Hard Times for Hard Money

What you need to know about contingency reserves

A Hard money loan is a special loan designed for the acquisition of a house needing rehab. Hard money loans usually cover the costs of property acquisition, closing costs and rehab expenses. These loans are sometimes used as a foreclosure “bailout” for homeowners that are delinquent in their mortgage payments and have significant equity in their properties but don’t have good enough credit to refinance with traditional lenders. Hard money lenders structure loans based on a percentage of the quick-sale value of the subject property. This is called the loan-to-value (LTV) ratio and typically hovers between 60 and 70% of the market value of the property. Hard money loans aren’t like traditional loans. They usually cost the borrower a minimum of 5 points (5% of the total loan amount including rehab costs) in fees that go right to the lender upon the purchase of a given property. Closing costs are rolled into the loan amount. Interest rates are usually at 14% or higher. The loan matures and usually requires full repayment in 90 days to a year depending on the lender.

Many hard money lenders have gone out of business due to the decline in home prices resulting from the credit crunch which began in 2007. Because of our current real estate market, most hard money lenders are taking a fee from borrowers called a contingency reserve. Set by the hard money lender on a deal by deal basis, this is a predetermined amount of the property buyer’s money held in escrow by the hard money lender. It helps to secure the lender’s stake in the property and collateralizes the hard money loan. The contingency reserve is paid by the borrower and is only returned to the borrower by the hard money lender upon the successful completion of the rehab project. To a hard money lender, “successful completion” of a rehab project is when the borrower repays the hard money lender in full either by refinancing with another lender or selling the property. Either method repays the hard money lender. If the borrower defaults on the hard money loan or does not complete the rehab project for whatever reason, the contingency reserve is seized by the lender along with the property. Contingency reserves are usually set on a percentage basis in relation to rehab estimates. Contingency reserves usually cost borrowers $2,500 – $15,000 and provide assurance to the hard money lender that the borrower is committed to completing the rehab project to the best of their ability and that the hard money loan will be paid back in a timely manner.

Hard money loans are most often used by experienced real estate investors who have cash set aside to put up for contingency reserve requirements; therefore a contingency reserve is nothing more than a minor inconvenience for an investor. Hard money lenders became more aggressive in withholding a borrower’s funds in the form of a contingency reserve when the real estate market began to implode in 2007. Many hard money lenders were left holding the bag, so to speak, as property investors saw the values of their projects decline and decided to walk away from their projects. As the hard money lenders began to reclaim these homes through the foreclosure process, they realized that they couldn’t sell them for enough money on the open market to recoup their losses. This is why contingency reserve requirements are prevalent today.