I get this questions a lot, so I figure it’s time to try to answer it. Why it’s called hard money is another story.

Hard money lending is also sometimes called private lending, equity lending, or trust deed investing. (I use these terms interchangeably.) In its simplest form it is generally short-term, low-leverage loans with relatively high interest rates, made by private individuals, groups or institutions, backed by equity in hard assets. The most common asset being real estate, of course.

This is a brief overview but hard money lending is distinguished from conventional lending in the following way:

Conventional (bank) loans are what I call cash flow lending. The primary underwriting factors involve the borrower’s credit worthiness: willingness and ability to pay. The value of the actual property–the collateral–is an important but secondary consideration. For a residential borrower this means your credit history, and income level and stability is all important. In the commercial realm it means the property’s ability to cover the debt, as well as the sponsors financial condition. In short, the primary issue is the ability to make monthly loan payments.

Hard money loans flip this around. The single most important factor is the collateral itself: how much is the property realistically worth and how much equity cushion does it provide to protect the loan. The lender’s primary concern is, if the borrower defaults and he has to foreclose, can he quickly and easily dump the property and recover all of his principal and (hopefully) interest and fees.

The second critical factor in hard money underwriting is exit strategy, or how will the borrower repay the loan at the end of the term. Since most of these loans are short-term–1 to 5 years–there has to be a clear and plausible strategy for repayment.

Below these factors comes the borrower’s credit worthiness: ability and willingness to make monthly loan payments. Before the credit crisis this was barely a consideration at all. Since 2007 even hard money is looking a little more carefully at a borrower’s ability to service the debt.

Hard money lending (as we call it today) has been around for decades and until 20 years ago or so had a pretty seedy reputation as being not much different than loan sharking. While there are still unsavory characters in the lending business, the hard money profession has, overall, become quite professionalized. There are lenders that specialize in all types of assets and transaction types, and that provide outstanding and highly professional customer service. It is also a common misunderstanding that all hard money borrowers are financial hardship cases. This is simply not true. Private money provides a speed and flexibility that conventional, “check the box” lenders simply can not match. Many, if not most, hard money borrowers understand the strategic value that it provides in the appropriate situations.

There has been a lot of excitement in the past week about the new “conforming” loan limits for Fannie and Freddie loans. The new limits were announced as part of the American Recovery and Reinvestment Act of 2009 which the President signed into law on February 17, 2009. Realtors and potential home buyers and owners are happy that the new conforming loan limits was raised to $729,500 from $417,000. If you live where I live, in the San Francisco Bay area, and a few other high cost areas, there is good reason to be happy. But for most of the country this provision doesn’t change a things. It’s a good provision to be sure, but there is a lot of misinformation among the general public so we should put things in perspective.

The new loan limits up to which Fannie and Freddie are allowed to underwrite home mortgages are established by county. These limits are equal to the greater of 125% of the 2008 local area median home price or $417,000 for Fannie and Freddie, with an overall maximum cap of $729,750. Here are some fun facts:

• There are 3,142 counties in the U.S. (excluding protected territories such as Puerto Rico and the American Virgin Islands.)
• Only 275 counties, or 8.8%, will see loan limits raised above the previous $417,000.
• Only 73 counties, or 2.3%, will have loan limits of $729,750.
• The new average agency loan limit nationwide is just $430,322, a 3.2% increase.
• The 275 jumbo counties are spread across 29 states, but just 5 of those states (VA, MD, CA, AK and NJ) encompass almost 60% of these counties.

You can check your counties new loan limits on the OFHEO page.

UPDATE: As of the first week in May banks have begun rolling out the new “Super High Balance” Conforming loan programs. Pricing is only slightly higher than regular conforming but underwriting guidelines remain very tight. (I.e., you better have a good job and excellent credit scores.)

Managing your credit in these challenging economic times.

Not long ago managing your credit was a hot topic. Everyone wanted access to the easy money floating around and there was plenty of advice on how to build and maintain a good credit rating. Suddenly those voices have gone silent, but now more than ever it’s critical to keep an eye on your credit ratings.

These days it seems most lending institutions have gone out of the lending business, making credit pretty hard to find even for the most credit worthy. This will eventually change and the credit markets will return – don’t ask me when – but they will. But when the worst is past and the banks are lending again the requirements will be much stricter than they’ve been for most of the past decade, and your good credit score will be key. While the math behind the credit score is complex and mysterious (my statistican wife claimed it’s a State Secret,) in general there are five key factors to be aware of:

How Fair Isaac Corp. weights the various parts of your credit management to determine your credit score.

1. Payment History

It may seem obvious but paying your bills on time is the most important thing you can do. If you’re behind on a credit account make it your financial priority to get current and stay current. While this is important on all your accounts certain types of credit will impact your score more. Always try to pay your mortgage first and then your credit cards.

2. Watch your utilization rate.

Your utilization rate is the total amount you owe divided by your credit available. So if you have a credit card with a $5,000 credit limit and a $2,500 balance, your utilization rate is 50%. Credit bureaus generally like to see utilization rates in the 30%-35% range. This is less an issue of what you owe than how you manage it. For example, do not close an established credit account as a short term strategy to improve your score. Here’s why…

Suppose you have 4 credit cards with $30,000 of total credit available, and on average you carry a total balance of $9,000. Your utilization rate is 30% and everybody is happy. Now you decide to cancel a card you never use, with $0 balance and $10,000 of credit available. All of a sudden your utilization rate is 50% and your score could take a big hit.

