Businesses and individuals alike turn to hard money when traditional bank lending is either impossible or just doesn’t meet certain needs. For example, a house flipper might use hard money to acquire new properties. The last thing any hard money borrower wants to do, regardless of the reasons for borrowing, is default.
Default is defined in the financial services world as failing to make agreed payments. If you miss just a single mortgage payment on your home, you are technically in default. The thing about defaulting on a hard money loan is that the consequences of doing so can be more severe compared to defaulting on a bank loan.
Hard Assets as Collateral
The most fundamental difference between traditional lending and hard money is how collateral is treated. Hard money lenders require hard assets as collateral. Usually, collateral is offered in the form of real property. It acts as security on the loan. It also gives hard money lenders a tangible asset through which they can recover their money if necessary.
Collateral also plays a role in traditional bank lending. However, the differences between hard money and traditional lending can be quite stark when a borrower defaults.
Default Rate Clauses
It is fairly routine for hard money lenders to include default rate clauses in their loan contracts. A default rate clause is a clause that states that the interest rate on a loan will increase automatically on default. Let us say you have a lender who loans at 15% with a default rate of 30%. Missing just one payment could increase the borrower’s monthly payment from $1,200 to nearly $2,500.
Default rate clauses can make loan affordability impossible after just one missed payment. In addition, some of these clauses give borrowers only a short window of time to bring their loans current. If they fail to do so, lenders are ready to move forward with other means of remedy.
Foreclosing on Collateral
Unlike banks and credit unions, private lenders lend their own money. Thus, they cannot afford to be as flexible when a loan goes into default. Failing to bring a default loan current gives lenders all the reason they need to proceed to foreclosure.
According to Actium Partners in Salt Lake City, Utah, hard money lenders generally have two options when defaulted loans are not made current: foreclosing or issuing a deed in lieu of foreclosure.
Foreclosing is pretty straightforward. The lender exercises its lien authority to reprocess the property and sell it. Any revenues generated from the sale will go to paying off the loan. In some cases, the lender gives the difference back to the borrower. In other cases, the borrower forfeits everything, thus losing whatever was paid into the loan.
Borrowers can ask lenders to offer a deed in lieu of foreclosure instead. Why do so? Because it prevents an official foreclosure that would go on the borrower’s credit history and potentially create more problems.
A deed in lieu of foreclosure essentially transfers ownership of the property to the lender. In such a case, it is imperative that the borrower also obtain a release of lien from the lender. Otherwise, the borrower is still legally obligated to repay any remaining balance on the loan.
As you can see, defaulting on a hard money loan is serious business. Defaulting is a big deal on any form of credit, but hard money lenders do not have the luxury of being so flexible. They must move quickly to protect themselves in the event of default. More often than not, they do.