Any type of secured financing relies on some sort of collateral. But collateral’s impact on lending is not consistent across every scenario. Different types of loans utilize collateral differently. In the hard money game, collateral is the number one priority for loan approval.
An Asset-Based Lending Scenario
Hard money lending is often characterized as asset-based lending because approval decisions are made based on borrower collateral. Imagine a property investor looking to obtain a downtown office building. The property itself is an asset. It becomes collateral for the loan for which he is applying.
Contrast this scenario with a typical residential mortgage. The home a buyer hopes to purchase is also collateral. But its value has little to do with loan approval. Instead, banks are more interested in the home buyer’s credit history, income, and current debt-to-income ratio. The bank will rely on the borrower’s full faith and credit, which is to say his promise and ability to repay.
For Utah hard money lenders like Salt Lake City-based Actium Partners, full faith and credit is irrelevant. A borrower’s promise to repay isn’t worth the loan documents it’s printed on. What matters is the value of the target asset.
Lenders Look for Certain Things
Collateral is so valuable in the hard money game that lenders look for certain things before they give approval. First is the current value of the asset in question. How much is the property worth at the current moment? It needs to be worth at least enough to cover the amount being borrowed.
Lenders also look at:
1. Estimated Future Value
Let’s say a borrower is looking for a loan with a 12-month term. He could default four months before maturity and forfeit his collateral. That being the case, lenders need to estimate future value. In a down market, a valuable asset may not be as valuable at the end of the term.
2. Revenue Potential
Let us say a borrower is looking to buy a commercial rental. In addition to the actual cash value of the property itself, lenders will take a look at its ability to generate revenue. A high revenue potential adds to the property’s value as collateral.
3. Rehab and Renovation
A borrower looking for a hard money loan to purchase a property in need of rehab will have to take on additional obligations to fund the work. Rehab and renovation costs count against property value if the borrower plans to sell in the short term.
4. Ease of Disposal
Hard money lenders generally don’t want to become landlords. They neither want nor expect their clients to default. Yet sometimes it happens. Therefore, lenders need to consider how easily an asset offered as collateral can be disposed of. A lender forced to foreclose wants to collect and sell that asset as quickly as possible.
Why Down Payments Matter
Collateral is the most important factor determining whether a hard money loan gains approval. But down payments are also in play. A lender looks at the combination of down payment and collateral to decide how much will be offered.
In essence, a lender’s LTV ratio determines the size of the borrower’s down payment. The combination of down payment and collateral need to mitigate the lender’s risk in order to move forward.
Collateral plays a huge role in hard money lending. But there is no other choice. Collateral is what protects lenders against the higher risks associated with the projects they fund. If they are not happy with the collateral being offered, they will not move forward. If they are, it is full steam ahead.