Private Money Described
Private money comes from an individual or a group of individuals — even friends and family members — who pool their funds to finance real estate transactions. Private lenders establish their own lending standards, and as long as they apply their guidelines to all applicants without regard to race, sex or any protected class, they can pick and choose when and where to lend.
Private money is sometimes called "hard money" due to the typical "hard" terms of the note. It's become such a common term in the investor community that many lenders will market themselves as hard-money lenders. A hard-money loan can have interest rates in the teens, require a down payment of 50 percent or more and require higher rates and fees compared to traditional forms of financing.
Private loans are usually issued only for the time needed to buy, repair and sell the property. A typical private loan might require a 40 percent down payment, balloon in 24 months and have an interest rate of 14 percent as well as four or five points. With terms like these, why would anyone ever choose to work with a private lender? Does the private lender make the loan hoping to foreclose? Quite the opposite.
A loan for a real estate investment has two separate approvals — one for the borrower and one for the property. When a property falls into a state of disrepair, it can become so damaged that a bank won't make a loan to buy it. The borrower may have a credit score of 800, a sizable down payment and single-digit debt ratios, but if the property isn't up to standards, the loan won't be approved, regardless of the quality of the borrower.
Take the example of a foreclosed property that a bank owns but can't sell. Two major problems need to be fixed before a conventional lender will finance a purchase: The slab foundation is cracked and needs about $20,000 worth of repairs, and the entire roof has to be replaced, including new trusses. In all, the house needs about $35,000 in repairs.
The home is the bank's collateral, but it needs to be in good condition before a loan will be issued to a potential buyer. So it just sits there, listed at $100,000.
A real estate investor sees that property in a bank's inventory and makes a visit. Along with his contractor, the investor verifies the items that need correcting. He determines that once the property is rehabilitated and prepared for market, it could easily sell for $200,000, based on sales of similar homes in the area. Enter the private lender.
The investor lays out his plan for the property and provides the private lender with an application and with an itemized list of the needed repairs with their costs. Included is a new appraisal that supports the future value of the property once renovation is completed. The private lender is convinced and makes a $135,000 loan.
After buying the home, the investor makes the necessary repairs and sells the property for $200,000. Now that the property has been rehabilitated, any qualified buyer can finance it. A simple breakdown is:
- Acquisition price: $100,000
- Repair costs: $ 35,000
- Loan costs (including miscellaneous fees): $ 8,000
- Selling costs (based on a 5 percent sales commission): $ 10,000
- Final sales price: $200,000
- Net to investor $ 47,000
As mentioned earlier, because private lenders set their own terms, they can set their own credit guidelines. Many private lenders have credit score requirements well below traditional loans. In fact, they may not even require a credit score. Banks and mortgage companies need to verify income and assets by looking at income tax forms and bank statements, but a private lender may forego that vetting process entirely.
Instead, a private lender focuses on the outcome of the deal. What is the investors' final exit strategy and does the overall transaction make sense? If the investor can document how the property will be sold and at what price, a private lender may consider the loan application. Private lenders are usually more concerned with the story and less so about the nature of the individual borrower.
Do yourself a favor and get references for a few private lenders in your area. You may not need a private lender today, but if you intend to be active in the real estate investment community, at some point a private lender will be just the resource you need to pull off a successful transaction.
This information was originally published on Auction.com, LLC, the nation's leading online real estate marketplace. Founded in 2008, the company has sold nearly $20 billion in assets since 2010. Auction.com has more than 900 employees and offices in Irvine and Silicon Valley, California as well as offices in Atlanta, Austin, Denver, Miami and Newport Beach. Visit us at www.auction.com, or on Twitter, Facebook and LinkedIn.