Private Lending 101
- An investor looking for portfolio diversification, perhaps passive income to facilitate your retirement?
- An entrepreneur looking to start a private lending business?
- A real estate professional seeking private lenders to fund your deals?
In this article, we explain:
1. What is private lending?
2. Why does it work?
3. Is private lending only for the wealthy?
4. Where does it work?
5. What does a typical loan look like?
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What is private lending?
Individuals and/ or companies provide money (i.e. the loan) to qualified professionals using an asset (i.e. property) as collateral. The combination of the loan and the asset is considered the deal. Terms and condition vary from deal to deal, but each deal is for a specified duration of time and a specified return to the private lender.
A private lender lends their money in exchange for collateral, which is either a tangible asset (e.g. real estate) or an intangible asset (e.g. startup company).
Why does it work?
1. Legal protection - Laws are structured to protect the lender.
2. Protective equity in every deal - The asset or collateral value is worth more than the loan. This is due to the borrower putting a percentage of money (ie. the down payment), thereby increasing the equity while lowering the total loan amount. If there are repairs, a private lender will only lend up to a percentage of the After Repair Value (ARV). If the borrower defaults, the lender has multiple exit strategies thanks to the protective equity. Example exit strategies include selling the asset as-is for a discount (while still covering the lender's costs), complete the repairs then selling for a profit or renting.
3. Fast Turnaround - Larger financial institutions have lengthy underwriting processes. Their timeline to fund is typically 30+ days, while most real estate professionals fund their deals in 7-10 days.
Like any investment, private lending has risks. Factors that affect the degree of risk include loan-to-value percentage, economic conditions, diversification of portfolio, deal structure, reserves and the borrower. The three keys to successful private lending is knowing: 1) how to properly structure a deal, 2) what the asset is really worth and 3) who to involve and when. We will discuss these in further details in future articles.
Is private lending only for the wealthy?
No. However, there does need to be a certain amount of money available to start investing. This minimum amount should not exceed 10% of a person's total net worth for an unaccredited investor.
Where does it work?
Private lending is allowed in all 50 states in the US. The Safe Act and the Dodd-Frank Act are two laws every private lender should be familiar with along with the Security Exchange Commission (SEC) recommendations on how to raise capital. Private lending is different from Notes Investing, which we will cover in a later article.
What does a typical loan look like?
Here are three typical scenarios. We will expand upon them in later articles.
A. Bob the Builder has just bought a dilapidated $50K house at auction, currently unfit for a family to live in. Bob calculates that he needs another $25K to complete renovations to make the house worth $150K. Bob talks to his friend, Pete the Private Lender, and after a 3rd party appraisal, Pete confirms Bob's numbers and lends his money using a Deed of Trust and a Promissory Note at a rate below the usury laws.
B. Bob's cousin, Brian the Builder, also found a $50K dilapidated house at a different auction in a different state. However, Brian needs $50K more to make the house worth $150K. Brian calls their mutual friend Pete the Private Lender, and after a 3rd party appraisal, Pete confirms Bob's numbers. Because Brian is in a non-broker state and due to the the additional risk and complexity of the rehab, Pete works with a real estate attorney (in the same state as Brian's deal) to draft the Deed of Trust and Promissory Note that carries a significantly higher rate than his deal with Bob but below the usury limits of that state.
C. Bob has found another stellar $50K deal at auction and only needs $25K to rehab this property as well. However, Pete The Private Lender has no more funds so Bob goes to Harry the Hard Money Broker (HMB). Harry does the same due diligence as Pete but Harry also charges points to originate the loan as well as a higher percentage than Pete. These fees are high but Bob needs to move quickly, so he accepts this deal.
DISCLAIMER: We are not licensed attorneys or tax professionals. Please seek professional advice before making or entering into any loans as a private lender or with a private lender.
In summary, we've covered how private lending works, who can participate, where private lending occurs, and what a typical loan looks like. In our next series on Private Lending, (subscribe to our blog here), we'll go into more detail on these various topics.
What else would you like to learn about private lending? Which topics interest you the most? Feel free to leave a comment or contact us directly for more information.
Kevin + Kiri