When are hard money loans illegal? What are the conditions that can make these types of loans illegal? Read on to find out…
Loans secured by collateral (aka “hard money”) are not illegal per se. Lenders with capital can provide loans to borrowers as long as 1) their rates are not usurious, and 2) they comply with state and federal lending laws.
So what creates an illegal hard money loan?
Loan Purpose: Traditional Loans vs. Hard Money Loans
Traditional Loans
Banks, savings and loans, and credit unions are required to comply with strict state and federal lending laws. This means every loan requires reams of documentation, approvals, appraisals, guarantees, notarization, etc.
Traditional lenders like these look at a borrower’s income, outstanding debt, and credit score to determine if they can repay the loan.
In addition, many loans come with government guarantees, such as the HUD first time homeowner’s program or SBA small business loan program. These programs require lots of documentation and participating banks must thoroughly screen borrowers.
Finally, traditional bank lenders generally require a higher income-to-loan ratio. The borrower’s personal or business income is the primary means banks use to ensure the loan gets repaid. Banks are very adverse to having borrowers default then trying to collect or foreclose.
This is often the reason why getting a loan from a bank takes significant time and a lot of document preparation to get approved.
Bank loans are often not the best option for real estate investors, rehabbers and flippers. Traditional loans don’t work well if the borrower has negative credit, high existing debt, or needs cash for construction or bridge financing.
…vs. Hard Money Loans
Hard money lenders fill this need by providing an option for those who cannot get loans from banks.
These type of lenders are typically funded by “private money” — in other words, equity investors putting up their own cash and lending it out. This means they do not fall into the standard bank business model of borrowing money or taking deposits, then lending it out. Hard money lenders stand to lose their own money.
They are also largely unregulated in many U.S. states, requiring them to meet minimal or no interest rate limits or regulatory approvals.
Hard money lenders can provide cash in a matter of days to get a time-sensitive property purchase or bridge financing done.
Hard money lenders look to the cash flows and collateral value of the real estate itself in their loan decision. The do not primarily consider the borrower’s credit history, because they do not look to the borrower to recover when there is a default.
These reasons are why hard money loans exist. They serve the needs of real estate investors and speculators who need cash right away, are willing to pay high interest rates, and intend to repay the loan after a short period.
When Hard Money Loans Are Illegal
Unfortunately, because the industry is largely unregulated, hard money lending is open to abuse. While most lenders are professional and reputable, offering reasonable rates and lawful transaction fees, there are a small percentage that engage in illegal lending activities.
Hard money loans become illegal if / when:
- The lender charges interest rates that exceed maximum amounts mandated by law (aka usury)
- The loan(s) exceeds the legal size limit(s) allowed by law
- The hard money lender fails to fully disclose all fees and charges
- Detailed terms are not fully disclosed to you
- Loan terms or other key cost factors are made purposely vague so you can’t understand them
- Your deposit is not returned in full after repayment
- Collateral posted to secure the loan is not returned promptly and in full after repayment
- The hard money lender fails to furnish borrowers with written loan agreements
- The loan does not come with a clearly stated grace period within which the borrower can rescind the loan (this applies on some states)
- Any activity threatening illegal action to collect money, such as taking away your valuable property that was not included in the security agreement, spurious lawsuits against you or your partner, withholding property title documents, etc.
- The hard money lender has failed to register as a business or lender in the state(s) where it’s making loans
Usurious Interest Rates
The most obvious sign that a hard money loan is illegal is if it charges usurious (legally excessive) interest rates.
Your state may impose a maximum interest rate that can be charged to consumers or businesses. While each state differs in the interest rate ceilings, and the rates can vary by loan type, most states have some sort of a maximum rate.
See this article on FindLaw for links to maximum interest rate laws in all 50 states.
This is why it is crucial that you check your state usury laws so you can identify whether the interest rates are within the legal limit or not.
Failure to Register
You should check to see if your hard money lender is registered in the state where it’s making loans. Doing your due diligence as a borrower can help you avoid hard money lenders that engage in unscrupulous activities.
Lending to Consumers
Many states’ consumer protection laws prohibit hard money lending to consumers. The reason for this is it circumvents bankruptcy and foreclosure laws which are designed to protect vulnerable consumers from predatory loan practices.
The majority of reputable hard money lenders only lend to businesses. This means, as a real estate investor / borrower, you should be operating as a business entity rather than an individual.
In Summary
If you’re not already working with a reputable hard money lender, and are in the market for this type of loan, then it’s smart to understand when hard money loans are illegal. That way you don’t fall into a predatory relationship, or one that can creates legal issues.
Additional Resources:
REFlipper’s Hard Money Lender Directory here > (a great resource if you’re in the market for a hard money loan).
https://www.investopedia.com/terms/u/unlawful-loan.asp
https://www.arixacapital.com/investor-resources/hard-money-lending-faq