Are you looking to finance your property through a hard money loan? Hard money loans are emerging as a practical solution for borrowers looking for short-term financing options and flexibility. It is important to understand all the aspects associated with hard money loans, like points. In this blog, we will understand why getting insight into hard money loan points can help you know more about the true cost of borrowing and the structural dynamics of loans.
Understanding Points in Hard Money Loan
Points on hard money loans are upfront payments or fees charged by a hard money lender as a percentage of the total value of the loan. The percentage is typically between 1% to 5%. Factors like loan-to-value ratio, buyer creditworthiness, market conditions, etc., can influence points. There are 2 types of points:
- Origination Points: It is the fee charged by the lender for underwriting and processing the loan. The fees are used as compensation for the time and effort taken for the loan approval process.
- Discounted Points: It is the additional fees to reduce the interest rate on a loan, used as a long-term strategy to reduce monthly payments. Each point results in a reduction of the interest rate by a certain fixed amount, such as 0.25-0.25%.
Why Lenders Charge Points?
- Risk Compensation: As hard money loans are given to borrowers with a low credit score, resulting in high-risky loans, points give lenders a way to mitigate the risk as an immediate source of income to the lender.
- Coverage of Transaction Cost: Various administrative costs, such as originating, underwriting processes, broker commission, etc., are involved, so charging points can help in covering transaction costs.
- Ensuring Profitability: If the loan is for a short term where interest payment may not ensure profitability, charging points can help them get a portion of the profit from the upfront payment.
What are 3 factors that influence the cost of points?
- Loan-to-value ratio: A higher loan-to-value ratio generally indicates higher risk for the lender, as they are lending a larger amount relative to the property’s value. To compensate for this increased risk, lenders may charge higher points.
- Buyer creditworthiness: Borrowers with a strong credit history and a lower risk of default are likely to negotiate lower points compared to borrowers with poor credit, as they represent a lower risk for the lender.
- Market conditions: When market interest rates are high, lenders may charge lower points to attract borrowers. Conversely, during periods of low interest rates, lenders might increase points to offset potential losses in interest revenue.
How Points On A Hard Money Loan can Affect A Borrower’s Monthly Payments?
Points can lower monthly payments
Paying points upfront can result in a lower interest rate on the loan. This lower interest rate, in turn, translates to lower monthly payments. This is because the interest portion of the monthly payment is calculated on the loan principal, and a lower interest rate means less interest accrues each month.
The Trade-off
While paying points means higher upfront costs, it can save money in the long run through lower monthly payments, especially for longer-term loans. The table in source illustrates that higher upfront points lead to lower monthly payments and potentially lower total cost over time, making it advantageous for long-term loans.
Let’s break down why:
- Points are prepaid interest: Essentially, by paying points, the borrower is prepaying a portion of the loan’s interest upfront. This reduces the outstanding principal balance faster and leads to long-term savings on interest payments.
- Negotiation is key: Borrowers can negotiate with lenders to lower the number of points charged, especially if they have a strong credit history, real estate experience, or if the loan is considered low-risk. This negotiation can help minimise the upfront costs while still securing a potentially lower interest rate and subsequently lower monthly payments.
Mutual Benefits of Points for Borrowers and Lenders
Points on a hard money loan, while seemingly complex, offer advantages for both the borrower and the lender.
Let’s break down these benefits:
Benefits for Borrowers:
- Lower Monthly Payments: When a borrower pays points upfront, they essentially prepay a portion of the loan’s interest. This can result in a lower interest rate on the loan, leading to reduced monthly payments. This is particularly beneficial for long-term loans, as illustrated in the “Impact of Points and Interest Rates on Loan Costs”
- Tax Advantages: Borrowers may be eligible for tax deductions on points paid for the purchase or renovation of an investment property. However, it’s important to note that for residential properties, the deduction might be limited or spread out over the loan term.
- Potential for Favourable Loan Terms: While not explicitly stated in the sources, our previous conversation highlighted that paying points might give borrowers leverage to negotiate better loan terms, such as an extended repayment period. This could provide greater financial flexibility.
Benefits for Lenders:
- Risk Mitigation: Hard money loans are generally considered high-risk due to factors like the borrower’s creditworthiness and the shorter loan durations. Points provide lenders with an immediate source of income, which helps mitigate their risk exposure.
- Coverage of Transaction Costs: “Origination points” specifically help lenders cover the various administrative costs associated with the loan process. These costs can include underwriting, processing, broker commissions, and other related expenses.
