There are many things about hard money lending that differentiate it from traditional financing. Perhaps the biggest difference is the need for strong collateral. If nothing else, hard money lenders expect borrowers to bring high-value collateral to the table. Without strong collateral, approval is a lot more difficult.
So what’s the deal? Why is collateral so important in hard money lending? Because it is the foundation on which the hard money business model is built. Once you understand that model, you also understand that collateral is everything in the hard money game.
Lending on Full Faith and Credit
Understanding how important collateral is to hard money lending is easier if you understand the concept of lending on full faith and credit. The latter is what banks and other traditional lenders do. They lend on the good faith assumption that borrowers will pay back what they owe. The credit portion comes into play when traditional lenders look into borrower credit histories, credit scores, etc.
Traditional lenders must leave no stone unturned when trying to determine a borrower’s creditworthiness. This is simply due to the fact that full faith and credit only go so far. Just because a borrower says they can pay back a loan doesn’t make it so. Looking into every detail of a borrower’s financial life is imperative in determining creditworthiness.
Lending on Collateral Value
Hard money lenders do things differently. As the experts at Salt Lake City’s Actium Partners explain, hard money lending is asset-based. Approval decisions are made based primarily on the value of the borrower’s collateral. Given that most hard money loans are made to cover real estate transactions, such transactions clearly illustrate how hard money lenders work.
A hard money lender’s business model is based on making loans against collateral. In the case of a real estate deal, the piece of property being obtained is the collateral. In order to approve, the lender needs to know that the value of the property is at least equal to the amount of money being requested. In most cases, it needs to be worth a bit more to cover the lender’s expenses should the borrower eventually default.
Property is a pretty liquid asset. So as long as the value is there, a hard money lender can generally see its way to approving a loan. The property backs the loan rather than the lender lending on the full faith in credit of the borrower.
Collateral Isn’t the Same
If you are wondering how collateral in hard money differs from collateral in traditional financing, note that it is not the same in both situations. In a hard money scenario, ownership of the property being purchased is almost always held in trust by a third party – usually a title company. This allows lenders to take action more swiftly if a loan goes south. Lenders can usually recover everything they’ve loaned plus their expenses.
In a mortgage scenario, ownership of the property is transferred to the purchaser at closing. Should the loan go into default, the lender needs to work through a lengthy and expensive process to foreclose. It could take a year or more and cost quite a bit of money. The chances of the lender recovering the balance of the loan plus the associated costs of foreclosure are pretty slim. Banks almost always lose money on foreclosures.
The hard money business model is built on collateral. It is everything. Anyone hoping to get a hard money or bridge loan needs to have the collateral to support it. That is just the way the game is played.