Discounted Paper vs. Hard Money Loans
|There is a good reason that "hard money" loans have that name. They can be hard on your bank account and hard to do. |
Many paper investors get involved with placing hard money loans after seeing the profits of discounted paper and getting excited to get started. They are not the same and the differences are important to weigh.
With a hard money loan, the payor needs the money. If he is coming into the private market and paying higher rates, it is because he has been rejected by or can not go to the banks. I like paper because it can have a lower risk factor than any investment that I know. I am an equity investor. I know the property can pay me when the payor cant. I do not want a loan turned down by the institutions unless there is enough equity that I would love to own the property and have the staying power to re-market it. When I buy a discounted mortgage I am doing so because the seller of the note needs the
money - not the payor. In addition, my yield is derived by buying the note at a discount, not because the payor is being charged usurious rates. Which brings up another important point!
If you are loaning money at high rates you may be in violation of your local state usury laws. "Usury" is charging more interest than is allowed by law. These laws vary from state to state. In a situation where I make a hard money loan at 18% interest, I could be in violation of a local state's usury laws. If I buy a 10% note discounted to yield 18% - that would not beusury. Making or buying a usurious loan can lead to a complete loss of all interest as well as other potential damages.
Truth In Lending
There are federal "truth in lending" laws that apply to mortgage lending as well as local state versions in some states like California. For example, the APR - Annual Percentage Rate must be disclosed on a loan that includes points and other loan costs. It can be a violation of federal law not to do so. Violation of these laws could lead to a total loss of interest and principle on a loan, lawsuits or judicial problems. Buying a discounted mortgage is a whole different matter. Most laws do not apply to a secondary buyer.
Discounted mortgages are far more liquid than hard money loans. They are easier to sell or finance. Few buyers will pay more than par for a mortgage. In other words, if I have a $10,000 hard money loan with a face rate of 18%, I have no potential of selling that note at a 14% yield for a profit. I can buy a note at a discount to yield 18% and then in some cases turn around and sell it at as low as a 10-12% yield for a large profit.
Loss of the Upside Potential
When I make a hard money loan my return comes from the rate I charge. If the loan pays off, my yield ends and I have costs in placing the money again. When I buy dicounted paper, my yield comes from the discount that is paid back over a period of time. If I am paid off early, my uield is enhanced substantially. In a market of lowering interest rates and loose financing, my portfolio yield plumets when high rates are paid off and have to be invested at lower rates or in riskier markets. The same market enhances the yield on a portfolio of discounted mortgages as the acceleration of the discount cause a major jump in yield.
Why Do I Buy Paper?
I buy paper to improve it and profit substatnially. I want the highest possible profit. The yield I buy a note at is only the worst case scenario. Double to triple the market yield on your portfolio should be your goal. I can show you over 117 different ways to improve the yields on discounted paper. There are only a handful of ways to improve the yield on hard money loans.
Scuttling the Scammers
Many discounted mortgage investors end up hooking up with a hard money lender because the yields look attractive and it seems to address the problem of finding enough paper. The problem comes when many hard money brokers make their money off of the points and do not fend for the investor. Most brokers are reputable, but whenever a scam seems to go down, it seems to be a hard money lender. Most of the legislation and criticism discounted mortgage investors face come from the "hard money" problems. When money is lost in paper, it is almost invariably in hard money loans. I'm not saying that no one should place hard money loans, just that it should be weighed carefully. Most beginning investors do not have the expertise to deal in the hard money loan market. I want everyone to be clear that they are very different animals.
Positioned for "Points"
Several hard money brokers have come to my seminars. One that stands out was Kent Hicks from Texas. The first day of a five day seminar he struggled with why he should stay. It seemed too basic. At the end of the five days, he said he learned more in 5 days than in 20years experience in the business. One element that has been hard for some hard money brokers to see is how to profit when brokering a mortgage. They are used to "points" and may want 5 points or more. Let me show you an example that I illustrate for some of them.
Let's compare an investment of $71,760 invested at 14% in a hard money loan with the same amount invested in a mortgage discounted to yield 14%. The hard money broker wants 5 points (5%) on the money invested as his fee. This would equal $3,588. He then places this loan with an investor.
The discounted loan is a $100,000 loan at 8% interest payable $955.65 per month for 180 months. This loan would be purchased for $71,760 when discounted to a 14% yield.
The broker's cost of funds is 12% and he can borrow $79,626. This leads to an in pocket profit of $7,866 which is the equivalent of 9.88 points.
In addition, let's say that 90 days later the mortage above can be packaged with otherr notes and brokered to an institution at a 10% yield.
This note would sell for $88,931 when discounted to a 10% yield. This would equal an additional profit of $9,305 (11.68 points).
That is a total cash profit for the broker of $17,171 (21.56 points) and the investor has a safer note during the time of ownership and maintains higher liquidity and lower risk of interrest rate fluctuation or changing market conditions.
Even though there was a total spread in the yields of 4%, the cash amount was the equivalent of almost 22 points.
Mark-up and Flooring
From a business view point you could look at the previous example and instead of seeing yield, you can see it as a retail mark up and the investor loan as inventory flooring cost.
What if the broker split his profits with the investor? What rate of return would the investor have? If half of the $17,171 profit went to the investor that put up his money for 90 days, his return would be 43% annual.
Deepened Due Diligence
The due-diligence needed to verify the safety and accuracy of a hard money loan is more critical for several reasons.
The incidents and potential for fraud and are much higher with hard money loans than with discounted paper. In particular, the highest safety lies with owner occupied single family homes.
The payor's ability and desire to pay the loan becomes far more critical in hard money loans. In a seasoned discounted mortgagewith a good payment history, the payor has proven both his or her ability and desire.
Second, an overwhelming majority of loans that go into default do so within the first year. The greatest safey comes from "seasoned" paper. Again, let me emphasize that I am not saying you shouldn't be involved in hard money loans. The risks and rewards are different and deserve your attention and careful consideration.
I'm not anxious to take sides, pass judgement or be offensive in relation to the recent lawsuit between a mortgage broker and a mortgage buyer, but all mortgage buyers and brokers can learn from the experience. I do have to disagree with both the fact that there even was a lawsuit and the premises it was based on. I believe as a matter of principle and practice, all mortgage buyers both private and institutional should practice careful underwriting procedures.
Never rely on the representations of others - especially someone that would benefit from you buying the note. As the facts were presented by letters from both parties, a fraud occured when an un-related party forged documents from a title company. If these are indeed the facts, I can not imagine that a note was purchased off of the paper work alone without even a call to the title company. It's also hard to believe that a mortgage buyer wouldn't choose the title company. This illustrates the risks in both funding and brokering paper. Proper education and procedures could have prevented it.
|John D. Behle is one of the foremost educators and practitioners in the field of discounted paper investment. His innovative strategies and techniques have shaped the industry. With over two decades in the industry and an extensive background in real estate and finance, John adds a wealth of knowledge and experience to his creative money-making techniques.|
John holds a National Council of Exchangors "Gold Card" and an EMS designation. He is also listed in Who's Who In Creative Real Estate. John Behle is the author of several hundred articles published in national magazines and newsletters and of several ground-breaking real estate paper books.
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