Many investors are sitting on the sidelines as they wait to see what the market—equities and real estate—will do in the coming months. While active investing may not be as desirable at the moment for the more conservative investors, private money loans can be a great way to keep your money working for you while you play the “wait and see” game. Loan terms can range from three months to any number of years you are comfortable with, so it’s a great way to put capital to work between projects.
Before you get started in private money lending, you should first define the range of rates and terms you’d be comfortable lending with as well as your personal needs and wants from private money lending as an investment strategy.
This first step is pre-work called “Calculate & Evaluate” and is an important beginning to the process. During this step, you determine where, how much, and to whom you’d be willing to lend to. This will establish a much-needed framework for finding the right loan opportunity and funding it quickly without delays on your part as the lender. Being clear and specific on your lending criteria will actually make it easier to find deals, so don’t be afraid to narrow your focus. It will not eliminate every borrower as you may initially believe.
Step 1: Connect
After establishing your private lending standards, the first step would be to find your future loan opportunity. The goal here is to find a prospective borrower by attending local events that real estate investors attend, such as local real estate meetups, conferences, and other educational or networking events.
This is a fast and easy way to connect with potential borrowers or get referrals to investors seeking private money in your chosen market. If you choose to invest in an area that is not local to you, finding virtual meetups can be a great way to network from the comfort of your home. Because of the high demand for private capital, private lenders are always some of the most popular people at these events.
Be prepared to ask a lot of questions and share some of the lending guidelines established in the previous step.
The goal is to find qualified borrowers with a strong reputation within a local real estate community. We recommend not looking for your loan opportunities through national social media platforms and instead focusing on local face-to-face functions or virtual networking events for your chosen market.
Step 2: Contact
Now that you’ve begun networking, some prospects that you’d like to get to know better will appear. This can include learning about past and possibly current projects that might need private funding.
Here, you’ll want to focus on pre-qualifying the borrower and the property that would be used as collateral to secure your loan. This is an important step so that you don’t waste your time (or the borrower’s) if the loan opportunity or the relationship isn’t a good fit for you. Basic questions you’ll want to answer include:
- The borrower’s past experience (validated through references)
- Use of funds
- High-level project financials
- Potential exit strategies
If, after learning more about the project and borrower, you wish to proceed with the loan, you will complete this step by communicating your rates and terms both verbally and in writing for the borrower to review and accept before moving to the next step.
If you are unsure of rates and terms at this point, get some insight from other private lenders or even secretly shop for hard money lenders in your market to find prevailing rates. You will also want to reach out to an attorney familiar with lending to ensure you stay compliant with usury laws in your state.
Step 3: Collect and Condition
In traditional lending, loans go through a processing phase where borrower information and documents are collected and packaged for review in the underwriting phase. As an individual private lender, you will likely do both of these steps simultaneously since you’ll be acting as both a loan processor and an underwriter.
As you collect documents from the borrower about their credit, income, or capital sources, you’ll be researching the property and project to determine if the borrower’s numbers are accurate or not. If you uncover data that doesn’t quite sit well with you, you may choose to add conditions to the loan, such as requesting more documentation, requiring more cash upfront, or adjusting your rates and terms to a more acceptable level.
For example, suppose your research shows a lower after-repair value (ARV) than what the borrower indicated on their project pro forma. In that case, you may consider lowering your loan amount or raising your interest rate to be commensurate with the higher associated risk.
Remember that requesting more documentation just for the sake of having it will create more work for you and more hoops to jump through for the borrower. If you request something, be clear about what you are looking for and why that information is important to the decision of funding the loan.
Step 4: Compose and Close
You’ve received and reviewed all the documents collected from the borrower and approved rates and terms. Now it’s time to get your loan documents created by a legal professional. While this could run you several hundreds of dollars, this is not the time for DIY loan docs or skimping on quality to save on cost. These documents: a promissory note and a few security documents like a deed of trust or mortgage, depending on what state you are lending in, are literally what will protect you and your principal investment.
You will be wiring money to the closing agent and the only thing you get back are legal documents. Why wouldn’t you want those to be as solid as you could make them? Spend the money and get them done right!
You will also need a professional who can coordinate the closing and funding of your loan. Again, depending on the state, you may either work with an attorney or a licensed escrow closing agent, but it’s important you engage a professional who’s licensed to close real estate transactions in the state where the property is located.
Step 5: Collect and Convey
Your loan is now active and earning interest each month! Welcome to passive income!
Depending on the terms of your loan, you may be collecting monthly interest payments, or it could be paid in advance or at the end of the loan. Regardless of what you and the borrower agree upon, the point is you are making money with your money!
Once the loan is ready to pay off after the project is completed and under contract to be sold or refinanced, you will be contacted to complete a payoff demand (a document stating the principal and interest balance owed) as well as any fees required to close the loan. In other words, you legally acknowledge that your loan with the borrower has been fully satisfied and can be removed from the title.
While there is much more to contemplate before, during, and after the loan, following these steps will ensure you do not miss a critical component of finding the right loan opportunity and ensuring it’s one you can feel confident in funding.
The best time to find possible problems with a loan is before it closes, not afterward. Take your time, engage professionals who can support and guide you through this process, and make sure you’ll be able to sleep well at night after placing your funds with a borrower.
After all, private lending is meant to be a relatively passive investment, so if you find yourself thinking about the loan too much or dealing with problems after a loan is closed and funded, you aren’t achieving the original goals you set for yourself.
Do your due diligence right, though, and you’ll have a great time relaxing and collecting money.
Want to invest in real estate without the hassle? Learn how to create financial freedom and passive income in real estate as a private money lender.
With more than two decades of experience in the mortgage lending space and real estate investing, Alex Breshears and Beth Johnson show you how to invest in real estate from anywhere in the world—all you need is an internet connection and a cell phone.
Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.