Private Money Lender Basics

What is Private Money Lending?

Private money lending involves a private individual or organization providing a loan, typically for real estate investments. Unlike traditional banks that focus on a borrower's credit history, private lenders primarily concern themselves with the value of the property securing the loan.

Private money lenders often move quickly, approving and disbursing funds in days rather than weeks. This speediness is a godsend for real estate investors who need to act fast on their transactions. Such loans, usually short-term, with ranges from six months to a few years, cater specifically to projects like property flipping, where the goal is to renovate and resell.

Interest rates on private money loans hover between 15% and 20%, reflecting the higher risk taken by the lenders. However, if you're borrowing from a friend or relative, the rate might be more generous. Payments may be interest-only, with a substantial balloon payment due at the end.

Qualifying for a private money loan involves presenting a solid plan that showcases the potential profitability of the deal. Rather than dissecting your personal credit score, the lender is more interested in whether the project makes fiscal sense. The down payment requirement is usually higher too, often around 25%, but this is balanced by the relaxed scrutiny on borrowing.

Naturally, there are trade-offs. The leniency of private loans means that lenders safeguard themselves with higher interest rates. Borrowers must act quickly to sell or refinance the property before the loan term expires. If not, they could face hefty balloon payments or lose the asset ensuring the loan.

Identifying reputable private lenders can be tricky since they don't typically advertise like big banks. Investors often rely on professional networks, social media platforms, or real estate investment events to find potential lenders.

Loan Scenarios and Types

Private money loans come in various forms to cater to the diverse needs of real estate investors. Whether it's tackling quick renovations, bridging a temporary financing gap, purchasing directly, or leveraging property equity, the flexibility and expedited process of private money lending provide a critical advantage in the fast-paced world of real estate.

• Fix and flip loans are specifically created for investors looking to purchase and renovate a property with the intention of reselling it quickly for a profit. These loans usually have short terms, often six months to a year, and focus heavily on the after-repair value (ARV) of the property.
• Bridge loans serve a slightly different purpose. These loans are temporary financing solutions meant to "bridge" the gap between the purchase of a new property and the sale of an existing one. They are short-term, often spanning from a few months to a year, with the expectation that the loan will be paid off through the proceeds of the property sale or long-term financing.
• Purchase loans are more straightforward and geared towards acquiring a property directly. While traditional purchase loans from banks usually come with stringent credit and income verification processes, private money purchase loans are faster and less restrictive, focusing more on the property's value and the investor's equity.
• Investment property loans generally encompass a broader range of real estate investments, including rental properties. They can have variable terms depending on the strategy—whether it's long-term rentals or shorter-term projects like vacation rentals. These loans usually require higher down payments and might charge higher interest rates due to the perceived risk.
• Probate and estate loans are created for situations where an investor needs to quickly purchase a property from an estate or probate process. The flexibility and speed of private money lending make it suitable for these time-sensitive transactions.
• Cash-out refinance loans offer a viable solution for those looking to leverage equity. Investors can refinance an existing loan to draw out equity from their property to fund new investments or other financial needs. This type of loan typically requires significant property equity and entails a more lenient approval process compared to conventional refinancing options.
• Owner-occupied private money loans cater to properties where the borrower intends to live while also investing. These loans come with additional regulatory requirements but usually provide the same speed and flexibility as other private loans. They are particularly helpful for borrowers with less-than-perfect credit who might struggle to secure traditional loans.
• Multifamily private money loans focus on properties with multiple units, like apartment buildings. These loans are particularly beneficial for investors aiming to expand their portfolios by acquiring multifamily properties for rental income.
• Private money 2nds refer to second-position loans that sit behind an existing mortgage, enabling the borrower to secure additional funding without refinancing the first mortgage. These loans come with higher interest rates and stricter terms to offset the increased risk for the lender.

Cost and Interest Rates

Cost and interest rates for private money loans are notably higher than those for conventional loans, and several factors influence these rates. Typically, private money loans carry interest rates ranging from 8% to 20%, depending on various criteria.¹ In comparison, traditional mortgages generally have interest rates between 3% and 6%. The higher rates in private lending reflect the increased risk and the flexible, expedited nature of these loans.

One significant factor influencing these rates is the loan-to-value (LTV) ratio. The LTV ratio is the loan amount divided by the appraised value of the property. A lower LTV (below 60%) means that the loan represents a smaller percentage of the property's value, which typically results in a lower interest rate due to reduced risk for the lender. Conversely, a higher LTV ratio (above 80%) could lead to higher interest rates because of the increased risk associated with lending a more substantial percentage of the property's value.

The type of property securing the loan also plays a critical role. Residential properties, particularly owner-occupied homes, often come with lower interest rates compared to commercial properties or land. This is primarily because residential real estate is considered more stable and liquid than commercial real estate or vacant land, potentially making it easier to sell and recover the loaned amount if the borrower defaults.

Perceived risk is another crucial element affecting interest rates. Perceived risk is evaluated based on the borrower's experience, the condition of the property, and the overall market conditions. For instance, a borrower with a track record of successful real estate projects might secure a lower interest rate than a novice investor. Similarly, a well-maintained, highly marketable property in a stable area will likely incur a lower rate compared to a distressed property in a volatile market.

Loan terms also influence the rates. Shorter-term loans typically have higher interest rates than long-term loans. This is partly due to the lender's need to recoup their investment quickly and the higher risk of short-term market fluctuations. However, the flexibility and speed of private money lending often justify these higher costs for investors needing quick access to capital.

