lending – especially because loans are backed by real estate.
Lenders should also thoroughly understand:
1. Primary Risks
Lenders are exposed to a number of risks whenever they make loans. The primary risks with hard money are default, property overvaluation, liquidity, and fluctuating property markets. Each of these risks impacts lenders in a slightly different way.
2. The Necessity of LTVs
Hard money lenders utilize LTVs (loan-to-value ratios) as a means of mitigating some of their risks. An LTV should never be set randomly. LTVs not only reduce risk, but they also provide a buffer against declining property values. Therefore, thought must go into setting an appropriate LTV for each loan.
3. Portfolio Diversification
Hard money is an investment at the end of the day. Like any other investment strategy, it should not be concentrated exclusively on one or two projects. Lenders need to be careful to diversify their portfolios in order to spread risk across multiple projects.
When Risk Is Managed, Things Work
There is little doubt that hard money lending is riskier than its traditional counterpart. Still, things tend to work out very well when both parties manage their risks properly. Hard money’s history proves as much.
Hard money has helped borrowers with unique needs meet their financial goals for decades. That is unlikely to change in the future. Therefore, risk management should always be a priority for both borrowers and lenders. When risk is managed properly, hard money lending benefits borrower and lender alike. Everyone walks away happy because financial goals have been met.
