Private Money Lending: What Investors Need to Know

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When you first think of real estate investments, flipping properties, running short-term vacation rentals, or becoming a landlord are the first things that typically come to mind. 

Many investors purchase properties and either renovate to resell them or rent them out, but there’s another way to work as a real estate investor without actually needing to be involved in the sales or renting processes.

Private money lending is an alternative to active real estate investing that requires more hands-on involvement—and the potential return on investment (ROI) can be exceptional. 

What Is Private Money Lending?

Private money lending is the process of an individual or a private organization loaning money to a real estate investor in a private money loan. The investor may use that money to purchase or renovate a home for rental or resale purposes. 

Private money lending is less regulated (and thus more flexible) than lending from financial and licensed organizations like banks or mortgage brokers. That being said, private lenders do have to follow state usury laws, which limit how much interest a lender charges. Depending on the state, there also may be a limit to how many loans a private lender can create.

Private money loans can be appealing to real estate investors because the qualification process is different. Lenders are more likely to focus on whether the specific deal is a smart financial opportunity, instead of solely focusing on the credit history or debt-to-income ratio of the borrower. 

Two Private Money Lending Options

There are two options for real estate investing: becoming a private money lender, or leveraging loans from such a lender to fund your real estate investments.  

1. Find a private money lender 

If you want to look at unconventional financing so that you can grow your own investments more aggressively, private money lending may be a great option.

It’s not uncommon for real estate investors to build strong relationships with private money lenders who they work closely with for multiple projects. The flexible terms and unique qualification processes may make it easier for you to find a perfect fit to help you flip a house or snag the perfect rental property—even if the interest rate is on the high side.  

2. Become a private money lender 

If you have capital and want to put it to work, you can consider becoming a private money lender.

The high interest rate and the typically short loan duration periods can work to your advantage, netting you a solid return on investment in a relatively short period of time.

While there is some risk involved, a lawyer can help you protect your financial investment, and the potential rate of return can be significant.

Pros & Cons of Private Money Lending

If you’re considering real estate investing, you may be interested in either becoming a private money lender or getting a loan from one. We’ll look at the pros and cons for both. 

Pros

The pros of private money lending will vary depending on whether you’re the lender or the borrower.

For the lender, these are the pros to keep in mind:

• It’s more hands-off than active investing. You don’t need to deal with tenants, renters, general contractors, or real estate agents. You’re just dealing with the borrower directly. 
• You don’t have the direct risks of property ownership. If a property floods or you’ve got a squatter trashing your home, it can be financially devastating. Private money lending separates you from those risks. 
• You can charge more than standard interest rates. Private money lending allows you to set the terms of the loans (within legal parameters), and you can charge high interest rates than traditional lenders do with a traditional loan. It’s standard to charge 15% to 20% interest, and balloon loans are also common. This means more profit for you. 

For the borrower, these pros are most significant:

• Funding is flexible. If you see a great investment opportunity but your debt-to-income ratio is a bit high or your credit is still a work in progress, you may have better luck with private money lending than traditional lending. 
• The money may be available faster. While there is still a vetting process for private money lending, it’s possible that the loan closing process can be completed much quicker than traditional loans. Going with private lending can be a huge asset if you’re trying to move fast on an investment. 
• The terms may be better for your needs. Sometimes unconventional lending works better for investment opportunities. Balloon payments may not be ideal for a personal home purchase in many situations, but can work well for investors who are flipping homes and just need the initial capital to get started. 

Cons

Just as there are pros to private money lending for both lenders and borrowers, there are also cons to consider.

The cons for private money lenders include:

• It’s a risk. Unlike a traditional loan, you’re using your personal or business capital to fund someone else’s real estate investment opportunity. If they default on the loan, you can take a significant hit, even if your lawyer put protections in place through your contract. 
• You tie up more of your own funds. Your own capital will be restricted through the life of the loan, limiting other opportunities you can invest in. 
• Qualifying borrowers can be tricky. It’s a lot of pressure to ensure you’re betting on the right horse, and that the horse in question has done their own homework. This can be time-consuming and nerve-racking. 

The cons for private money borrowers include:

• The interest is high. This is a pro for lenders and a significant con for borrowers. The interest rate is much higher than most conventional lending options, which can eat into your profit significantly.
• The loans are often short term. Short-term loans put more pressure on borrowers because you need to be ready to repay them quickly. If a project drags on longer than expected—or if surprise costs pop up—this can be difficult. 

Is Private Money Lending Risky?

Private money lending is definitely risky for private lenders. They’re using capital from their own personal accounts or their business accounts. 

And while you can put protections in place to hopefully recoup payment even if the borrower defaults on the loan, they aren’t ever truly guaranteed, and it may take time to get that money back.

Private money lending can also be riskier for borrowers, typically due to the short duration of the loans. It’s not uncommon for real estate investment costs to exceed initial expectations while dragging out longer than expected, or for there to be unexpected costs or damage to a property. This can make short loan terms more risky because there’s less wiggle room involved. 

How Does Private Money Lending Work—The Process

Private money lending is a fairly straightforward process.

A borrower contacts a private money lender and asks if they have funding available.

In many cases, the lender will review the following:

• The specific investment opportunity, including the financial and logistical plans for the investment; a detailed, written plan is expected
• The investor’s own professional background, including reviewing licenses and checking for lawsuits against their building company
• The investor’s personal or business finances
• Proof of identity 
• Proof that the business is in good standing 

If the lender is interested, they’ll create a loan offer. This offer will detail the terms of the loan, which will include the interest rate, repayment period, and protections for the lender. 

The borrower can negotiate the terms of the loan, potentially asking for a lower interest rate, a longer repayment time, or a different loan structure. 

If the lender and borrower come to an agreement, the lender will provide the funds to the borrower, who will make regular payments at an agreed-upon schedule.

In many cases, private money lending may involve balloon payments. In this situation, borrowers make interest-only payments for the duration of the loan. At the end of the loan, they pay the full loan balance in a lump-sum payment.

For even more information, check out our video on private money lending below!

Private Money Lending FAQ

Final Thoughts

Real estate investors should always be keeping an eye out for alternative ways to make more money or improve returns on their investments. A private money loan may open new doors for profit for both lenders and borrowers, and should be considered when you’re looking for less-traditional financing opportunities, or when traditional lenders aren’t willing to play ball.

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.