I know the schemers among you are thinking “I’ll just run out and apply for a bunch of new credit to drive down my utilization rate.” Unfortunatley they’re on to you because…

3. Length of Credit History.

Longer credit histories are more heaviliy weighted than new ones. So if you’re going to cancel a card try to cancel a newer one. New credit accounts will reduce your average account age, and that can result in a lower score.

4. Type of Credit.

Mortgages and HELOCs tend to have the strongest impact on your credit score, followed by credit cards. If you’re going to close down a credit account close your department store cards first. (In fact, better would be not to get sucked into those one-time 10% discounts to open new revolving credit account.) Then consider your newer bank cards such as Visa or Mastercard. But try to avoid the shell game of moving balances around. If you really want to stop using a card, pay it off first then shred the card.

5. New Credit

If you’re looking for new credit – maybe a mortgage or a new card – be focused and do your inquiries over a short period of time. The scoring systems will track the length of time over which new credit is sought and distinguish between the search for a new line of credit from trying to open a bunch of new credit accounts. Many commercial inquiries into your credit score over time can really pull down your score. But remember, checking your own credit report will never affect your score, and this is something you should do regularly.

6. Expanded Use of Credit Scoring

If everything we’ve said so far seem old news to you, this last one may be a bit of a surprise; more and more institutions are using, or contemplating using, your credit score to evaluate you as a customer. Insurance is a big one. It’s controversial still but be prepared, it’s coming. If you have a bad credit score you very likely will not only pay more for your mortgage but you’ll pay more for insurance as well (if you can get either.) There is talk about credit scores being used in evaluating job applicants as well. For now the major reporting agencies claim they do not make credit scores available for employment evaluations, but a growing population of employers claim they do look at a person’s credit history. Whatever the truth, a well managed credit history is becoming ever more important in our modern world.

“CMBS Market Begins to Show Fissures”

The following is an excerpt from the Wall Street Journal – WSJ (11-19-08):

The market for debt used to finance hotels, offices and shopping malls tumbled Tuesday on worries that the long-feared rise in defaults for commercial mortgage-backed securities had begun, possibly ushering in the next phase of the financial crisis.

According to a Citigroup Inc. report, the overall number of commercial mortgages packaged into securities that are 30 days or more past due rose to 0.64% in October from 0.39% at the end of last year, with most of the increase coming in October. The latest figure, though low by historic standards, marked the highest delinquency rate in two years.

The jump in soured commercial loans was mainly due to the financing drought and a lack of buyers. Property owners have been unable to refinance mortgages as they have become due, forcing defaults if existing lenders have been unwilling to extend loans under the same terms.
(You can read the full WSJ article here: CMBS Market Begins to Show Fissures – WSJ.com.)

Despite the dire headlines I can tell you that nobody in the industry is surprised by this.  The commercial mortgage market has lagged the devastation of the residential market but a downturn was inevitable.  Most commercial mortgages come due in 5 to 7 years, so all the commercial mortgages originated during the meteoric rise in real estate prices are starting to come due just as economic pressures come to bear and available financing disappears like the dinosaurs.

What the article just glosses over though is that delinquency rates are still at all time historic lows. Over-leveraged property owners with little equity are more likely to default, but those that have something to lose are not so willing to hand the keys back to the bank.  Solution?

Enter the Commercial Private Mortgage Lender.  Private lenders are not subject to the whims of the public debt markets and do not make their money by selling the paper to someone else. (The key implication of that last point is that we do not make stupid loans on the basis that we can offload the risk onto some other unsuspecting investors.)  A quick assessment of the property’s potential and it’s protective equity can be just the lifeline troubled property owners need.  The money is expensive; much more expensive than a conventional bank loan, but it’s far less than an equity partner. Private money is not the solution for everybody but it can save your property, and your financial life – and fortune. Risk is appropriately accounted for and everybody wins: borrower gets a low friction loan and the trust deed investors get a great return on their money.

As Wall Street Titans Fall, Hard Money Lenders Step Up To Fill The Void

Wow! I’ve been saying for a long time that this current financial crisis is worse, and will last longer, than most of the public pundits or government officials will ever admit. (Especially in an election year.) But even I’m a little in shock at just how brutal the carnage has been. First Bear, then Fannie and Freddie, now Merrill Lynch is auctioned off, AIG is holding a sign saying “will work for food,” and Lehman Brothers is in bankruptcy! Wow! Even the largess of the US government (thanks to you and I the taxpayers) has hit its limits with this one. Whatever we may think of the Wall Street culture, it is a bit sobering to see so many financial titans go down so hard and so fast! They really screwed the pooch on this one. (The pooch, by the way, is likely to be us taxpayers again.)

The press will beat this to death so I won’t ramble on about how we got here, but if you thought credit has been tight lately for any sort of residential or commercial real estate deals, watch how fast the remaining commercial banks pull their limbs into their shells. Private money lenders are nearly the last bastion of real estate credit out there. Even some of the big hard money lenders are finding themselves capital constrained as the volume of high quality deals is skyrocketing.

Now there has truly never been a better time for hard money mortgage pool investors!