- Private money lenders are individuals or non-banking companies that extend credit often based on the business or project and require collateral like a home or other property.
- Private lenders are often used by those investing in real estate projects, like flipping homes or rentals.
- Success in these ventures is more reliant on your project than on financing, so real estate knowledge and experience are key.
Real estate and other investments are attractive to many. They can result in nice lump sum payouts, or even passive income in the case of a rental. But in addition to having the right real estate knowledge and the right project, you need the funds to complete it. Private money lenders are one option to fund your venture.
Funding can be a major hurdle in real estate investments. Banks or other financial institutions can have strict standards around loans, making it difficult to fund certain ventures through those traditional routes. Even with a great credit score, you might find that traditional lenders will shy away from your real estate project because they’re not interested in taking on that kind of risk.
Enter the private money lender. First, let’s look at what private money lenders are and how they function, then dive into use cases, perks, and risks.
What Are Private Money Lenders?
Traditionally, loans come from financial institutions or creditors, such as major banks or credit unions. Private money lenders are individuals (or a pool of individuals) with their own wealth that loan money to those wishing to pursue different ventures, often in real estate. Unlike a financial institution, private lending is typically handled by the borrower and the lender directly, without middlemen.
Private money loans often have loan terms, primary of which is a sizable return on investment for the private investor. This could be through an interest rate that’s often higher than traditional financing, a cut from whatever profit is turned by the person taking out the loan, or from repossessing the collateral pledged against the loan.
In some cases, a borrower can secure private money lending through companies or brokerage firms that deal only in private lending. Still, these will be handled like a private loan and not like a loan through a financial institution.
How Private Money Lenders Operate
Like a traditional loan, private money loans involve an interested borrower, a lender, and a dense contract. This contract serves to protect both parties, as it will lay out the loan amount, interest rates, additional loan terms, and any other fine print details. In some cases there will be a down payment required, but often times a private loan only makes money from interest charges, and the loan is repaid with a balloon payment at the end of the agreed-upon term.
If you’re taking a private money loan based on collateral, they’ll examine the property you own and determine the value of your home or project. They may accept a down payment as good faith in some cases, but usually the collateral is what they’re most interested in. When you’re looking to secure a private money loan, lenders will generally look at what it’s for more than who it’s for. Your credit score and your job are less important to the lender than if:
- You have experience with real estate investing, and you have a track record of paying off your loans.
- The real estate project or investment property has a clear payout on the horizon. They will factor in the repair value here as well, if it’s a fix and flip type situation.
- The property has enough equity in it to sustain an unexpected downturn, providing a buffer for paying off the loan
- You have enough cash to finish the project and won’t need to come back to borrow more.
Why Use Private Lenders?
Private lenders generally have fewer credit restraints than a bank or other financial institution, but carry higher interest rates. So, why use one? Some borrowers may be interested in pursuing a business and simply need startup capital, but primarily private lenders are used for real estate.
In the case of commercial real estate, it’s not uncommon for hard money loans or bridge loans to be used. These short-term loans have higher interest rates than most loans, but are typically used for very short periods to tide a commercial property project over until full financing is secured via investors or backers.
If someone is wanting to buy a rental property or purchase a house to flip it, private lenders are a common choice. Typical real estate loans from banks can have terms of up to 30 years and require a high credit score and money down, making them impractical or impossible for some. For those looking to get into short-term real estate deals, like a house flip, who want quick approval and only need the cash for a brief period, private lenders can make sense.
If you’re interested in pursuing a rental property for the long-term, however, a traditional mortgage loan can be a better choice, as the interest rates will generally be lower and your income from the rental can be used to pay down the loan over time.
The Pros and Cons of Private Money Lenders
Private lenders, in general, carry certain risks that don’t come with a financial institution. But, there are some pros to them as well. Let’s take a closer look.
Pros of Private Loans
- Those with bad credit or who don’t qualify for traditional financing can typically get private money loans, since private lenders are less concerned about your job and more interested in the collateral and the project itself.
- Lending companies and banks can take a long time to process a loan. Private lenders can get you funding quickly, an advantage if you’re competing to purchase property.
- Private lenders will generally lend for real estate as long as there’s a clear payout on the horizon, or you have extensive experience with real estate rehab or similar projects.
Cons of Private Loans
- Refinancing a private loan can be difficult or even impossible, depending on the lender. Bank loans typically have project refinancing built in, and can convert your loan into a mortgage, depending on your track record and payment history.
- The interest rates and fees on private money loans can be much higher than those from a bank.
- Private money lenders want to see their cash returned sooner than traditional lenders. They prefer bridge loans with terms as short as three months, and often no longer than three years.
What to Look for in a Private Lender
If you’ve looked through the pros and cons and decided a private lender could be for you, it’s important to know what to look for in one. Large financial institutions have standardized practices throughout their locations, while private lenders can vary greatly from person-to-person.
To ensure you’re getting the best deal possible, ideally you want to ask those in the real estate business and local community who they trust for private money loans. If the local network is coming up dry, look for the following when talking to potential private lenders yourself:
- Prior private money lender experience: The more experienced a lender is, the more likely it is that they’ve funded in solid projects with a good chance of success. Find out how much capital they have available as well, as this can assure you they have the money to help.
- Fair interest rates and terms: As you research potential lenders’ track records, gather data on interest rates and fees that each one charges for your project. Once you identify the range of rates and fees, compare their offers to determine which one might be offering the best terms for your loan.
- Real estate experience: Look for a private lender who has real estate experience, as their guidance can be useful to you in the success of the project. Their experience can also prepare them for any hiccups that come with real estate.
Laying a Safe Foundation for Real Estate Success
If you’re set on trying your hand at real estate, be prepared as a borrower. Ensure your finances are rock solid first. Put a simple budget plan in place, create a rainy day fund, and make sure your retirement plan is funded for the year. Ensure you and your family will be secure in the event your real estate business venture falls through or doesn’t go as planned.
Real estate knowledge is key in your situation. You need to know how to buy and sell, analyze the profitability of your project, and consider the worst case scenarios.
When it’s time to choose a private money lender, research extensively and get recommendations for lenders so you can be confident in your choice. There are also alternative private funding methods you can look into, like peer-to-peer lending.
Real estate investors need to expect the unexpected. Have the funds available and the resources to execute your business plan, like construction companies and a legal team. Taking risks can be rewarding, but be aware of the downsides, too. Start your real estate journey by instead laying a foundation of financial wellness, and then build from there.