Like all disasters, the financial crisis has its share of beneficiaries who profit from it. One of them is the hard-money lenders, who lend strictly on the basis of the collateral. These non-institutional lenders require a lot less paperwork than institutions because they don’t worry about whether or not borrowers can afford the payments, or whether or not they are creditworthy. They don’t bother with income, employment or credit reports.
If borrowers can’t pay, the hard-money lenders get their money back through foreclosure. They typically require 30-35 percent down to make sure that there is enough equity available to cover foreclosure expenses. Interest rates are much higher than those charged by institutions, and terms are short.
The earliest mortgage lenders of the 19th century were focused entirely on the collateral. Of necessity, they were hard-money lenders. There was no way to document anyone’s income in those days, and credit reporting had not yet emerged.
Over the decades, loan underwriting increasingly came to emphasize the capacity of borrowers to repay their mortgage as indicated mainly by their incomes relative to their expenses, and their willingness to repay as indicated by their credit record. Rules regarding how both the capacity and willingness to pay had to be documented came to fill many pages of underwriting manuals. As collateral became less important, down-payment requirements declined, and in many cases disappeared entirely.
Hard-money lending today is thus a throwback to the era before the capacity and willingness of mortgage borrowers to repay became important parts of loan underwriting.
The financial crisis has been good for hard-money lenders because it has made loans with less-than-complete documentation of income and assets very difficult to obtain from institutional lenders. Here is a recent example.
"I bought my permanent residence for $300,000 in 2005, paid all cash, but now I need $80,000 to make repairs and can’t find a loan. I live off the income from other properties that I own, but I show very little income on my tax returns because most of it is shielded by depreciation and interest costs … None of the lenders I have approached will give me a loan."
Before the crisis, this borrower would have had no difficulty finding a "stated-income loan," meaning one where the borrower stated his income but was not required to document it. Indeed, the stated-income loan was designed to meet the needs of exactly this type of borrower. The interest rate would have been only 0.25-0.5 percent higher than the rate on a fully documented loan.
But as underwriting rules loosened during the go-go years 2000-2006, stated-income loans came to be called "liars’ loans" because they were so often used to qualify borrowers for mortgages they could not afford. The presumption was that rising home prices would allow them to refinance to a lower rate later on, or if necessary, to sell the house at a profit. Instead of reflecting real income that could not be documented, stated income often reflected income that did not exist.
As the financial crisis emerged and foreclosures mounted, hostility against liars’ loans grew. The notion took hold, among regulators, legislators and even many loan providers that every mortgage borrower should be required to document his or her ability to repay the mortgage. While to my knowledge none of the attempts to enact this rule into law were successful, the market’s response to the crisis has done the job for them. Stated-income loans have become difficult or impossible to obtain from institutional lenders.
So I had no choice but to advise the letter-writer to find a hard-money lender. The rate premium, relative to the cost of a documented loan from an institutional lender, will be much higher than 0.25-0.5 percent. As partial consolation, there are a lot of them — when I entered "Pennsylvania hard-money lenders" in Google, more than 400 entries came up. Hard-money loans should be relatively easy to shop because their rates don’t bounce around from day to day, as they do in the institutional market. I don’t have any experience with this market, however, and readers who have taken loans from hard-money lenders are invited to let me know how they did.
The writer is professor of finance emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.
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