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Private Money Lending: A Case Study

What Is Private Money Lending?

Let us start with some definitions. Private money lending is the act of lending money to a company or individual by a private person or organization. This is very useful to people and organizations that have nontraditional qualifying guidelines. There are higher risks associated with private money lending for both lenders and borrowers. There are also a lot less restrictions and qualifications and it is frequently done with a conversation and a contract between lender and borrower. This is an age-old way to purchase real estate.

Screen Shot 2015-02-05 at 11.27.58 AMPrivate money lending is very lucrative right now because single-family homes and investment properties are at an all time low in price. A couple of years ago, you would have to invest thousands of dollars in rentals just to make them cash flow. Now, an REO, short sale, or motivated seller are avenues for profits for those that are smart enough to see the opportunities.

The hard part right now is being able to get a bank loan. Banks want to see at least 20% down with excellent credit and traditional employment. Also, if the property you want to purchase has any problems, FHA will not agree to the mortgage… Which means you have to go with a conventional lender, resulting in higher rates and larger down payments.

For those of us who usually invest our money in the stock market, the current economy has opened up a golden opportunity to instead invest in real estate by being a private money lender. This is not as difficult as it sounds. Think about the last month of your life. Have you come into contact with someone that was thinking of buying a house or refinancing their mortgage? Networking is one of the best ways to find the properties and people you want to invest in. For those of you who would never lend money to friends and family, don’t worry! There are plenty of opportunities to invest and remain unknown to the borrower.

A Case Study

If you are familiar with today’s current real estate market and lending situation, you can probably guess the frustration and headache of buyers trying to conform to the bank’s confusing list of rules and regulations. Here’s a perfect example.

Let’s call her Carol. Carol has a dream of buying herself a house. She has worked at the same job for 10 years, in the same field for over 20 years. When Carol went to Countrywide Bank, where guidelines are stringent, she was an instant approval. Unfortunately, the house was not.

The house was built in 1947 and was lacking a crawl space and vapor barrier underneath it, along with many other small problems that would need to be fixed in order to qualify for a loan. It was the only house in the town she grew up in that she could afford. Carol was devastated by the news.

Meanwhile, the Smith family in the same time just sold their huge 65-acre farm to downsize into a residential home. The Smiths made some money on the deal and wanted to invest it in real estate. They decided to tour the home Carol wanted and thought it was cute and a very good investment. The only problem was that the Smiths did not know how to rehab a property; they had the money to fund the deal but not the know-how.

Since Carol could not get a mortgage from a bank, she decided to get creative to make this house her dream home. If she could just get a private money lender to lend her enough to buy the property and fix up the house, she could make her dream come true.

Screen Shot 2015-02-05 at 11.20.53 AMThrough word-of-mouth, Carol came into contact with the Smith family. She explained to them that it would take $90,000 to complete the deal, including $70,000 to purchase the house and $20,000 for repairing the house up to bank standards. The Smith family agreed to lend Carol the money. They would sign a 5-year balloon payment mortgage in which they would receive interest-only payments of $675 each month. They were ecstatic because they were getting paid 9% in interest just by lending this investment money to Carol. Carol was ecstatic because she found someone willing to lend her the money so she could fix up her dream home just the way she wanted!

Six months later Carol completed the required work and is enjoying a wonderful house. She was smart and made the changes before she moved in. Now the house is completely ready to refinance into a traditional loan. Not only did she save an older home from being demolished, but also she improved the whole neighborhood and made her investors lots of money!

Keeping Yourself Protected

Now, what is the worst-case scenario when it comes to being a private money lender? As a private money lender, the worst-case scenario would be that the borrower stops paying the mortgage and you are stuck with a property you don’t want and now have to pay for every month.

Screen Shot 2015-02-05 at 11.25.16 AMThe good news is, most borrowers come into the deal with some money invested. When you are loaning on these properties, keep the loan-to-value ratio in your favor. The loan-to-value ratio is the loan amount divided by the After Repair Value (ARV.)

For instance, a home that is currently on the market for $100,000 may be worth $120,000 after new paint, new flooring, and a general cleaning. It is amazing what completely painting a house inside and out and a general clean-up can do. It makes a home clean and ready for a new buyer. In this case, the loan amount would be $100,000 and the ARV would be $120,000.

The cost of paint, flooring, and cleaning comes to $1200. So if you paid $100,000 for the property and have invested $1200 for repairs, you now have $18,800 worth of equity. If you had to put that house on the market now you could sell it for $120,000, which gives you $18,800 to pay an agent and cover utilities.

So, even in this worst-case scenario, it is still highly probable for you as a lender to not only get all of your money back, but to make a nice profit. That is why it is important to keep the loan-to-value ratio in your favor.

Want to learn more about being a private money lender? Keep reading our blog or Contact Us with any questions!