When you want to buy a home, start a business, or pursue higher education, loans give you the money to achieve your dreams. There are a wide range of lending options and sources for those who need capital. If you have been researching loans, you’ve probably stumbled on private money lending and are wondering what that entails. Private money loans can be an excellent tool for those looking to get finances quickly, but they can be confusing and intimidating to the uninitiated. Let’s take a closer look at private money lending and how it works.
Unlike traditional loans that come from banks or other financial institutions, private money loans come from actual individuals or private lending entities. While they can technically be applied to almost anything, private money loans are short-term loans primarily used for purchasing forms of real estate, including:
- Single-family homes
- Apartments and condos
- Multi-unit properties
- Commercial real estate properties
Traditional loans primarily rely on your credit-worthiness, which often means providing the bank or loan institution with all of your financial information, including credit score, employment history, income, and previous debt history. This is all designed to help the bank determine your ability to actually make loan payments on time and in full. Banks also require an asset in case you default on your loan. This is known as collateral. However, even if you have significant collateral, there’s no guarantee that the bank will approve your loan.
Private money lenders are not traditional banks, meaning that they have different guidelines, qualifications, and requirements. Most private money loans are secured by a note or deed of trust, and while some private money lenders may ask for your credit history, it generally will not have as much of an effect on the approval of your loan.
Your Private Money Lending Circles
Unlike traditional loans, private money lending is based more on the borrower’s relationship with the potential borrower. Private money loans can come from three separate degrees or circles of relationships. See below for more information on how to find private money lenders.
Your primary circle consists of friends and family members. These are people you already know and are familiar with, and you will likely naturally gravitate towards them first before you ask for money from anyone else. This primary circle is popular because it’s much easier to get in front of your friends and family with your proposal, and they are generally more inclined to say yes.
However, borrowing from your primary circle does come with its potential drawbacks. Your friends and family may not necessarily be aware of the potential risks involved with the investment, which can lead to some broken relationships if the deal does not pan out. Your primary circle also tends to be your smallest pool of capital. This money can absolutely help you, but it is best to think of your primary circle as your initial angel investors who will buy you the time to find other forms of funding.
Your secondary circle of potential private money lenders comprises the people that your friends and family know. These are the friends of friends, so the bigger your primary circle, the bigger your secondary circle. This group will be receptive to your proposal given that you have a mutual contact through your primary circle. The secondary circle also tends to have a larger capital pool as well. The drawback is that you will have to spend more time building the relationship in order to raise money from this group. You have to spend more time networking and prepare an investment presentation to give your secondary circle more information about your project.
The third-party circle is the most removed from your social networks. Third-party circles generally comprise hard money lenders and private companies. It will take much longer to develop a relationship with these potential lenders, but this is also your largest source of capital. Third-party lenders are also the most reliable lenders and have standardized loan terms, fees, and interest rates, which can be a bit of comfort for borrowers who may not know the ins and outs of private money loans. For this reason, many people who talk about private money lenders are actually referring to hard money lenders.
Hard money loans are short-term bridge loans secured by real estate. Where traditional loans go through the entire process of determining your credit worthiness through your financial history, hard money lenders generally only care about the value of your property. With hard money loans, the property that you are borrowing money for becomes the main form of collateral. Because the property is the most important aspect of the deal, the overall process is much faster than with a traditional loan. You have to deal with less paperwork and fewer delays. However, these loans often come with a higher risk, which often results in higher interest rates and lower LTV (loan-to-value ratios)
Hard money loans are usually reserved for:
- Short-term financing
- Quick turnaround projects
- Situations where borrowers have poor credit but a substantial amount of equity in a property and are trying to prevent foreclosure
The Pros and Cons of Private Money Lending
The advantages of using private money loans include:
- Low credit qualifications – Most third-party lenders have a minimum credit qualification of about 550. However, even with low credit, you can still get approved for a loan. Remember, private lenders focus mainly on the potential profitability of your property purchase more than your finances and credit history. Even if you have negative marks on your credit, you may still qualify (though the loan’s interest rates might go up).
