Are private/hard money lenders “shady”?
Private/hard money lending does have a stigma. There were previously some bad apples in the business. But like any business, hard money had its good and bad players as the business evolved over time. Today there are many more good players than bad, and the key is knowing how to find the good ones.
Selecting an experienced Private Money Lender (PML) requires the same careful due diligence you would use in selecting any financial advisor. The objective of PrivateMoneyLendingGuide.com is to help you become familiar enough with a private money loan transaction to know the questions to ask when conducting your due diligence. So don’t let the stigma scare you. There are a plethora of new PMLs emerging who are well-trained professionals acting in the best interest of borrowers and the investors they represent. The industry has changed significantly over the last decade and a cottage industry of professionals has emerged which pride themselves on serving as a conduit between you and note investment opportunities.
What are some of the ways I can participate in a private/hard money loan?
There are many ways you can participate in a private money loan transaction. You can buy an existing loan, fund a new loan, invest in a mortgage pool, or combine your investments in a fractionalized note with other investors. Each of the investment types are explained in more detail throughout the PrivateMoneyLending.com web site, or you can click on the links to learn more.
Why do they call it “hard money”?
The term “hard money” is used in conjunction with a loan which is “hard to get” from a traditional lending source, such as a bank. The term also comes from the asset pledged as collateral in return for the loan. When a borrower pledges the asset as collateral, the asset goes “hard” as collateral against the loan.
The term private money and Private Money Lender is working its way into the vernacular and is more descriptive of the professional lending practices in place today. Private parties funding loans, individually, or as a group, for transactions which fall outside the scope of traditional bank loans.
How do I find qualified borrowers?
Unless you want to originate loans yourself it will be best to locate a PML who specializes in the type of loan in which you would like to invest. PMLs spend considerable resources looking for borrowers in their area of expertise and are an excellent way to be matched with a borrower who meets your loan specifications. For example, if you are interested in construction loan notes you’ll want to find a PML experienced in construction lending, or if you prefer residential rehab loans, you may wish to find a PML specializing in that area. The Private Money Lending Guide can assist you in locating a PML that is right for you.
If you are an experienced investor and prefer to find your own borrowers, you can use an online loan exchange such as www.LoanMLS.com which also includes listings of borrowers wishing to borrower funds, set up a web site to attract the type of borrower and property/project you wish to invest in, and/or set up a Google Adwords pay-per-click ad campaign.
Who will be involved in the process of investing or purchasing a private/hard money note?
Multiple parties are involved from origination through to closing. In addition to yourself, the PML and the Borrower, there will be a Title Company, Escrow Services Company, Appraiser and Loan Servicer. Click here to see more details on these parties and the role they play.
Is Loan to Value (LTV), the best criteria to use when investing in private money loans?
Yes and no. Just because your loan is private and not a bank loan, doesn’t mean you should ignore traditional lending practices commonly referred to as the three “Cs”: Credit, Capacity and Collateral. Credit refers to the borrower’s past history of paying bills. Capacity is their ability to make the payment required by the note, and Collateral is the type and equity of the real estate pledged as collateral in the event the loan is not repaid. So you can see that LTV is just one piece of the three C’s, and should not be the only criterion with which you evaluate a transaction.
Simply using LTV as a loan criterion could lead to irrational decisions if the total loan picture is not considered. For example, which loan would you rather have: a 40% LTV loan on a $100,000 property or a 55% LTV loan on a $1 million home? If LTV was the only criterion, the 40% LTV would be the logical choice. But consider that a 40% LTV loan leaves only a $60,000 equity cushion whereas the 55% LTV loan leaves a $450,000 equity cushion. The larger equity cushion in this example, all other things being equal, is a more logical choice even though the LTV of 55% is the higher of the two LTVs.
Cross collateralization is another reason LTV should not be the only determinant in your investment decision. In the previous example, if the 40% LTV transaction was cross collateralized with a free and clear (debt free) $500,000 rental property, the loan transaction would become more attractive than the 55% LTV alternative.
Your objective as an investor is to maximize your return and minimize your risk. LTV is one of many criterions to use, but there is no substitute for evaluating the loan transaction based on a comprehensive consideration of all of the risk factors.
Aren’t private/hard money loans more expensive for borrowers?
The issue with private money loans is not so much that they are more expensive, but that they are available. Private money lenders rarely compete with banks. If a borrower is qualified to obtain funds from a bank, that is usually going to be the best source of funds at the lowest rate.
But borrowers turning to private money are typically looking for something outside the box of bank loans. The borrower may need the loan quicker than a bank can deliver, or vested in a borrower entity the bank doesn’t lend to, or wants to borrower against property the bank doesn’t accept as collateral, etc. The special needs of these borrowers creates opportunity for the private investor and sets up the perfect win-win. The borrower wins because they get a loan that is otherwise unavailable, and the investor wins because they can earn an above average return compared to the alternatives.
