2 Reasons Hard Money Construction Loans Are a Bad Idea

A hard money construction loan is often an easy and quick way to obtain financing. As with most things in life, the easy and quick path can be a huge mistake. The fact that obtaining financing the normal way can be a difficult and time-consuming process should raise red flags about hard money loans. There are a couple of very important reasons these loans are a bad idea.

Definition of a Hard Money Construction Loan

Lenders generally provide financing based on the financial stability and repayment ability of the borrower. The borrower is responsible for providing documentation to qualify for loans. Additionally, lenders independently verify that the information they have received is true and accurate. Hard moneylenders do not take these factors into account or verify credit and financial information. These loans are asset-based. This means that the hard moneylender will base the lending decision on the value of the property being financed. So, a potential borrower could have a poor credit history and unstable income and still qualify for a hard money loan.

The hard money loan is base entirely on whether the property, which secures the loan, has sufficient value to repay the lender. Typically, a hard money loan can only be obtained up to a certain percentage (usually 60%-70%) of the value. This percentage is commonly referred to as the loan to value. Since, these loans do not require the credit and financial evaluation other traditional loans require, they can often be consummated in a few days. The short time frame can be particularly attractive to the borrower who is in need of a quick-fix to a bankruptcy or foreclosure. The hard money loan might seem to be the answer.

High Fees and High Rates

Hard money loans are considered high-risk loans. These are loans offered to those who have few other alternatives. There is always a relationship in lending between the risk a lender is willing to assume and the amount the borrower is required to pay. The high-risk borrowers always pay more. Therefore, borrowers often pay extremely high interest rates and fees for hard money loans. Since these loans often involve significant amounts of money, the interest and fee can be substantial. Also, there is little, if any, regulation, which limits how much lenders may charge. Since most hard moneylenders are private lenders, even if regulations did exist, it could be difficult to enforce.

Short-Term Focus Problem

Most hard money construction loans are obtained to address a short-term needs. The idea is to address the immediate situation and refinance the loan later at a more reasonable term. Therefore, a project that took off on a short term quick fix could potentially stop moving forward while going through the lengthy traditional loan process at a later time. This can be an extremely risky gamble because there are no guarantees the borrower will ultimately qualify for refinancing. Many times these loans are obtained to avoid foreclosure or bankruptcy, when it may in fact hasten the inevitable.