Because hey, your portfolio could always use a little more risk.

Personal finance bloggers hate the payday loan industry, for a number of very predictable reasons. Payday loans are incredibly expensive. If the borrower falls behind he’s harassed more than a moderately attractive woman at a sports bar. And getting payday loans in the first place is usually an indication of a much bigger overall problem.

Besides, payday loans are slowly going away. Provinces are reigning in the rules, announcing things like interest rate caps, penalty restrictions, and limitations on how often a borrower can renew their loan by just paying the interest. Critics have long argued that these loans do nothing but keep poor people poor, so these changes are quite popular. Even among people who aren’t finance bloggers.

But something is going to have to replace these loans. Even dirtbags need access to credit.

At least here in Canada, Goeasy Ltd. (TSX:GSY) thinks it has the solution. The company offered unsecured loans at an APR of 46%, which seems like a terribly high interest rate for anyone with a credit score starting with a six or above. But in reality those loans are much cheaper than payday loans — which cost 15% for just two weeks here in Alberta — and at least offer a little flexibility for the borrower because they’re unsecured.

This segment of the market is called hard money lending, and there’s a boatload of money to be made doing it for a small-scale investor. Assuming you can get over the skeeze factor.

The basics

Here’s how hard money lending works. Buddy shows up at an Easy Financial store or one of its competitors. Say he needs $1,000 and can pay back $100 twice per month. They agree to do the loan at the usual charge of 46% annually.

By the time it’s done, the borrower has paid back $1,119.41 in approximately six months, or a little over 11% on the original $1,000 borrowed. Math would dictate that the total cost would be $230 for six months (46% divided by two) but keep in mind it’s a declining balance. 80% of the first payment goes towards principal, with more of each subsequent payment going towards the original balance.

There are two kinds of hard money loans. The first is the unsecured one, which usually comes at a sky high interest rate. Easy Financial’s 46% isn’t that outrageous. I own a stock called Advent Wireless (TSXV:AWI) that recently got into this business and they charge 40% annually. That’s what you’re going to pay.

The interest rate goes down a little if the borrower can put up come collateral. A house is obviously the best kind of collateral, but a car or even something less will do in a pinch. These loans are typically 2-3% per month.

GICs pay about 2% a year. It might suck to have to pay 3% a month, but it sure is sweet to collect it.

How you can do hard money lending

The beauty part of hard money lending is as a small investor, the regular person can be incredibly patient.

I’d never even hint that these kind of loans should be a large part of one’s portfolio. I’d argue 5% should be the maximum allocation, and that’s only after years of experience. It’s best to start really small.

Thus, the average person who even tries this will only have a handful of loans outstanding at any time. If you’re only looking to do a few loans then you pick and choose the ones you want.

Say you charge 2.5% a month or 30% a year and you have just 2% of a $100,000 portfolio invested in these things. That’s just $2,000 worth of loans, yet they could generate $600 per year in cash flow.

You’d need $30,000 in GICs earning 2% to earn the same return as hard money lending.

The paperwork is easy. Dear lord, do your paperwork. Do not rely on your buddy’s friend’s good word. He’s borrowing money from you at 2.5% a month. There’s a reason why he’s doing this.

You’ll also have to provide a total cost of borrowing. This can be built using your own spreadsheet or using an amortization calculator online. Software also exists that does this, but you won’t be big enough to afford it.

The hard part: collecting

I have a few hard money loans in my portfolio. These are largely from folks who wanted to borrow small amounts of private mortgage money.

There’s one loan I did for $1,500 at a 2% monthly interest rate. I would have been happy to lend that person more money at 8% annually, but all they needed was $1,500. It doesn’t make sense to register a mortgage on someone’s property for a $1,500 loan. It would cost half of that just to register the mortgage.

But at the same time, I’m taking more risk by giving an unsecured loan. Thus, I want a higher interest rate.

The hard part is collecting these things, which is why I advocate being incredibly selective. If the you know what hits the fan, you better believe buddy is going to pay his rent before he pays you. Consistently bugging him on his payday could be the only thing standing between you and a capital loss.

I’m very poor at this. Just terrible. So I do very little hard money lending. It is less than 1% of my portfolio and going down. If I wanted to scale up and do tons of these things — demand I’m certain exists, btw — the best solution would be to hire someone to harass borrowers who fall behind.

Final thoughts

Hard money lending isn’t going to be a popular investment. Most of you will feel terrible just thinking about charging 2 or 3% a month to someone, even if they are a poor credit risk. And while it’s a pretty passive way to make money, there’s still work involved.

Still, it can be a very profitable way to invest some of your money. A selective portfolio will have very few write-offs. If you’re smart with it, hard money lending can be an effective way to make a few bucks.

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