Banks earn a return on the spread between what they pay depositors and the rate at which they lend to borrowers. Banks often write government guaranteed loans (e.g. SBA loans) so they can afford to earn a relatively small spread which translates to a rate just at or above prime rate for borrowers.
Private investors are looking for a return on their investment as compared with other alternatives, such as stocks, bonds or other real estate investments. Rates will vary, but in general, the lower the risk, the lower the rate to the borrower.
What are the costs to the investor on a private/hard money loan investment?
Investors may pay one or all of the following as part of a note investment:
- Loan Servicing
- Legal/Advisory Fee
Loan Servicing - If you do not service the loan yourself, you will have to pay either the PML or an outside servicing company to do so. Servicing fees vary by provider and can be priced as a flat fee (e.g. $40 per month) or as a % of the original loan amount. Expect to pay your servicer for a variety of ancillary services such as negotiating forbearance agreements, foreclosure, advances, loan modifications, etc.
Advances - Certain circumstances require an investor to advance funds in order to protect a loan investment. Advances can be for a variety of reasons, typically when the borrower fails to pay something required as part of the promissory note. Example of advances could be to reinstate a senior lender for a default, paying delinquent property taxes, insurance coverage lapse, etc.
Advances are typically not costs because they can be recovered. But advances will require cash to be advanced by the investor. Whether or not the cash can be recovered will depend on whether or not there is sufficient equity to protect your loan investment.
Foreclosure – If the borrower breaches the agreement, an investor is responsible for paying the cost to foreclose. The foreclosure costs are an advance, as described in the previous section, but encompass a variety of costs such as legal fees, fees to a trustee or Sherriff, and various recording and statutory fees. Most promissory notes call for fees advanced to foreclose to be added to the balance of the debt, but whether or not you collect depends on the value of the property relative to the debt. If the property value has substantially declined by the time a foreclosure is complete, it is possible that the property is worth less than the debt and the fees advanced for the foreclosure may not be able to be recouped.
Legal/Advisory Fees - Expect to have legal fees from your attorney during note negotiation. On simple transactions, most investors rely on their PML to assemble the loan documents, but on more complicated transactions, the investor and PML jointly hire counsel to draft specialized loan documents, guarantees and review title. More often than not, the borrower pays legal fees at the loan closing, but if the loan falls through, or the investor backs out because of something discovered during due diligence, the investor will be responsible for fees incurred during the transaction.
If you are purchasing an existing note, the fees for reviewing loan files, and other due diligence costs are not recoverable. To compensate for the costs, investors will discount the loan purchase price to offset the expenses.
Do private money loans only cater to desperate or risky borrowers?
Not at all. In most cases, private money loans are made to entrepreneurs who just don’t otherwise qualify for a traditional bank loan. Many borrowers prefer private money lenders to banks because they can originate loans faster, require less documentation, and are more savvy and open to alternative sources of collateral than banks.
What can I do to minimize my risk as an investor?
- Work with an experience PML who can help you select loan investments which meet your yield expectations and risk tolerance. PMLs look for long term win-win relationships with their investors. Find a PML who’s incentives are aligned with yours and has experience in the area in which you choose to lend.
- Perform your own due diligence. Carefully research the PML you plan to work with, and carefully evaluate the underlying collateral of each note investment. There is no substitute for your own carefully completed research.
- Analyze each note investment carefully. Use IRR and NPV analysis to review the financial return on your note to make sure the loan meets your criteria. See “Financial Analysis for Note Investing” and “How to Calculate the IRR on your Note Investment”.
- Seek outside advice. While a PML’s incentives may be aligned with yours, it is always adviseable to have independent experienced counsel evaluate your investment. Additional information can be found in the article “Working with Attorneys”.
- Require personal guarantees. While it is common to lend to legal entities as opposed to individuals, without a personal guarantee from the borrower you may limit your ability to fully recover your investment in a foreclosure situation. PMLs and attorneys will be able to advise you on what type and when a personal guarantee should be required.
- Carefully Review Title Endorsements. Obtaining a title policy without endorsements is like driving a car without air in the tires. Work with your counsel to carefully review the loan transaction and select endorsements that work for you.
Is it true I can use funds from my IRA to originate or purchase notes?
Yes. It is possible through a self-directed IRA. You would set up the account through a custodian experienced in these types of investment options. For more details see the article “Lending & IRAs.”
Is interest on my note investments the only way I can make money when originating a new loan?
No. There are other ways to increase your yield on a new loan origination through fees and deal structure. For more detailed information see “Earnings Beyond Interest.”