The specific regulations and lending environment of the state or region can impact interest rates. In states with stringent usury laws or where private lending is less competitive, interest rates might be on the higher end of the spectrum. Conversely, states with numerous private lenders competing for business, like California, may offer slightly lower rates due to increased competition.²

To illustrate, North Coast Financial, a well-known private money lender, offers first position loan interest rates ranging from 9.5% to 12%, and second position loans between 12% and 14%. These rates are competitive within the private lending market but still significantly higher than conventional banking rates.

Qualifications and Requirements

In private money lending, qualifications and requirements differ significantly from the rigid frameworks seen with traditional bank loans. One of the foremost criteria private lenders prioritize is the property value over the borrower's credit score. This focus ensures that even individuals with less-than-perfect credit histories can secure financing, provided the underlying asset possesses substantial value.

The property's current condition and potential after-repair value (ARV) are crucial in the lender's decision-making process. Private lenders seek assurance that the investment will generate enough return to cover the loan. Detailed property appraisals and assessments often play a vital role in determining the loan's feasibility.

Equity is another critical factor. Lenders typically require the borrower to have considerable equity in the property or to make a substantial down payment. The down payment requirement usually hovers around 25%, ensuring that the borrower has a vested interest in the investment. This equity cushion acts as a safeguard for the lender, mitigating potential risks in the event of market fluctuations or borrower default.

Aside from property value and equity, a viable exit strategy is paramount. Borrowers must present a clear and actionable plan detailing how they intend to repay the loan. Common exit strategies include:

• Selling the renovated property
• Refinancing with a traditional mortgage once the property's value has increased
• Using rental income to fulfill loan obligations

The strength of this exit strategy can significantly influence the lender's confidence and, consequently, the approval and terms of the loan.

Borrowers often need to provide a comprehensive written plan outlining the project's scope, financial projections, and timelines. This documentation reassures the lender of the project's viability and the borrower's preparedness. It demonstrates a thorough understanding of the investment and a proactive approach to mitigating risks.

The Loan Application Process

To apply for a private money loan, the process is generally more streamlined compared to traditional bank loans, enabling quicker access to funds. Here's a look at the typical steps a borrower needs to follow:

1. The borrower must submit a loan application to the private lender, which includes personal information, property details, and an outline of the investment project. The key is to be comprehensive yet concise.

2. The borrower needs to provide supporting documentation, such as:

   • A detailed property appraisal
   • A written plan of the project's scope
   • Renovation budgets
   • Timelines for completion
   • An exit strategy showcasing how the borrower plans to repay the loan

3. The lender assesses the property's value and viability, focusing on the collateral provided by the property. They perform their due diligence to ensure the property holds sufficient value to cover the loan amount.

4. The private lender might require an in-person or virtual meeting to discuss the project further, allowing the borrower to elaborate on their plans and the lender to gauge the borrower's competence and commitment.

5. The lender moves to the underwriting stage, scrutinizing the borrower's financial structure, the property's value, market conditions, and the proposed exit strategy to determine the loan's risk level. This process is typically quicker than that of banks.

6. Upon successful underwriting, the lender issues a loan offer detailing the terms and conditions. The borrower needs to review this offer carefully, perhaps seeking legal advice.

7. Once both parties agree to the terms, the loan agreement is formalized through signing legal documents and disclosures.

8. The closing process involves coordinating with an escrow or title company to handle the necessary financial transactions and legal requirements. The private lender funds the loan, and the funds are disbursed according to the agreed terms.

Throughout the loan process, borrowers should maintain open communication with their lenders, providing requested documents and updates on the project's progress.

By following these steps diligently, borrowers can secure quick and flexible funding tailored to their real estate investment needs.

Benefits and Risks of Private Money Lending

When considering private money lending, understanding both the benefits and risks is essential for making an informed decision.

One of the most significant benefits is the speed of approval and funding. Private money lenders can often approve and fund a loan within days, which is crucial for real estate investors who need to act quickly to secure a property.

Private money loans offer considerable flexibility, as they can be customized to the specific needs of the borrower and the project. This flexibility includes negotiating loan terms, repayment schedules, and adjusting the loan amount based on the project's progress.

Private lenders have less stringent requirements compared to traditional lenders, focusing more on the property's value and the project's potential profitability than the borrower's credit score or income history. This opens up opportunities for a broader range of investors.

However, these benefits come with certain risks. Private money loans have higher interest rates, ranging from 8% to 20%, reflecting the increased risk taken on by private lenders and the premium for flexibility and speed. Borrowers need to calculate the potential return on investment to ensure the high-interest cost is justified.

Private money loans are typically short-term, often ranging from six months to a few years. Borrowers must act swiftly to complete their projects and repay the loan to avoid large balloon payments or foreclosure.

A well-thought-out exit strategy is critical in mitigating risks. Borrowers should clearly outline how they plan to repay the loan, whether through selling the property, refinancing, or generating rental income. Lenders will evaluate the proposed exit strategy to gauge feasibility and risk.

Private money lenders often require higher down payments to secure the loan, ensuring the borrower has substantial skin in the game. This higher equity requirement can be a hurdle for some investors but ensures only committed borrowers can secure these loans.¹

By weighing these pros and cons and ensuring a comprehensive plan is in place, investors can effectively leverage private money loans to achieve their real estate investment goals.

In summary, private money lending offers a fast, flexible option for real estate investors willing to pay higher interest rates for quick, less-regulated loans. The focus is more on property value and the profitability of the deal rather than the credit history of the borrower.