Mortgages & Creative Financing
Investors: Don’t Be Intimidated by Private Money! Here’s What You Need to Know.
Expertise: Business Management
17 Articles Written
One of the most common ways to get started with real estate investing is to utilize some form of private lending. There is a lot of literature on the subject of finding private lenders and convincing them to invest in your deals. But what does a private loan actually look like? What are the terms and how do these loans actually work?
This is actually a really simple topic, but it seems to be somewhat ignored in the world of REI education. At the core, private loans are very similar to conventional loans. In fact, I would say they are very similar but much simpler!
Below is a quick guide to help you understand what it means to borrow money from a private lender.
What is a Private Lender?
I define a private lender as an individual (or small group of individuals, e.g. a married couple) who loans money. That’s it! This lender is “private” because you are borrowing from a person instead of a financial company or institution. In some cases, these lenders seek liability protection through an LLC or corporation, but in general, private lenders are individuals.
It’s important to distinguish private lenders from hard money lenders. While these two categories do have some commonalities, they are certainly not the same. Hard money lenders are institutions with well-defined lending criteria and terms. Their core reason for existence is to lend money and make a huge return. On the contrary, private lenders almost always have other primary jobs, careers and/or business ventures. They are usually lending money as a side project to something else that takes up the majority of their time.
Private lenders come from all different careers and backgrounds. A common source of private money is from your immediate social and family networks. Parents, uncles, in-laws, neighbors, co-workers, and fellow volunteers are all common sources for private lending.
Related: How My Investor Friend Grew a Student Housing Empire Using Private Money
3 Key Documents
The Promissory Note
The promissory note is the core document of any private loan. The promissory note is the contract signed by you and the lender indicating all the relevant and import details about the loan and the loan repayment. This document can be as short as one paragraph or as long as 30-page document. While there is no set standard for what a promissory note should look like, most tend to include the same terms and conditions.
The Mortgage
Many loans will also have a mortgage. A mortgage is a separate document from the promissory note. The mortgage details the real property that is to be pledged as collateral for the associated promissory note. Depending on your agreement, your private lender may or may not require a mortgage. As many of us a know, a mortgage allows the lender to foreclose and take possession of your property should you default on your loan.
The Amortization Schedule
The amortization schedule lays out all the payments you will make on the loan. This is usually a large table indicating date of payment, principal amount, interest amount, remaining balance, etc.
Loan Terms
Please keep in mind that the examples below may or not be typical. I am simply providing my personal experience. I am sure there are many loans that are way different from what I describe below. Nonetheless, I hope you find use in real numbers.
Principal
The amount of money being loaned. At some point in time, this money must be returned to the lender. This can be paid in monthly installments, a one-time balloon payment, or a combination of the two.
My experience: There is really no low or high limit to private loans. I’ve borrowed as little as $5,000 and as much as $210,000 from private lenders. My average loan is about $50,000.
Interest Rate
The interest rate is usually the main cost associated with any loan. To you, this is considered your “cost of money.” To your lender, this can be translated into “return on investment.” Interest rates are usually defined in annual terms. However, it is common for interest to be calculated/compounded on a monthly basis.
Many investors are not familiar with how your monthly interest payment is calculated. Your interest is actually accrued on a daily basis from the day of your last payment. The annual interest rate is converted to a daily rate by dividing by 360 (sometimes 365, depending on the lender).
Accrued Interest = # of Days Since Last Payment x ([Principal Balance] x [Annual Interest Rate] ÷ 360)
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In a traditional, amortized loan, you pay off your total accrued interest + a little principal with every payment. As you move through the amortization of your loan, the proportion of your payment allocated to interest decreases while the amount paid to principal increases.
My experience: For the most part, private lenders are happy with an interest rate that is at least as high as what they might expect from more traditional investments (e.g. the stock market). I’ve paid as low as 7% and as high as 16% on private loans. My average interest rate is 8%.
Points/ Loan Initiation Fee
This is an additional cost added to some private loans (and conventional loans for that matter). This is often a flat fee that is paid at closing (instead of “paying” the fee, points are often withheld from the principal at closing). Points will usually be represented as a percentage of the loan principal.
