Hard Money Loan Prepayment Penalties Explained

A hard money loan is similar to a mortgage loan. It uses a piece of property as collateral; the property may or may not already contain a home. Hard money loans are different from traditional mortgages on several levels, however. They tend to be extended by independent financiers to a sector of borrowers who do not qualify for traditional mortgages. As a result, the terms of the loans are less favorable to the investor. The loans are issued with much higher down payments, much higher interest rates and with less flexible terms.

Prepayment Loan Terms

All loans carry some risk of prepayment to the lender. Borrowers can be confused into thinking prepayment is actually a good thing. The lender wants the money back for the loan, right? Yes, the lender does want the money, but the lender also wants to collect interest. When you prepay, you may be cutting into the interest a lender can earn on the financing. To protect against this, there is often a penalty for prepaying. This can either encourage a borrower to fulfill a loan contract as promised or provide the lender with some additional profit in the case a loan is closed early.

Interest Charges on Hard Money Loans

Prepayment penalties on some loans are very small. However, on hard money loans, the penalties can be astronomical because of the way the loans are structured. Essentially, there are two ways of allocating payments on an installment loan. In the first model, interest is charged each month. The payment goes toward the small amount of interest charged on that month's payment, and the remainder of the sum goes toward the principal. The principal sum is reduced each month, starting with the first month.

The second method is often used by hard money lenders. In this method, one interest amount is calculated for the entire loan sum up front. The interest on the loan is paid off first, and then principal debt is repaid. The sum delivered to the lender each month during the beginning years of the loan goes nearly 100 percent to interest payments. The principal is reduced very little. This method is actually illegal in some cases.

Prepayment of Hard Money Loans

When the second method for charging interest is used, the principal balance of the loan remains high well into the loan's maturity. If the borrower decides to prepay the loan, the lender will issue a prepayment quote based on this principal sum. The sum may be as large as the entire initial loan. Despite years of payments toward the debt, the borrower has paid off only the interest and failed to actually gain equity in the property. 

In addition to this very high fee charged, a hard money lender can issue credit penalties for prepayment. Instead of reporting that the loan was repaid in a satisfactory manner, the lender may report the loan was closed in a manner not satisfying the contract. Since most hard money borrowers suffer from bad credit already, this negative report can be detrimental. 

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