Hard money lending is an area of investing I have wanted to get into for some time now. The general rule of thumb to determine if you can do it is that you need an amount of cash equal to the purchase price of two average houses in your area. I'm not close to that yet, but I did have an opportunity arise recently that was more in my financial range.
I was contacted by someone who was looking for a hard money loan of $1,200 and they wanted to know if I was interested. The money was needed to purchase some vacant land that a family member was selling to this person, but the offer was for a limited time because the family member needed some money in a hurry and if this person didn't buy it, the family member would sell the land to the general public. The borrower offered me their primary residence as collateral.
Now, this was intriguing because it was a relatively small amount and, if what the person told me was true, there was over $100,000 in equity in their primary residence. Why couldn't this person draw on that equity? I was told they recently refinanced and couldn't do it again so soon. Why couldn't a credit card cash advance be used? Don't know. What I did know was that this person was willing to pay up to $500 to borrow this amount provided I could offer an interest-only loan for 3 months. This person claimed to be a real estate agent, but was having difficult selling right now because snowy weather had slowed things down and, therefore, commissions were slow in coming.
Hmm. Time to do some research. Real estate agents are licensed, so I looked up the licensing authority in this person's state and confirmed they were in fact a licensed agent in good standing. I also verified the home address given had this person's name on the title and that the estimated value given appeared to be in line with what I could check (of course, I have no idea of the condition of the property). The amount requested was relatively small (to me, anyway) and the loan period was short, so I figured I'd go ahead and give it a try. I doubt I'd get another chance to break into hard money lending on such a small scale.
So I made an offer: $1,200 loan at 18% interest for 3 months with a $200 loan origination fee and 10 points. Payments are interest only, paid monthly in advance and the entire amount is due in full in 3 months. The points ($120) and origination fee are rolled into the loan and can be paid after 3 months. This means the monthly payments are $22.80 and after 3 months, I will be repaid $1,520. The terms were accepted and I drew up a short one and a half page promissory note and faxed it over. My borrower got it signed and notarized and mailed it back to me, along with the first month's interest payment. Once I got that, I got a cashier's check for $1,200 made out to the person's name and sent it.
A lot of people would think I am crazy to do this deal. They can't get past the fact that this person couldn't come up with $1,200 through some other means. I made the decision that, although it's not how I would handle it if I were in this position, if the person wants to get a hard money loan for such a small amount, that's ok with me. Of course there is risk in this and I may very well lose this money. If I do, I'll consider it the cost of obtaining lending experience. (And if I have to, I can mitigate the loss somewhat by writing off the bad loan on my income taxes.) In addition, my ROI is more than the 18% interest I am charging. The interest I will receive isn't even really worth the risk and hassle of setting this up - $22.80 a month for 3 months is only $68.40. The real money is made from the points and origination fee. That extra $320 boosts my total return to $388.40, or 32.2% in three months. That's an annualized return of 129.4%. Pretty good! And since it's less than the $500 the borrower was willing to spend, it's a win-win situation.
In looking at the big picture, the points and origination fee allowed me to create money where none existed before. I created $320 from the 45 minutes of my time I spent putting this deal together. In other words, I made money from nothing.
Friday, April 08, 2005
Creating Money From Nothing
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16 comments:
Out of curiosity, how would you have handled it if you were in his situation?
I'd probably use my HELOC or a credit card.
I loan money to people from my work. I works well for me. Higher interest than sitting in the bank. Had no problems collecting
Good Thinking on your part. I'd of done the deal as well.
You didn't mention recording the loan as a lien against the property. If it is not recorded, how is it secured by the borrower's house?
The process of giving public notice of a security interest in a property is called "perfection." The loan document states I "will be listed as a lender on the title of the [house] whether or not [I] elect to perfect the security interest in [the house]." So, technically I do not need to record this document. However, should the loan go into default, my first step would likely be to record this document, thus "perfecting" the security. I could then proceed with legal recourse. I could proceed without recording and my claim would be just as valid, but recording would just add an additional layer of evidence as to my position. It would be cheap insurance.
Sorry, my previous comment referred to the "loan document." Technically, it's a "promissory note."
Shaun, without recording your lien, you run the risk of the Borrower going out and borrowing money from other people. If they record liens, then in a default they will be in front of you and that $100K of equity could rapidly disappear. Also, I don't beleive that recording the lien would necessarily be "cheap". Typically it is a percent of your loan amount, and thus would eat in to your return - unless you asked the Borrower to pick up those costs, which is actually typical.
ok, I was the first anonymous. I agree with anon2. You are not secured. Your borrower could take down a second on the property, or they could file for bankruptcy and you would be subject to a cramdown with the other unsecureds.
The reason for perfecting is to give notice to other potential lenders. A private agreement with the borrower does not do that. You would have a legal claim against them, but typically that is worthless. Also, the amount you have at risk is far too low to justify hiring a lawyer.
Not trying to overcomplicate this, and I understadn this first deal was just to get your feet wet, but this is an area of law that requires a lot of attention to detail. BTW, I really enjoy your blog.
I understand that by not recording the document, another lender can get in front of me. Perhaps I am being too naive in judging the character of the lendee.
As for being cheap, in Arizona, the cost for recording up to 5 pages is $9.00. Additional pages are $1 per page. From what I can tell, the fees for the county this person lives in are around $10 - $20.
I can't believe people are willing to pay such high interest rates! Oh wait, I just passed 10 "PayDay Advance" shacks on the way to work. Loan shark away! =)
Jonathan@MyMoneyBlog
I saw your post on richdad and I am also interested in hard money lending.
Looks like you had a great learning experience with little risk. I am wanting to start next year and maybe loan out about 5K-7K. Right now I am trying to learn about the basics of hard money lending, required documents, etc. Do you have any good resources/websites?
Again congrats on your lending :)
TC&GB,
Xtian/STG
Xtian,
Not really. You could try reading the Paper Assets forum on richdad.com. The talk there is mostly about stocks, but there occasionally is some hard money lending info. You could always ask for some info there too.
I find it interesting that you use the words money for nothing when you used both your time and capital to create the opportunity -- something for something.
When I said "money from nothing", I was referring to the loan origination fee and points. Those are fees that are basically created out of thin air. If I lend my capital to earn interest, by definition, I am originating a loan. In charging a loan origination fee therfore, I am getting paid extra for doing something I would have done anyway. Same thing with points. So rather than earn just interest on my money, as I would if it were in a bank account, I earn interest and additional income in the form of fees. But I did no additional work to get those fees - money from nothing!
How about if they avail of mortgage for bad credit? They may actually have a much lower interest rate plus they can further extend their payment period and they may not even have to use their home as equity.
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