Private lending can yield better returns than stock and bond markets. If
you understand the fundamentals and know how to conduct proper due diligence
for each transaction, you can earn solid returns while minimizing your risk.
A little more knowledge and effort can give you better returns in private
money loans. Electronic transactions that require pushing a button to
buy or sell stock are fast. But if your focus your time and attention
to learn the ins and outs of private money lending, you can win lucrative
deals. Read these tips and learn the lending game.
PRIVATE LENDING 101
Investing in private money loans is similar to investing in a bond. They
both have a fixed yield and pay off at maturity.
Example: If you make a loan to a borrower for $100,000 at 8.00% interest, and
require interest-only payments, you will earn an income of $8,000 annually.
If the loan is paid, it will pay off at or before the maturity date. You
will also get the original vested principal.
Tip: Look for a real estate investor who flips property. Offer to lend
the total project cost that includes the acquisition of property plus
renovation cost. He should make a down payment of 20%. The down payment
will demonstrate his “vested” interest and proves the appropriate
due diligence. These factors will contribute to a higher chance of success.
Research how to lend capital to others for an annual return. Discover the
pivotal factors that make the private loan investment considerably more
involved than a bond investment.
Study these rules so you can master the process and invest with confidence.
Do not become a private lender if you think you will need the money that
you want to invest before the maturity date of the loan. Most loans payoff,
but some do not.
If you do need cash before the maturity date, it may be possible to sell
your loan. You can utilize an online loan exchange like Loan MLS. Consider
offering it to another private investor for sale through a hard money
loan broker. If you do need to sell a note that is not paying, keep in
mind that non-performing private money loans are typically sold at a discount.
2. Collateral Assessment
Reduce your risk! Collateral for a hard money loan is important. “Drive
the comps yourself” is the philosophy for lenders. Get in your car
and drive to the house that you will be appraising. Take photos. Use an
Automated Valuation Model or Broker Price Opinion to determine market value.
3. Loan Advances
Some transactions require advances because of delinquent property taxes,
attorney fees or foreclosures. Lesson #1: Leave yourself a cash cushion.
Provide for enough liquidity in your finances so you can fund for any
4. Fraud Protection
Make sure your title company insures your lien position as a lender. Get
fraud protection to address possible forgery. Title insurance is indemnity
insurance. To get reimbursed, you must be able to prove a loss.
5. Credit History
Analyze the borrower’s credit report carefully. Private money loans
are based on hard assets and collateral. Make your assessment of a borrower's
creditworthiness on their ability to repay the loan when a balloon payment
occurs, or when the loan reaches maturity.
6. Fire & Liability Insurance
Make sure the property owner has the correct type and adequate amount of
fire and liability insurance. As a private lender, the insurance company
must notify you as an additional insured on the policy. In a case of loss,
have the reimbursement check sent to you first.
7. Written Agreements
You must document the loan. Create security documents and disclosures for
the borrower. There are numerous state and federal regulations that must
be followed and should not be ignored. A violation could render the loan invalid.
8. Loan Servicing
Conduct a quick Google search to get the proper tax and regulatory statements.
Many private lenders hire a servicing company to manage this part of the
process for them.
If a borrower defaults, investors must go through the foreclosure process
to claim the collateral. The complex foreclosure process varies from state
to state and requires expertise and understanding of the law, so get the
proper guidance. Seek advice from other seasoned professionals or attorneys
who specialize in real estate law.
The role of a private money lender is a specially trained person that originates
private or “hard” money loans. If you are new to the private
money lending arena, it’s best to let experienced professionals
help guide you through the pros and cons associated with each transaction.
Here is a list of the types of private money opportunities and the positives
and negatives to consider for each.
New Loans. The purchase or construction of a new property requires renovation; or
refinance of existing debt on a property.
Pro: Because you are lending to one party, you have control regarding origination,
documents, terms, etc. You will not have potential liability for a previous
originator’s errors. If this involves a former client, you have
access to his performance history.
Con: New borrowers do not have a prior payment history that you can evaluate
for a lending decision. Use reports from previous lenders.
Note Purchases. As a private money lender, you can purchase loans that have already been
originated. When you buy performing or non-performing loans, they can
be purchased at face value, at a lower rate.
Pro: There is a performance history that can be analyzed. For non-performing
loans, a combination of solid valuations for collateral and deep discounts
can give excellent yields if an investor is willing to risk foreclosure.
Some non-performing notes may payoff to avoid foreclosure or be restructured
in the future.
Con: If the note wasn't originated properly, you could be purchasing
a liability. Non-performing loans may result in foreclosure. Your due
diligence is limited to records from the current lender.
Loan Pool. The process of buying several loans in one transaction.
Pro: Bulk loan purchases typically come with a discount. Performing loans
have histories available for evaluation.
Con: Files may not be accessible. Buyers are often rushed to make a bid
resulting in potentially costly mistakes. You’ll get a mix of good
and bad loans.
Mortgage Funds. There are companies that collect funds from multiple investors and create
a single entity to loan money. A Limited Liability Company (LLC) is the
structure for most mortgage funds. The investors would hold a membership
interest in the LLC. The fund manager makes decisions regarding the note.
This arrangement typically avoids conflict with respect to the disposition
of loans by the fund.
Pro: Pool managers handle the transaction, and your investment is diversified
across a wide variety of loans.
Con: Since you are an owner of the LLC, foreclosure is not an option to
recover your investment. You may be subject to the entire pool closing
before you can get your funds returned to liquidity.
Your success is dependent on the success of the pool. If the pool manager
makes poor decisions, the entire fund is affected.
It can be difficult to sell your position as there are often restrictions
on to whom you can transfer your interest.
Fractionalized Loans. In the case of a fractionalized loan, private investor funds are collected.
Each investor is vested on the security instrument. For example, if a
borrower required a $1 million loan for a shopping center, the note may
be fractionalized across ten different investors, each investing $100,000.
All ten investors would be vested as beneficiaries on the recorded security document.
Investing in a fractionalized note is different from investing in a mortgage
pool. In the fractionalized note, all investors have an interest in one
particular note. When the note liquidates, the investment liquidates.
In a pool, members have an interest in the entire investment.
Pro: Multiple fractional transactions allow investors to diversify their
Con: Everyone in the fractionalized group must agree on foreclosure and advances.
Junior (2nd Position) Liens. Buying a second or junior lien brings higher returns. However, risks
associated with the junior position and complications with servicing escalate
Pro: Less initial cash up front and a higher rate of return.
Con: Significantly higher risk. If a borrower defaults on the first mortgage,
you may have no choice but to bring the 1st mortgage current or pay it
off to protect your investment. Junior lien investments are not for the
faint of heart. If the market drops or bankruptcy is filed, you could
Nurture your relationships with other private money lenders. Practice due
diligence and weigh your options carefully.
Comparably, private lending can be lucrative. It can offer greater returns
than stocks, bonds and mutual funds. Strive to understand all aspects
of the industry especially your personal investing.