Don't Be Intimidated By Private Money | Real Estate

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.

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.

Related: 4 Simple Steps for Newbie Investors to Start Raising Private Money

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!

Kevin Fox

Replied over 3 years ago

Hey Nick. AWESOME article. I think you really hit on most of the key sub-topics of private lending. Keep up the great work!

Earl Minnis from Santa Barbara, California

Here we go again. Very inexperienced people talking about things they know little about. Lets dissect this article on just a couple points. Neither hard money or private money is simple. They are virtually the same and are regulated by fed and state laws. A hard money lender is almost always an individual in the end which has lent thru a hard money broker. The worst part of this article is talking about borrowing from family,friends,co workers, neighbors ect. Go ahead and see how that works when something goes wrong with the deal such as a cost overrun, a non paying tenant, you make a bad buy ect. And now you can’t make the payment. Now you don’t want to be around family, friends, and work. This is just one of the worst pieces of advice I’ve ever heard. The mortgage- all loans have a mortgage or trust deed that accompanies the note and gets recorded against the property generally thru an escrow or title company. If this is not done you have an unsecured loan which is subject to being wiped out in numerous ways. I could go on and on about this article that this Nick person wrote but I prefer to take my dog for a walk. You people need to be very aware of the things you are being told about in these articles. These people say they are professionals, they are not. They don’t have the experience to talk about these things. I’m 61. Bought and sold well over 2000 properties in 5 states over 40 plus years and lent tens of millions of my personal funds. Started with nothing. You dont see me trying to tell people how to do this stuff. There are two old saying I will close with. Those who know how to, do. Those who don’t, teach. The other is ” a fool and his money will soon be parted.” Take care and be very careful who you listen to. Earl Minnis

Bret Faszholz Rental Property Investor from Miami, FL

Thanks for the reality check Earl! Good advice.

Michael Sadler from Edmonton, AB

I used to be a mortgage broker helping borrowers stay in their home with high interest short term private money after an incident. You’d be stretching to do a deal – depending on the cash flow numbers – using private money.

Nick Baldo from Buffalo, New York

Thanks Michael. Yes! This is our experience as well. We typically use private money on a short term basis to get into a deal. We either sell it quickly or refinance with a more conventional loan that allows a rental property to cashflow.

Timothy Friars

Nice one, Nick. Had to go through your examples a couple times to make sure I understood everything correctly since my math skills are always so terrible.

Andrew Syrios Residential Real Estate Investor from Kansas City, Missouri

Private money is awesome and IMO the best way to acquire properties, especially if you’re using the BRRR model. Great article!

Adrian Becoat Investor from Raleigh, North Carolina

I’d like to see a rebuttal of Earls argument…..he seems very strong in his stance that this article is over simplifying the process.

Adrian – Earl’s response was much less of an “argument” and much more of a disgruntled, ignorant rant. The two tangible points he made were: 1. All loans require a mortgage and 2. Borrowing from family & friends is a bad idea. 1. Fact – You can have a loan without a mortgage. True, a good proportion of loans hold real estate as collateral…but it is certainly not all. Unsecured loans exist and have their place in the world of real estate investing. 2. Borrowing from family & friends is a bad idea – This is his opinion. You will find several successful REI investors (including Brandon Turner) who have successfully utilized this strategy. If you don’t trust yourself and your deal enough to make your lender whole…I agree, avoid this strategy. Other than that, he ignorantly discounted my experience and knowledge. I have no desire to spend time arguing with someone who is randomly trolling BP. My time, and those of the thousands of other amazing contributors, is better spent providing useful, real world advice to those who want to learn and grow.

Adrian, the reason you don’t see any rebuttals is because there arent any that would hold any water. Again, you are having fairly or totally inexperienced people chime in on all this stuff. Rarely the truly experienced spend their time reading this stuff. If they do they roll their eyes and on to important stuff like walking the dogs on the beach. I guess I feel compelled to call out a lot of this as what it is. Either inaccurate, nonsensical or just plain self serving for trying to sell you something. I have caught a few good common sense articles. Earl Minnis

Nick, really? Is that all you’ve got? I would guess a response from a young inexperienced person like the one you made. You appear to have next to no experience in this business. What are you 20 years old?I am far from the ignorant one. Let’s get down to substance. 1. Anyone who lends money without a security interest is just plain stupid. Ask anybody who has any experience in the business. Of course you can have a loan without a security interest. Would you buy a stock and not have have a stock cert. or something showing you bought it? Unsecured loans have no place in real estate unless you are just plain stupid or you don’t care about getting repaid. Come on. 2. You bet that borrowing from family and friends is a bad idea is my opinion. Just like everything I write is my opinion. How many years and deals Nick do you have under your belt? Can’t be many by the comments and information your putting out. I would never depend on somebody who wants to borrow money from me knowing what he is doing. Again ” a fool and his money will soon be parted”. You say I ” ignorantly discounted your experience and knowledge “. Not at all. You are the one who made the ridiculous, inaccurate and dumb comments.i wouldn’t trust anything you say. The proof is in the pudding. This is my last response to you. You don’t deserve my time. Earl Minnis

Pamela Smith Real Estate Professional from Bear, Delaware

Replied about 3 years ago

Earl there’s a way of passing a message without being antagonistic. I have read a couple of your responses on various blogs here and you are always on attack mode. We get that you have a lot of experience in REI. Please use that experience to educate and not criticize all the time. Nick thank you for your post. It touches on the important points that a new person to REI needs to know.

Earl Minnis

Pam, I am anything but politically correct so you’ll have to look past that. I am not in the educational business as numerous people envolved in this BP site are. Also you’ll notice I’ve pretty much knocked off my responses after challenging Josh to come to Santa Barbara at my expense to prove up a bunch of his ideas with absolutely no response from him. This tells me he is really not convinced of his ideas and many others talked about here. So with that said I’ll let ya’ll to talking about the many goofy ideas that are talked about here. As you’ve probably seen me say before ” a fool and his money will soon be parted”. Thought in the beginning I could throw out some common sense ideas that people would think about but in the new age of technology everybody thinks they have discovered a new and better way of doing things. I obviously disagree. Take care, Earl Minnis

Lee C. Real Estate Agent from Marietta, Georgia

Wow. You can’t please them all! Thank you for the article Nick! This relieves my initial anxiety about private lenders. I’m ready to research the possibility further.

Gloria Dulan-Wilson from Philadelphia, Pennsylvania

Replied over 2 years ago

Wow – very informative – I was concern that the amortization amounts would be cut throat – but I presume that’s the difference between Private Money lenders and had money lenders – do you ever do deals where they also take an equity position as opposed to a fully amortized repayment? And is refinancing the best source or repayment?

Hi Gloria, Thanks for the comments! I personally do not engage in equity partnerships with my lenders. Not because I have anything against it…the right opportunity has just not come up. Refinancing, selling or simply paying off the loan as it amortizes are all fine ways to repay. Obviously, the higher the interest rate, the more motivated you may be to sell/ refinance so that you can get a better rate on your money elsewhere. However, I have had several cases where it made sense to keep my private investor “in” a deal. While the interest rate might be a little high, it was a source of funding that I did not want to extinguish. It all comes down to your opportunity cost of capital. If you think you are able to make your money go farther through an alternative investing source, then it makes sense to exit the loan. However, sometimes keeping your money going is the best (and easiest) way to move forward!

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Investors: Don’t Be Intimidated by Private Money! Here’s What You Need to Know.

What is a Private Lender?