If you were to apply for a residential mortgage through your local bank or private mortgage lender, the lender would have to apply the ability-to-repay rule in its decision to approve or deny your request. But if you were to apply for a hard money loan as a real estate investor, the same rule would not be in play. Do you know why?
The easy answer is that hard money lenders are subject to a different set of rules. The rules that apply to retail banks and private mortgage lenders do not apply the hard money lenders. But there is more to it than that. So let’s take a deep dive, beginning with how the ability-to-repay rule came about.
Part of the Dodd-Frank Act
The ability-to-repay rule came about as a result of the Dodd-Frank Wall Street Reform and Consumer Protection Act (a.k.a., the Dodd-Frank Act) of 2010. Dodd-Frank was enacted in response to the housing crash and financial crisis that began in mid-2007.
More than a decade of irresponsible mortgage lending led to millions of people being granted mortgages even though they could not truly afford them. When the housing market began to soften and property values fell, a large number of these homeowners could no longer afford their monthly payments. The market crashed, the financial sector suffered, and America entered the Great Recession.
Lawmakers subsequently overhauled financial regulations. The ability-to-repay rule was included in that overhaul. The rule stipulates that mortgage lenders must make every reasonable effort to verify a borrower’s long-term ability to repay before approving a residential mortgage. If there is any reason to believe a borrower might not be able to repay, his application is denied.
Hard Money Is a Different Kind of Lending
An understanding of the ability-to-repay rule leads us to the question of hard money lending and why the rule doesn’t apply. Hard money is a different kind of lending.
The first thing to note is that hard money lenders are private companies or individuals rather than banks and licensed mortgage lenders. Therefore, they are not subject to the same rules banks and mortgage lenders must follow.
Next, hard money loans are not residential mortgages. This is true even when a borrower uses a hard money loan to purchase a residential property. Salt Lake City’s Actium Partners explains how this is possible.
The majority of Actium’s loans go to real estate investors. These investors are not purchasing residential properties they intend to live in. The properties are either long- or short-term rentals. In many cases, investors are purchasing multi-family properties.
Because the properties are investment properties, the loans used to secure them are considered commercial loans. And commercial loans are governed by a different set of rules.
Approvals Are Based on Asset Value
The other thing to remember is that hard money loans are backed by assets. In other words, an investor looking to borrow from Actium Partners must offer collateral with enough value to cover the amount being borrowed.
A hard money lender will base its approval on the value of the collateral. The borrower’s ability to repay will not even be considered. If the asset in question has enough value, the loan will likely be approved. If not, the loan will certainly be denied.
The ability-to-repay rule was implemented to stop banks from writing residential mortgages for consumers who couldn’t truly afford to buy homes. It has fulfilled its purpose. However, the rule doesn’t apply to hard money lending for reasons explained in this post. That is a good thing. If it did apply, hard money lending would be quite different.