by Elizabeth T. Erhardt, Partner

The “Opportunity” – Hard Money Lending to Distressed Homeowners

In light of the precipitous decline in California real property values and widespread job layoffs, many homeowners are faced with mortgages they can no longer afford and cannot refinance at more favorable rates. Institutional lenders have clamped down hard on their residential lending practices, greatly tightening credit standards and limiting loans to 80 percent (or less) of the value of the home. And as appraised property values decline, the loan-to-value requirement becomes even more problematic. Consequently, very few residential loans are being issued by the major lenders. Many homeowners are therefore searching for “hard money” lenders for help in saving their homes from foreclosure.

Hard money lenders are typically individuals or other non-institutional lenders who loan cash to homeowners in exchange for either a note secured by the home, or a direct ownership interest in the property subject to the owner’s option to repurchase the lender’s interest at a premium. With more and more investors looking for investment opportunities outside of the turbulent stock market, and greater numbers of homeowners encountering financial distress, hard money lending will be on the rise.

The Risks - Usury Laws

Unfortunately, many would-be lenders are unaware of the myriad of California laws which tightly regulate hard money lending on residential property. First, California’s stringent and complex usury laws are a trap for the unwary individual lender. In general, non-institutional lenders cannot charge interest greater than 10% per year (unless an alternate higher ceiling applies) on residential real property loans which are not made or arranged by a licensed real estate broker. Cal. Const., art. XV, § 1; Cal. Civ. Code § 1916.1. Lenders who violate the usury laws are not entitled to collect any interest whatsoever and may be compelled to refund any amounts collected beyond the principal loan amount – and in some cases triple the collected interest.

Another Risk – Home Equity Sales Contracts Act

Another less known but even more onerous law, the Home Equity Sales Contracts Act (Cal. Civ. Code § 1695), imposes civil and criminal liability on hard money lenders who obtain equity interests in the homes of defaulting owners without providing strict statutory notice of the owner’s rights. The Act was passed when California real estate values were increasing at a rapid pace and was designed to protect distressed home owners from unwittingly transferring large amounts of home equity to hard money lenders in exchange for funds needed to stave off foreclosure. Under the Act an owner may sue a lender for triple damages and attorneys’ fees if the lender fails to give specified notices and acquires title to the home (subject to the owner’s option to repurchase), while the owner’s mortgage was in default. An ill-informed hard money lender may face liability for damages and legal fees that will substantially exceed any anticipated profit from the loan – and even may face criminal prosecution with possible fines and imprisonment. (Cal. Civ. Code § 1695.8)

Moreover, under law, the transaction may be construed not as the transfer of title to the owner’s home in exchange for an option to repurchase, but rather, as a mortgage, meaning that the owner retains title while the lender only has a lien on the property, which is behind any prior mortgage. This subordination of the lender’s interest to liens which are already in default strips the lender of any practical means of recovering the investment.

Owners who continue to struggle to stay afloat despite the temporary relief of hard money loans are wielding these laws as a sword to cut off the proverbial hands that fed them. As a result, many well-intentioned individual lenders have become victims of their own ignorance.

In recent months, many private hard money lenders have learned to their astonishment that they are not only unable to collect on their loans, but are facing substantial legal fees and costs defending lawsuits by the very homeowners they thought they were helping. If the lender cannot enforce its interest in the property because of failure to strictly comply with notice requirements, there may be no practical way of recovering the now-unsecured investment.

The Need for Due Diligence

It is imperative for hard money lenders to obtain legal counsel BEFORE entering into real property loan transactions. The legal fees incurred defending against the owner’s suit for noncompliance with the statutes will dwarf any preventative fees incurred to insure that the transaction meets legal requirements so that the lender has some hope of recovering its investment.

If you have any questions about any of the techniques discussed above, please contact Elizabeth Erhardt , James Janz or Robert Cross at Sideman & Bancroft.

This summary is not meant to be an exhaustive discussion of the issues or laws on the subject. You should consult an attorney for advice regarding your specific circumstances.

Pursuant to IRS Circular 230, unless expressly stated to the contrary, any tax advice is not intended and cannot be used to (i) avoid penalties under the Internal Revenue Code or (ii) promote, market or recommend any transaction or matter to another party.