Lending is risky business regardless of how one goes about it. But some forms of lending are riskier than others. Take hard money lending. It is not for the faint of heart. Hard money loans are inherently risky. They can also be quite rewarding.
Hard money is the name of a game at Salt Lake City’s Actium Partners. With many years of experience making hard money and bridge loans in Utah, Idaho, and Colorado, they can testify to the fact that lenders must do what they can to mitigate their risks.
So how do they do it? Here are the five most common risk mitigation strategies in hard money:
1. Short Terms and Higher Rates
Rates and terms are the top two risk mitigation strategies in all types of lending. In the hard money space, lenders prefer terms as short as possible. Most hard money and bridge loans are offered for 6-24 months. Up to three years is possible when circumstances warrant, but most hard money lenders like to stick with two years or less.
As far as interest rates are concerned, the rates on hard money loans are higher than their traditional counterparts. How much higher is up to the lender. Several percentage points are not unheard of. By charging more interest, lenders can mitigate potential losses.
2. Conservative LTVs
Next, hard money lenders are known for their conservative loan-to-value (LTV) ratios. Where a traditional lender might be willing to go as high as 75-80%, hard money lenders are known to go as low as 50-65%. A more conservative LTV makes it possible to maintain a buffer against a future decline in the target property’s value.
3. High Collateral Value
Collateral is the basis for approving a hard money loan. That is why hard money is considered asset-based lending. According to Actium, collateral value is everything. Lenders like to see high-value properties backing the loans they make. The greater the value, the less risk the lender faces.
This is not to say that a low-value property won’t get funding. A hard money lender could still choose to write a loan on that property. But rates, terms, and LTVs might be less attractive.
4. Reasonable Exit Plans
Hard money lenders require that loan applicants furnish an exit plan with their applications. Furthermore, exit plans need to be reasonable. In other words, a lender needs to be able to look at an exit plan and trust that the borrower will be able to pull it off on schedule.
Here is an example: a property investor once approached Actium Partners looking for a loan to acquire a multi-unit apartment complex. His plan was to obtain traditional financing after acquiring the property and allowing it to generate income for several months. Actium approved the exit plan, approved the application, and ultimately made the loan.
5. Loan Diversification
Finally, a common strategy among hard money lenders is to diversify their loans. Understand that hard money is private money supplied by either an individual or a group of investors. Rather than making two or three large loans with available funding, the lender will make more than a dozen smaller loans.
By diversifying, the lender isn’t placing all of its eggs in a single basket. Potential losses are spread across more loans, increasing the chances that no substantial losses will occur.
Hard money lending is more risky than other types of lending. Lenders need to demonstrate a significant risk appetite to succeed. Nonetheless, they also take every opportunity to mitigate risk. Less risk means fewer losses and higher profitability – exactly what lenders are looking for.
