NEW YORK ( MainStreet) — With bank lending on the decline, hard money lending is enjoying a financial boom much like payday loans. But bear in mind: there are differences between the two.

"A hard money loan is usually related to real estate with some sort of tangible collateral whereas a payday loan is a short term, unsecured loan," said Kenny Schaum of Park National Mortgage Servicing. "The default rate on payday loans are much higher than hard money loans because there is nothing securing the payday loans."

Hard money lenders are individuals or a small company that are willing to loan money at high interest rates over a short term for the acquisition of distressed real estate properties.

"Residential home buyers often use hard money loans in order to pay cash for homes at auction," said Tim Lucas, vice president of Mortgage and Editor in Chief at real estate website MyMortgageInsider.com. "They set up the hard money loan, buy the home at a discount then try to refinance into a conventional mortgage."

Hard money loans are usually written with a promissory note and a simultaneous, written personal guaranty.

"The downside is the lender may demand more in the way of disclosures or periodic reporting from you on your finances or business," said Richard Lee, a partner with Salisian Lee, a law firm in Los Angeles. "In litigation, we generally see hard money loans in the commercial real estate context as homeowners usually get financing through a bank that gets a deed of trust on the residence in exchange."

Hard money loans are a risk because many conventional lenders prohibit refinancing a home too soon after it was purchased. If a conventional lender denies the borrower's loan, the borrower ends up paying exorbitant fees to keep the hard money loan open.

"They typically are executed with an attorney and paper work. Usually the lender gets title insurance but the loans can be soft seconds meaning there is no recording of any of the documents and the lender is not insured if there is a default by the borrower," Schaum told MainStreet.

Avoid handshake deals at all costs, Lee says.

"Oral agreements on a hard money loan are not recommended for anyone for any significant sum of money as both borrowers and lenders alike have a habit of conveniently forgetting the terms," Lee told MainStreet.

The biggest problem most people have in relation to dealing with a hard money lender is finding one in the first place, according to Todd Tretsky with Financial Funding LLC. Follow the guidelines below to assist the process:

  • 1. Ask for a referral from a loan broker.
  • 2. Join a local real estate investor group to network with other real estate investors who invest in distressed properties for an additional source of investment cash.
  • 3. Online Directories- Some are free but expect to pay a small fee for the very best of them.
  • 4. FinancialFundingLLC.com charges 7 to 12% compared to the 15 to 20% that most hard money lenders will request.
  • 5. Gather together financials, create a spreadsheet and print out the results to present to the prospective lender.

--Written by Juliette Fairley for MainStreet