loan to value ratio

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.

Private 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.

Through 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.

The 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!

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Rules to Follow with Private Money Lending

Private money lending involves YOU as the private money lender and another person or organization as the borrower. When you are a private money lender for real estate investment deals, you are protected by the loan-to-value ratio and the fact that you will own the house if the investor walks. Even so, follow these rules to make sure you are completely protected:

  • Make sure the property has INSTANT EQUITY. Look for lots of room between value and price. To protect your investment money, avoid risking it on a property priced at or above the market value; it is not worth the risk. Choose properties that can easily be resold.
  • Have a clear contract and plan of action. Put everything involved in the deal on the loan papers. If the borrower is required to put a certain amount of the loan into repairing the property, include these requirements on the loan documents and specify the date the work is to be completed. To protect yourself in case the borrower fails to complete the work, include such ramifications as a late charge, spike in interest rate, or even calling the loan due and payable. If the borrower is not able to come up with the whole amount, you can foreclose and take the property back, citing specific performance. The point is, you must keep excellent documentation of who is supposed to do what in the transaction, and be sure it is clear and admissible in court. You want it clear enough that you can show a judge and they will understand exactly what was agreed to.
  • Don’t let your emotions get in the way. The only numbers that matter are the comparable sales, comparable listings, and the amount of money you are making on the deal. Don’t let attachments to the house or the borrowers get you into financial trouble.
  • Always use an escrow officer. We cannot stress this enough. For the couple of hundred dollars it will cost you, not only will you have a professional handling the closing of your investment, but also you will have title insurance. That way, you can be sure that the property you are buying has a clean title, does not have past liens or encumbrances, and that all the paperwork is structured exactly how you and the borrower have agreed upon.
  • Always use a neutral party to keep track of payments made. An escrow company usually has the option of having all payments made by the borrower go into an escrow account that accumulates or is released to you on a set schedule, whichever you prefer. This usually costs under $5 per month and it keeps everybody on the same page.
  • Review everything with an attorney. Make sure you review everything – even this article – with an attorney before making any financial decisions. Laws and restrictions are changing all the time, so make sure you get the latest information with a qualified local attorney.

Have other suggestions to keep yourself protected? Include them in the comments below!

Introduction to Private Money Lending

What is Private Money Lending?

If you’re not consistently getting big returns on your current investments such as your IRA, savings account, or stock portfolio, then you will be excited to learn about a smarter way to invest in today’s market – especially in today’s market. This method has been successfully used for years by real estate investors.

If you have funds to invest but know that the stock market and other traditional investments are either not the safest decision right now or not getting satisfactory returns right now, consider the world of private mortgage lending. Private money lending could offer a much higher rate of return, from 8% – 15%, and is backed by a tangible asset: real estate. The best part is that you make the rules when it comes to terms and interest rates and therefore you have control over how your money is being invested.

Who is involved?

Your borrowers are real estate investors who come across great deals at deeply discounted prices and need to fund the purchase quickly or risk missing out. These properties are often in need of repair, which is what allows investors to sell them for a big profit. This is called “rehabbing” or “flipping.”

Lots of times, these rehabbers choose not to work with traditional lenders. Instead, they borrow private money from lenders (like you) who understand the real estate business and can fund deals quickly. Because the rehabbers need funds quickly and usually for a short amount of time, they are more than happy to accept loans with higher interest rates and terms that favor the lender (you.)

This works out to your advantage because now YOU make a profit in today’s busy real estate market without leaving the comfort of your home. In this situation, you are the bank and the investor or rehabber does all of the work. You are lending money just like a bank would.

Is it safe?

Rehabbers only need to borrow around 60-70% of the home’s “after repair value” to fix up a property, so the worst-case scenario is that your borrower defaults on the loan and you walk away with a deeply discounted house. Since you choose who borrows from you and you decide whether or not to lend for a particular house, this works out in your favor.

To make sure this process is a smart one, you’re going to want to make sure an attorney, title company, or escrow company handles all the paperwork on your behalf as the closing agent. The good thing about this setup is that traditionally you can have the borrower pay all costs involved out of the proceeds.

Never sign a check to the real estate investor yourself; make sure this is all done through a professional third party to handle the closing. To further protect your investment you’ll also want to make sure the real estate investor gets title insurance and property insurance with your name as the “loss payee” to protect your investment. After you have provided the funds and closing has concluded, the closing agent will send you all the paperwork including the mortgage or trust deed with you in the first position.

As a private mortgage lender you have your money is working for YOU and is in YOUR control. While others are complaining about the current economy, you can take advantage of this boom time for real estate investors by offering short term loans and high rates for consistent, high yields on your investment.