I hear all the time that, with conventional home mortgage interest rates hovering around 3.5%, now is one of the best times ever to secure a real estate loan. Yet, when I talk to a hard money or private lender, the quoted rate always seems to come back in double digits. I understand that these types of loans should be priced higher, but why such a disparity?
There are three primary reasons why the cost of capital for hard money loans is higher than conventional mortgages:
- Greater project risk profile,
- Increased speed in funding, and
- More flexibility with loan terms.
First, let’s talk about risk. Many homes that are purchased for renovation, re-sale, and investment purposes are in extremely dilapidated conditions. Broken windows, holes in the roof, no appliances, and over-grown vegetation are but a few of the typical conditions found in these types of properties. With construction and performance risk so prevalent, most conventional lenders aren’t equipped to underwrite and lend on such investment properties. Simply put, can the investor finish the project within the forecasted budget and timeframe, and if not, does a traditional bank have the capability of seeing the project through to the end? This conversation is much different than, say, evaluating whether a family has the means to make the mortgage payment. If the loan profile is riskier, then the interest rate theoretically should be higher to compensate for the additional layer(s) of risk.
Second, the name of the game is speed. The next time we hear, “You can fund my deal when you get around to it,” it will indubitably be the first time we hear it. These deals are often time-sensitive, which means not only being able to underwrite and understand moving parts of a transaction quickly, but also being able to source and deploy large amounts of capital posthaste. The ability to fund and manage a closing on a tight timeline typically calls for a premium in the cost of capital.
And third, there is the issue of flexibility. Conventional lenders have their lending conditions, and you either meet them . . . or you don’t. A few of these conditions include debt-to-income ratios; minimum amounts and verifications of down payments, assets, and income sources; credit score minimums; and limitations on the number of properties owned.
Meanwhile, private lenders generally can set their own underwriting rules and criteria, and borrower and project profiles are often analyzed on a sliding scale rather than simply “checking all the boxes.” Does the deal make sense? Has the investor done this before? In other words, private lenders have the flexibility to bend on certain conditions if they are comfortable with other material aspects of the loan.
So what does this all mean to me, the real estate entrepreneur? In short, yes, private money loans are more expensive than conventional loans, but private money loans are not designed to act as permanent financing – they are instead intended for projects that carry greater risk, shorter timelines, and/or a need for flexibility.
Use private money loans where they can add value to your business. For example, if you can renovate a property and add $100,000 in value in six months, the fact that it costs $10,000 in interest is a tradeoff that you would take every day of the week.