One of the knocks against hard money lending is the higher interest rate. Private lenders are known to charge rates that can be several percentage points higher than what traditional lenders charge. If you are afraid to consider hard money for this reason, relax. Higher interest rates are not as bad as they sound.
It is important to look at interest rates in context. Why do hard money lenders set higher rates? How do the higher rates impact your bottom line? Does a higher rate automatically guarantee more total interest paid?
If borrowers took the time to dig into interest and how it actually works, most would conclude that the higher interest rates that hard money is known for really are not that big a deal.
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How Loan Interest Works?
Interest on a loan is little more than an amount of money a customer pays for the right to temporarily use someone else’s money. Consider it a service fee if that helps you understand it better. The fee is based on a percentage of the amount you borrow.
Interest is assessed on an annual basis. To keep the math simple, imagine a loan with an interest rate of 12%. At the start of the loan, you pay 12% of the total outstanding balance over the first 12 payments. That works out to 1% per month.
At the 13th month, interest is recalculated based on your outstanding balance. Again, you pay 12% at a rate of 1% per month. This continues until the loan is paid in full. In real terms, a $100k mortgage at a rate of 6% over 30 years would translate into total interest in excess of $115k – if you actually took the full 30 years to pay.
The Term Makes the Difference
What most people do not understand about lending and interest is that the term of a loan really makes the difference. Time is the enemy when borrowing money. The longer it takes to pay off a loan, the greater the total amount of interest paid over the loan’s life. This is where hard money loans have a distinct advantage.
Despite private lenders charging higher interest rates, they also keep terms extremely short. Salt Lake City’s Actium Lending explains that terms are generally no longer than 24 months. They say most hard money and bridge loans have terms of 6-12 months.
Paying 24 months of interest will still yield a lower total amount of interest paid, compared to a 30-year loan that is paid over 360 months – even if the hard money rate is several percentage points higher.
Early Repayment Penalties
Something else to consider is that many hard money and private loans do not come with early repayment penalties. A private lender may include a guaranteed interest clause requiring that borrowers pay a minimum amount of interest over a certain number of months, but that’s about it.
What does this mean? It means that more often than not, a hard money borrower can repay his loan early without having to pay extra for the privilege of doing so. Early repayment is one way to avoid additional interest. Remember, the longer it takes to repay a loan, the more total interest paid.
Higher interest rates on hard money loans look bad on paper. But in the real world, when loan terms and early repayment penalties are added to the equation, higher interest rates are not so bad after all. Higher rates give lenders an opportunity to earn their profit while shorter terms minimize the total amount of interest borrowers pay. It is a win-win.