- Profitability Assurance: Since hard money loans often have shorter terms, the accumulated interest payments might not always be substantial enough to ensure profitability for the lender. Upfront points help address this by guaranteeing a certain level of profit from the loan.
Essentially, points offer a mechanism for balancing the risk and reward dynamics inherent in hard money loans. While borrowers can benefit from lower monthly payments and potential tax advantages, lenders gain a level of security and assurance for their investment.
How do Points Affect Hard Money Loans – Overview through Its Advantages and Disadvantages
Let’s understand through this table various pros and cons of points on a hard money loan to get a clear view of your investment and the potential impact:
| Pros of Points | Cons of Points |
| If points are paid upfront, then it can reduce the overall interest rate on the loan. | As borrowers need to pay upfront costs, it can lead to high cash flow and reduce reserves. |
| If points are paid to purchase or renovate the property, it can be tax deductible, giving financial benefits to the business or borrower. | The cost-benefit analysis can be a complicated process to understand whether payment of points is beneficial or not. |
| Paying points can be beneficial to get favorable loan terms like an extended repayment period. | If a borrower is refinancing the property or selling before the period, then the cost of the upfront payment may not be recovered via interest savings. |
| This can lead to lower hard money loan monthly payments due to reduced interest rates if points are paid. | If the loan term is shorter, then the cost of points can lead to the potential of overpaying as it can overpower the benefits obtained from a lower interest rate. |
Understanding Calculation of Hard Money Loan Points through an Example
It is important to understand how points are calculated and how they can impact your loan cost. Formula:
Points Cost = Loan Amount * (Points Percentage)/100
Example: If your loan amount is $ 4,00,000, points charged are 3, the interest rate is 12%, and the loan term is 10 months.
- Calculate point cost: 3 points on $ 4,00,000
- Point Cost = 3/100 * 4,00,000
- $12,000 needs to be paid as an upfront cost.
- Calculate the total hard money loan interest rate cost.
- Annual Interest=12/100* $4,00,000
- $48,000 will be paid as an annual interest
- Total Cost = Annual Interest + Point Cost
- $12,000+$48,000=$60,000
- 2 negotiation scenarios: if you negotiate your points charged from 3 to 2, then
- Point Cost = 2/100*$4,00,000
- $8,000 will be the point cost.
- So now the total cost of the loan will be $8,000 + $48,000 = $56,000.
So by reducing your points from 3 to 2, you saved $4,000 on the total cost of the loan.
How to Negotiate on Points with Hard Money Lenders: Tip to Borrowers
- It is important to research the average market rates that fluctuate based on the lender, project risk, loan size, and more. Getting quotes from multiple lenders to know the market trend is advisable, so you can negotiate accordingly.
- With having a strong credit history and experience in real estate, you can negotiate with the lender to reduce hard money loan points, as it is a less risky investment for the lender.
- The borrower can also negotiate other aspects of the loan to offset points such as lower interest rates, longer loan terms, a flexible draw schedule, and more.
- If a lender is not willing to negotiate on points, then have backup lender options to strengthen your negotiating position.
Conclusion
Points are not just another aspect of hard money loans, but they can help borrowers in strategically planning and optimizing their financial strategy. For example, you can analyze the impact of paying points on different loan offers and evaluate the upfront costs versus long-term savings parameter to align your loan with long-term financial planning. To know more about the strategic implications of points on your loan, connect with Munshi Capital experts, and get tailored professional financial guidance.
Read More: No Credit Check Hard Money Lenders: Myths and Realities
Frequently asked questions
- What is the average range for hard money loan points?
The average point range for a hard money loan is between 1% and 5% of the total value of the loan.
- In hard money loans, are points tax deductible?
It depends on the type of property the loan is taken for; if it is an investment property, it can be deducted as a business expense; for residential properties, the deduction can be limited or span over the loan tenure.
- What is the difference between points in hard money loans and conventional loans?
For conventional loans, the point percentage is between 0.25% to 2%, whereas for hard money loans, it is between 1% to 5%. In the case of a hard money loan, the percentage is high because it is used as a measure for compensating risk and speeding up the process.
- Can points affect the cash flow statement if the property is financed through a hard money loan?
Yes, points can affect the cash flow statement during the initial phase of the investment as they require an upfront payment, so it can reduce the cash for other expenses that can affect the liquidity.