- Faster approval and funding – The greater focus on the value of the property also means less paperwork and delays, allowing for a much faster approval process. Where traditional loans may take up to 45 days for approval, private money loans can be approved and issued in less than a week. Prequalification for hard money loans can take a few minutes, and the funds can be disbursed in 10 days. This quick process is especially beneficial in more competitive situations. For example, if there are several bids on a property, you want the money as quick as possible to beat out the competition.
- Greater flexibility – Traditional lenders have stringent rules and rigid terms. Private lenders are often just individuals whom you can talk to and build relationships with. Many do not always have standard terms in place, allowing you to negotiate certain aspects of your loan terms, including origination fees and repayment schedules.
- Rehab financing – Hard money lenders and other third-party lenders may offer rehab financing, which are loans specifically meant for financing the purchase and renovation of a home as one loan. Conventional loans often will not cover renovations and require a house to already be in good condition.
Private money loans do have their drawbacks though, particularly when it comes to the costs. You can expect to pay much higher interest rates with a private money loan over a traditional bank loan. On average, borrowers may see interest rates of 15 percent for a private loan, but some lenders may ask for up to 20 percent interest on top of any mortgage points if you have bad credit or the property poses some serious risks.
Private money loans also have much shorter payment periods. With traditional loans, banks may allow you to pay off a loan over the course of 30 years. Private money lenders expect you to pay off your loan in six to twelve months. More lenient lenders may allow up to two years. Granted, you also wouldn’t want to have to pay off that loan for a long period of time considering the high interest rates.
Requirements for Private Money Lending
The diverse range of private lenders coupled with the fact that there are few government regulations for private money lending mean that loans terms, conditions, and requirements vary greatly. If you’re getting money from your primary circle, friends and family are likely to loan you money as long as you have a basic proposal for making a profit because they know you and trust you. Lenders from your secondary circle, however, may require a note or deed of trust along with more thorough details and a complete investment plan.
Hard money lenders and private lending companies will require the most information. Expect to submit:
- Proof of identity
- A note or deed of trust
- A written investment plan that outlines the steps you will take, how you will spend the money, and the profits you expect to generate
Private lending companies will also often ask for your credit score, which will not have a bearing on your approval but may affect your interest rate. They may also require a down payment for the loan.
Private Loan Application Process
The application process can depend on who you are borrowing from. For friends and family, you probably won’t have a standard application process. However, for private lending companies and hard money lenders, the process is broken down into two parts: pre-qualification and funding.
During the pre-qualification phase, private lenders give borrowers an idea of their potential options, including the loan size, costs, fees, and terms. You can then use this information to figure out your own budget and proceed with an initial purchase agreement for your property. The lender will also provide a preapproval letter, which you can present to the seller when you make an offer on the property. This shows that you are qualified and can afford the property.
For pre-qualification, the borrower will need to provide:
- Two to three months worth of personal bank statements
- Your personal credit score
- Answers to some basic questions about the property
Pre-qualification can take as little as three minutes.
At this phase, the lender will require more specific information to make a final decision. Many lenders use this as an opportunity to gauge the borrower’s real estate investing experience and their choice of rehab contractor. This phase is more strict than the pre-qualification phase. The lender evaluates your financial standing as well as the property itself, including location, physical condition, and expected after repair value. Lenders may require documentation that includes:
- A purchase contract
- Contractor bids
- A list of past rehab projects
- A scope of the rehab work
- Property appraisals
- Any fees and upfront costs
If you are approved, the lender will issue the funds.
Who Should Use Private Money Lending?
Private money lending is ideal for fix and flip projects where borrowers plan to buy a home, renovate it, and put it back on the market, all within about a year. Landlord and other buy-and-hold investors may also benefit from private lenders. Buy-and-hold investors will purchase and renovate a rental property and then refinance it later with a traditional mortgage. While you can potentially use a private loan for a property that you plan to live in, you would likely want to refinance as soon as possible to avoid paying the high interest rates.
Del Toro Loan Servicing offers premier services for private lending professionals. If you have questions or need help with your private lending, please contact us today.