My experience: I’ve only had one private lender charge points. In this case, it was 3% of the loan principal. Most family and friends do not charge points. The lender I was working with was bordering on being classified as a hard money lender.
Amortization
A loan’s amortization is the time over which the loan principal is repaid to the lender. If a loan has an amortization of 10 years, the loan principal will be paid in full after 10 years (assuming the borrower makes the required monthly payments). The longer the loan’s amortization, the lower the monthly payment and the higher the total cost to the borrower over the lifetime of the loan.
It’s also possible to for a loan to be “interest only.” In this scenario, your loan does not amortize at all. Instead, you make monthly interest-only payments until a scheduled balloon payment.
My experience: About half of my private loans are interest-only. The other half are almost all 5-10 year amortizations.
Term
The total amount of time you will have an outstanding balance on the loan principal. Often, the loan amortization is the same as the loan term. In these instances, your final payment of principal and interest fulfills your obligation to your lender. In cases where the term is shorter than the amortization, we have what is called a “balloon payment.” A balloon payment simply means that on a date specified in the promissory note, the remaining outstanding balance is due to the lender. The borrow must find some means of repaying the entire remaining principal (refinance, sale, new loan, cash).
My experience: Interest only loans are typically due within one year. Amortized loans are usually due within 3-5 years.
Prepayment Penalty
A prepayment penalty helps to protect the lender against the borrower getting out of the deal too early. A lender makes a decision to lend based on the length of time he/she expects to make a profit on the deal. If they go into a deal expecting to receive interest for 10 years, they may be upset if you were to pay off the loan after only one year. Enter prepayment penalties. These penalties are usually a percentage of the original or remaining loan amount. They must be paid if the borrower pays back the lender too early.
My experience: Most of my private loans have short enough terms that the lender does not bother with a prepayment penalty. Loans with terms of 20 or so years may have a prepayment penalty for the first few years.
Examples
Now that we understand typical terms included in a private loan, let's see them in practice. Below are four examples to give you a taste of the types of private loans you may come across.
Example #1
A loan with the following terms…
- Principal: $100,000
- Annual Interest Rate: 8.25%
- Points: 0%
- Amortization: 10 Years
- Term: 10 Years
- Prepayment Penalty: 0%
- Paid Off at the End of 10 Years
Would mean….
- Monthly Payment: $1,226.53
- Last Payment: $1,226.53
- Total Cost of Loan: $47,183
Example #2
A loan with the following terms…
- Principal: $50,000
- Annual Interest Rate: 11.00%
- Points: 2%
- Amortization: 10 Years
- Term: 5 Years
- Prepayment Penalty: 0%
- Paid Off at the End of 5 Years
Would mean….
- Monthly Payment: $688.75
- Last Payment: $32,366.45
- Total Cost of Loan: $24,002.71 (interest:23,002.71 + points: $1,000 = $24,002.71)
Example #3
A loan with the following terms…
- Principal: $75,000
- Annual Interest Rate: 10.00%
- Points: 3.00%
- Amortization: 10 Years
- Term: 10 Years
- Prepayment Penalty: 5% in year 1, decreasing by 1% each year, 0% after year 5
- Paid Off at the End of 3 Years (2% of remaining balance as a prepayment penalty)
Would mean….
- Monthly Payment: $991.13
- Last Payment: $61,879.37 (balloon payment: $60,693.53 + prepayment penalty: $1,203.84)
- Total Cost of Loan: $23,836.94 (interest: $20,383.10 + points: $2,250.00 + prepayment penalty: $1,203.84 = 23,836.94)
Example #4
A loan with the following terms…
- Principal: $100,000
- Annual Interest Rate: 12.00%
- Points: 0.00%
- Amortization: NONE â Interest Only Loan
- Term: 1 Year
- Prepayment Penalty: 0%
- Paid off at the end of 1 year
Would mean….
- Monthly Payment: $1,000.00
- Last Payment: $100,000.00
- Total cost of loan: $12,000.00
Private Loans Are Simple
They may seem intimidating, but private loans are really simple. Once you have one or two under your belt, the terms of a loan will seem like second nature. Don't down play the importance of opening up your business to private lenders. You never know when a private lender will become your one and only source of funding on a career-changing deal.
Investors: Do you use private money to build your business? Why or why not?
Let’s talk in the comments section below!
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