What is private lending?
Private lending is an excellent way to generate an excellent return on money that might otherwise be sitting in a bank account making little to no return. In this article I’ll explain the advantages and disadvantages of private lending and what the common strategies are.
In it’s simplest form private lending is just one individual lending money to another individual or company. In effect the private lender is just “being the bank”. All of my private lending activies revolve around the purchase of investment real estate (rental properties, apartment buildings, etc) so that is what I’ll be discussing in this article.
What are the advantages of private lending?
The ideal private lending situation is one where both sides (the lender and the borrower) win. The lender wins by getting an excellent return on investment much higher than they would otherwise. This return is consistent and predictable and secured by real estate through a mortgage. The borrower wins by getting better rate, terms, or both than they would from the bank. This can help to take an investment from zero or negative cash flow to a positive cash flow, or reduce the amount of out of pocket expense for the borrower. In some cases the borrower may not be able to qualify for a bank loan, or the fees, expenses, and requirements of a bank loan may not make sense (typically very short term loans). The borrower also wins because a private loan can be completed much faster than a bank loan.
One of the biggest advantages for both parties is the flexibility of private lending as an investment tool. The terms of the loan can be just about anything that the two parties agree on. The terms include the interest rate, payback schedule, payback amount, amortization schedule, balloon payments (if any), transferability, payback penalities, and the list goes on.
What interest rate can I expect?
Interest rates will vary depending on a multitude of factors. Currently the market interest rate for bank loans on investment properties is in the 7-9% range. Private lenders could expect a minimum interest rate of 5%, and depending on the time requirement and other terms could expect as high as 15%. Typically an interest rate at a level that high would be for very short term deals (1-90 days), or very risky deals. If a borrower is offering a high interest rate (12-15%) and you can’t immediately figure out why it’s priced at that level it’s likely that it’s very risky and probably not a good investment for you as a lender.
To provide some examples we offer interest rates to our private lenders that range from 4% up to 12%. Most deals fall in the 7-8% range, which would be for a first position mortgage, 80% or less loan to property value, prepayment penalties in the first 3 years (you get a higher return if we refinance or liquidate the property within the first 3 years of the mortgage), monthly interest only payments, and the loan can be called due with 60 days notice once the loan has been in place for 5 years (but there is no requirement to call it unless you want to). On this loan the interest payment would be no more than 66% of the expected cash flow.
A 4% loan would be extremely low risk, with first position mortgage, very high prepayment penalties, 50% or less loan to value, and monthly payment would be no more than 40% of expected cash flow.
Conversely a 12% loan is typically shorter in term (3 months to 3 years) with no prepayment penalty, and a longer (9-12 months) period to call the loan due.
What are the disadvantages of private lending?
From the lenders perspective the biggest disadvantage would be the risk of default. It’s important to only lend money to reputable people with significant experience doing real estate deals similar to the one you’re lending them money to do. It’s also important to have enough of an understanding of the project they’re undertaking to have a feeling if it makes sense or not. If you aren’t certain that it’s a good idea you should either reconsider lending them money, or at the very lease make sure the terms account for the risk of the unknown.
Another disadvantage includes the fact that it takes time to get your principal back if you want or need it back. It’s best to loan money that is earmarked for retirement or long term investments because of this.
Interest rate risk is another concern, although you should be lending at a rate that is high enough to offset this for the most part. The interest rate on these private loans are usually fixed (but they can be set as a floating rate) so if interest rates go up you won’t be able to take advantage of higher rates. However typically rates would have to go up a lot for CDs or savings accounts to provide the same interest rate as a typical private loan.
What Else Should I Keep in Mind when Lending?
The biggest thing to keep in mind is to protect yourself as much as possible. Make sure you understand exactly what the money will be used for and the terms of the loan. Make sure you understand when you should be receiving money and how and when to get your principle back. Make sure the property is insured and you’re listed as the lien holder of record with the correct mailing address for you. Get a copy of the dec page DIRECTLY from the insurance agent. Check the reputation of the borrower, and it wouldn’t hurt to get a copy of their credit report.
How do I get started in private lending?
If you’re interested in getting more specific information or see what options might be available to you feel free to email me at email@example.com or call/text my cell at 318-218-0123. I have a steady stream of on and off market deals, too many to take advantage of with my own available capital, so I’m always looking for private lenders and/or partners so that we can take advantage of the best deals that come our way.