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It's fairly common for real estate investors to branch outside of traditional lending programs and instead use private money lending to finance investment properties. Using private funds to invest in real estate can be beneficial for both the investor and the private lender, allowing the active investor to purchase a new investment property while the private lender receives a return on investment.
If you're looking for alternative financing for an investment property or want to put idle money to work, it may be worthwhile to look into private money loans. This private money lending guide will explain what private money lending is, who can be a private lender, the pros and cons of private lending, and how to become a private lender.
What is private money lending?
Private money lending is when a private individual or small business loans another investor or investment company their own personal funds to use for investment purposes. In real estate, it's an alternative option for financing an investment property outside of a traditional bank or lending institution. Hard money lending, which is often used for rehab loans, is one example of private money lending, although private real estate loans can be used for bridge loans, development loans, residential rental loans, or commercial loans.
The private lender typically secures their investment using a note and mortgage or another type of security instrument, receiving a return on investment, equity split, or possibly a combination of both in return.
Since private money lending is private, it's up to the lender and the borrower to establish the terms of the loan. As long as the property is being used for investment purposes, it falls outside of the Dodd-Frank Act and allows the investor to determine the interest rate or loan terms that are agreed upon between both parties. The interest rates for these loans are often several percentage points higher than interest on a traditional mortgage would be.
Who can be a private money lender?
Private money loans are typically created by people the investor or borrower knows personally, such as a family member, friend, neighbor, or colleague. However, anyone who has idle money they would like to receive a better return on than their savings account interest rate is yielding can become a private lender. Private money lending is great for individuals who:
- Have idle money or a surplus of cash sitting in a savings account receiving little to no return.
- Have a sizable retirement savings account like an individual retirement account (IRA) or 401k that they want to continuously grow.
- Are looking for passive income or want to participate in the real estate market without actively working in it.
What are the pros of being a private lender?
The biggest pro of being a private money lender is being able to participate in the real estate market passively while receiving a return on investment. The investor does the hard work of managing the property while the lender gets to collect the check.
Another added benefit of being a private lender is that you typically receive a higher rate of return than most savings accounts offer, typically earning in the 6% to 15% rate of return or more, depending on the interest rate charged and whether there are points or other fees charged. Private money loans, if done correctly, can be a great way to grow a retirement account or to increase passive income.
What are the cons of being a private lender?
The largest con of being a private money lender is the risk of borrower default. Even with the most thorough due diligence, there is always the chance the investor won't pay according to the terms of the loan. While the lender is typically secured by the real estate, taking legal action to recover interest to the property can be a timely and costly hassle.
Additionally, the lender should be confident and educated in the real estate investing strategy and understand how to conduct their own due diligence on the investment and the borrower to reduce their liability and risk. While private lending is a passive investment in the long run, there is a significant amount of work upfront for the lender.
|Pros of Being a Private Lender||Cons of Being a Private Lender|
• Earn a higher rate of return to help grow retirement or savings accounts.
• Earn passive income secured by real estate.
• It's a passive investment, requiring very little ongoing work after initially vetting the borrower/investment.
• Risk of the borrower not paying and having to foreclose or take legal action.
• Having to vet the borrower and investment property.
How do I become a private money lender?
- Decide where the funds will come from.
- Find an investment opportunity.
- Conduct your due diligence on the investment and the borrower.
- Determine the loan terms.
- Finalize the paperwork.
- Begin collecting.
Decide where the funds will come from
If you're just getting started as a private money lender, you'll first need to decide where the funds will be coming from and how much you are willing to lend. You may have cash readily available in a savings account that you can wire or write a check for when the time comes. Or you may need to convert a traditional IRA or 401k plan into a self-directed IRA plan, which allows individuals to participate in private money lending for real estate.
Once your funds are in the proper account and available for lending, determine how much you are willing to loan at any one time. Make sure that you are not lending your entire savings and that you are diversifying your funds across different investment opportunities to mitigate risk.
Find an investment property
Once you've established where the funds are coming from, and how much you are willing to lend, you will want to identify an investment opportunity to lend on. A great way to find potential investors to work with is attending local investment associations. Talk with colleagues, friends, or family members who are active in real estate and discuss that you offer private financing if and when the time feels appropriate.
It's important to note that investors looking for private money should not explicitly solicit their need for financing if they are not a personal friend or colleague unless they have a private placement memorandum (PPM) and have filed for the proper regulations. Some investors do not follow the proper guidelines and regulations relating to raising private money, so as you get started, it's ideal to start with people you know and trust or ensure you are working with individuals who have gone through the proper steps to work with you as a private lender.
Conduct your due diligence on the investment and the borrower
Knowing how to analyze and review a real estate investment is imperative, even if you are acting solely as the lender. The investor may have a decent track record, but it's your job to vet the borrower and the investment property.
Confirm the information the investor provides, and do your homework on the individual themselves. Specifically:
- Have they failed to make a payment on other debt obligations?
- Have they filed for bankruptcy in the past?
- Are they involved in any past or active litigation relating to their investing?
You can research the borrower for a fee, paying for things like a background check or credit report, or simply research them online for free.
But before lending money, be confident that the borrower and the investment are worthwhile.
Determine the loan terms
The next step is to determine the terms of the loan. You can offer the same terms for each loan you create, or you can negotiate based on the investor and investment opportunity. Some lenders require a down payment, which is a percentage of the property's purchase price, while others do not. It's up to lender and borrower to establish the following for the loan:
- Interest rate.
- Interest type (adjustable or fixed).
- Length of loan (time for repayment).
- Closing costs or fees (like points).
- Whether there is a balloon.
Finalize the paperwork
While it's not required, it is best practice to have a licensed attorney draft or review any paperwork relating to private money loans. This ensures both parties are adequately protected and the proper legal terms were included in the event of default. The lenders should always keep the original note and mortgage or security instrument in their possession, providing a copy to the borrower. Depending on the state, if the borrower defaults and foreclosure action is pursued, the original note and mortgage must be produced in court in order to foreclose.
Now the lender can start collecting! Keep good records of the payments the borrower has made, including copies of checks or bank statements or an Excel spreadsheet, to confirm the proper principal and interest was accounted for with each payment. This reduces your risk if the borrower does default while also making the loan marketable if you ever want or need to sell on the secondary market.
Private money lending in summary
Becoming a private money lender is not for everyone. It can be a good optionIf you have idle money or want to grow your portfolio while investing passively in real estate, but it must be done properly. Make sure you stay informed on real estate investing strategies, the market, and lending practices and that your risk tolerance aligns with this form of investing.
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