Two things can affect the return on investment in a hard money note: Fees and Deal Structure.
Fees can be generated up front, at origination, and/or over the life of a loan. The following are fees in which investors commonly participate:
- Points – Points on a private money loan are paid by the borrower as part of their closing costs. It is common for an investor to request ½ to 1% of the loan balance as a yield enhancement.
- Late Fees – Private money loan late fees are paid by the borrower for not making a payment on time. Typically split 50/50 with the investor. Fees are generally paid when collected by the loan servicer.
- Default Interest – A higher interest rate which takes effect if the borrower defaults on the terms of the note or a loan covenant. For example, the note rate may be set at 8%, but if the borrower breaches in some material way, the rate may increase to 18%. Default interest participation should be clearly spelled out between the parties.
- Renewal Fees – It is not uncommon for commercial loans to have relatively short maturities. If your borrower has been paying on time you will likely wish to renew the loan. Commonly, loan renewals come with additional private money loan points and fees which can be shared with the Private Money Lender (PML).
The portion of these fees that you will receive is negotiable between you and the PML. The amount you receive will depend on a few factors:
Desirability: If the loan has desirable features such as an exceptionally low LTV ratio, or a particularly strong guarantee, the PML may have many investors interested in funding the loan, and the point share will likely be nominal, or may not be offered at all.
Relationship: The more loans you fund with a PML, the more likely you are to receive a portion of the points. PMLs look for long term reliable sources of investor funds because it makes it easier for them to operate. Once a PML gets to know your preferences for loan transactions, and your yield requirement, the PML will start tailoring loans to fit your needs.
Risk: The riskier the loan, the more the PML will be willing to share up front points in order to enhance the investor’s yield to make it more attractive to fund.
Funds: If a PML finds himself with more loans than investors, the PML will likely make loans more attractive by sharing points to attract more investors.
Borrower: When possible, the PML will pass on points to the borrower. If the original loan was quoted as 3 points, and the investor requests 1 point, the PML will likely first try to increase the borrower’s fee from 3 to 4 points and pass 1 of those points on to the investor. Whether or not the PML can raise the points for the borrower will depend on the competition in the marketplace for the particular loan.
When you are selecting a PML, ask about how they manage their business, and what fees they are willing to share with investors.
In addition to the points and fees, the structure of a note investment can substantially impact your yield. There is not much flexibility with the structure of a new loan transaction. The amount funded is the face value of the new promissory note, plus or minus closing costs.
- Term – For new loan originations, structuring the loan for the shortest reasonable time will return the biggest yield. Adding built in yield enhancements such as renewal points and fees will continue to enhance your yield beyond the initial term of the loan.
- Discount – Buying existing loans will provide the biggest return if the note pays off in full at or before maturity. For example, if a $300,000, 10% note is purchased for $240,000 and pays off in one year, the return is the 10% interest, plus the additional $60,000 in additional funds earned as a result of the discounted note purchase.