Every industry has its own terminology that players need to know and understand. Hard money is no exception. There are certain terms in the hard money game that, if confused, can create problems. Two examples are ‘down payment’ and ‘minimum investment’.
Perhaps they seem like the same thing at first glance. But dig a little deeper and you discover that the two terms reference distinctly different things. Get them confused and you could be in for a rough time while trying to apply for a hard money loan.
The remainder of this post will discuss the differences between the two terms using the example of a real estate investment. I have chosen real estate investing because, as Salt Lake City’s Actium Partners explains, the vast majority of all hard money loans are utilized to fund real estate deals.
The Down Payment
A down payment on a hard money deal is very similar to the down payment on a residential mortgage. Hard money lenders do not lend 100% of the total value of a real estate deal. They expect borrowers to come in with some cash of their own. That cash is the down payment.
This stipulates that hard money lenders make use of a tool you might already be familiar with by way of your mortgage: the loan-to-value ratio (LTV). The LTV is a measurement of the amount of money a lender is willing to provide compared to the total value of the property in question.
A lender with a 50% LTV would lend a maximum of $500k on a property valued at $1 million. The remaining balance would represent the borrower’s down payment. The one thing that is different with hard money is that the borrower does not have to fully cover the down payment with his own cash. He can combine cash with other sources of funding if necessary.
The Minimum Investment
The minimum investment in hard money is completely separate from down payment. It is also something you do not normally see in residential mortgage lending. What is it? Minimum investment is basically a measure of the amount of capital and/or equity a borrower has at the time of application.
Imagine a hard money lender with a minimum investment requirement of $100k+/$250k. This would mean that the borrow would have to demonstrate either:
- $100k+ in cash equity; or
- $250k in total invested capital.
The purpose of the minimum investment requirement is to ensure that the borrower already has sufficient financial resources and the experience necessary to manage his investments. Without those minimums, a borrower has a challenging time demonstrating that he is a safe bet.
The average hard money lender will not even look at an investor who doesn’t meet minimum investment requirements. Therefore, it wouldn’t be worth an investors time to complete a loan application if he doesn’t have the resources.
Protecting the Lender
Requiring both a down payment and minimum investment protects the lender from excessive risk. When you stop and think about it, it makes perfect sense. Investing in real estate is a fairly safe bet most of the time. As for funding investments, not so much.
A lender takes significant risk whenever funding a real estate acquisition. It is in a lender’s best interests to minimize risk as much as possible, especially in hard money where lending criteria are significantly more relaxed. Down payments and minimum investments are two tools for addressing risk.
Remember that down payment and minimum investment are not the same thing. One relates to individual deals while the other provides a picture of a borrower’s financial resources.