The recession, the collapse of the housing bubble and the banking crisis since the late 2000s have all resulted in banks keeping tighter reigns on writing new loans. And hopeful home buyers with less than stellar credit are having a harder time getting them these days. Subprime mortgages, or loans made to buyers with poor credit scores, are less commonly written by major banking institutions after foreclosure rates and short sales soared across the country, but some individual private investors are filling the void.
Also known as hard-money lenders, these private lenders are no longer just millionaires—as had usually been the case in the past. In recent times, individuals with more modest incomes, such as doctors and professors, have gotten into the game as a way to pad their retirement accounts.
How it works
Hard-money loans are based less on a buyer’s credit worthiness and more on the value of their assets, including the value of the home they are purchasing. In the event of default on the terms of the loan, the lender becomes the owner of the piece of real estate. Because a smart lender will want to be certain the value of the home meets or exceeds the loaned amount, buyers will need to fork out hefty down payments to cover 50 to 70 percent of the loan-to-value of the property.
By comparison, this is a similar amount required by conventional banks for current homeowners to refinance.
Loan of last resort
For most buyers, these loans are a last resort because conventional banks won’t lend due to low credit scores, unstable income history or a past checkered with late payments or other problems. To offset the risk, hard-money lenders charge interest rates which can be as high as 10 to 15 percent, and the terms can be very strict regarding late payments and other responsibilities, such as upkeep of the property. As Benny Kass wrote last year in Philadelphia Weekly, “There are many legitimate hard-money lenders.
However, as in every profession or industry, there are some bad apples. Some hard-money lenders are loan sharks whose sole objective is to take your house away from you.”
Risks to investors
Underwriting hard-money loans can be a risky strategy for an non-savvy investors as well. If housing values fall over the term of the loan and the buyer defaults, the investor may end up owning a house that is worth far less than the amount originally loaned. Many of these private investors are pulling the money to lend from retirement accounts and other investments with lower yields, so the results could be disastrous for anyone betting a large portion of their savings on these risky investments.
“A lot of private lenders got hammered like everyone else did during the market meltdown,” Larry Muck, chairman of the American Association of Private Lenders, said in the organization’s January newsletter. However, the same feature article announced, “Hard-Money Lending is Back” in its headline and stated demand for privately funded loans is on the rise, along with the supply of capital.
Hard-money lending in the future
The American Association of Private Lenders estimates that the number of hard-money lenders may be around 100,000 people in the U.S., and that the number is on the rise. If the loans are successful, then both the lender and buyer win at the game. The lender scores by earning higher returns than typical rates with other investments, and the subprime borrower is able to purchase a home with a mortgage that would otherwise be unobtainable. Would-be investors need to make sure the loans made are in stable housing markets and that enough of a down payment is made to weather fluctuations in housing values.
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