What Are Points on a Hard Money Loan and How Do They Work?

Hard money loans are a popular financing option for real estate investors and developers. Unlike traditional bank loans, hard money loans are provided by private lenders and fund quickly. However, they come with higher interest rates and fees like points. So what exactly are points on a hard money loan and how do they work? This comprehensive guide explains everything you need to know.

What Are Points on a Hard Money Loan?

Points refer to origination fees charged on a hard money loan, expressed as a percentage of the total loan amount Each point is equal to 1% of the loan amount.

For example, if you take out a $100,000 hard money loan with 5 points, you will pay $5,000 in points ($100,000 x 5% = $5,000). This fee is paid to the lender upfront at closing.

Points represent compensation for the lender for providing the loan. They account for the risk, effort, and costs incurred by the lender. More points mean a higher origination fee.

Why Do Hard Money Lenders Charge Points?

There are a few key reasons hard money lenders charge points:

• To offset the risk of lending to borrowers with poor credit or unconventional deals that may default The points provide a buffer against potential losses

• To cover the costs of underwriting and issuing the loan. Points help pay for the lender’s time and effort.

• Because hard money loans are short-term. With faster repayment, lenders collect less interest income, so points help boost their earnings.

• To align incentives by ensuring the lender profits if the deal succeeds. Points give lenders a stake in the success of the project.

How Many Points Should You Expect to Pay?

The number of points on a hard money loan can range anywhere from 1 to 5 points, with an average of 2-3 points. The exact amount will depend on several factors:

• Your credit score – Borrowers with lower credit scores represent higher risk and will typically pay more points. Those with higher scores can usually get away with fewer points.

• Loan-to-value (LTV) ratio – Loans with a higher LTV have a higher chance of default, so lenders will charge more points to offset the risk.

• Loan amount – For larger loans, lenders may charge slightly higher points. Smaller loans can have lower fees.

• Project type – Unusual or complex projects perceived as higher risk mean more points. Simple projects likely attract lower points.

• Relationship with lender – Existing relationships and repeat borrowers may benefit from discounted points.

Can Points Be Negotiated?

The number of points on a hard money loan is not necessarily set in stone. Savvy borrowers can try to negotiate with lenders to reduce the points.

You may cite factors like your strong credit score, low LTV, or relationship with the lender as justification for paying fewer points. Or bundle the loan with other profitable services from the same lender.

However, success will depend on the lender’s assessment of risk and profitability. Be prepared to shop around if one lender won’t budge on points.

Advantages of Paying Points on a Hard Money Loan

Despite the high upfront cost, there are some potential benefits to paying points on a hard money loan:

• Lower interest rate – Each point paid can lower the interest rate by 0.25% to 1%. This reduction applies over the entire loan term, leading to considerable interest savings.

• Tax deductions – Points paid at loan closing may be tax deductible as prepaid interest. This can provide some tax savings to help offset the upfront cost.

• Faster funding – Paying points upfront shows your commitment to the lender. In return, they may expedite the underwriting process for faster approval and funding.

Disadvantages of Points

However, there are also some downsides of points to consider:

• Cash flow impact – Large upfront payment can tie up working capital needed for renovations or other expenses.

• Not beneficial for short-term loans – If repaying quickly, the savings from a slightly lower rate may not outweigh the points paid.

• Prepayment penalties – Paying off loan early may still incur interest charges, limiting the impact of points paid.

Alternatives to Paying Points on a Hard Money Loan

If you want to avoid paying points on a hard money loan, here are some options to discuss with lenders:

• Request a no points loan – Though less common, some lenders may offer this.

• Take a higher interest rate – Skipping points means a higher ongoing rate, but no upfront costs.

• Finance the points – Some lenders may let you roll points into the loan amount rather than paying upfront.

• Pay for points over time – Ask if points can be paid in installments over several months rather than lump sum.

• Provide additional collateral – Extra assets to secure the loan may allow negotiation of fewer points.

Are Points on Hard Money Loans Worth It?

Whether paying points makes sense depends on your situation:

• For short-term loans, points may not yield enough savings to justify the cost.

• If cash flow is tight, points may not be affordable upfront even if they lead to eventual savings.

• For longer loans, the cumulative reduction in interest can outweigh upfront points.

• Borrowers able to deduct points from taxes recoup some of the upfront costs.

Carefully evaluating the costs vs. potential savings can clarify if points fit into your financial plan. An experienced broker can also provide guidance on negotiating the optimal combination of points and interest rate for your particular loan scenario.

The Bottom Line

Points are a complex but key factor that can impact the cost of financing substantially over the life of a hard money loan. While they require a large cash payment upfront, points provide the benefit of securing a lower interest rate from lenders. Weighing the tradeoffs based on your loan details, timeline, tax situation, and budget allows determining if paying points makes sense for your next hard money loan.