Private Money: How to Choose the Perfect Lender
This post is for you guys who maybe have a few private lenders lined up or maybe have private lenders who are coming to you that want to do some work with you.
Want more articles like this?
Create an account today to get BiggerPocket's best blog articles delivered to your inboxSign up for free
Maybe you’ve even followed some of the advice that I have in my BiggerPockets book Raising Private Capital, because this book is about how to attract people who want to work with you and loan to you or invest with you or work with you in one way or another as either private lending partners or private investors in your business. (If not, check out the book in the BiggerPockets Bookstore.)
But once you get these folks, how do you vet them and how do you decide which is the right private lender to work with for your business?
How to Pick the Perfect Private Money Lender for Your Real Estate Deals
Maybe you’ve got two or three different people. What can you do to pick or seek out the right private money lender for what you’re looking to set up in your business.
Ask a lot of questions.
The first thing you want to do is ask a lot of questions. Do NOT immediately start throwing deals at these people.
Question #1: Oh, hey, Uncle Charlie wants to work with me and lend me money for my business. Let me immediately throw Uncle Charlie deals. Instead you need to ask: What is the source of the money?
You need to ask this question because the source of the capital will in some ways dictate how you have to structure that deal. If they are taking their money from a self-directed IRA retirement account and they’re loaning it to you, then there are certain hoops that have to get jumped through with your self-directed IRA custodian. You might need to speak to that custodian. You might need to get some paperwork from that custodian. It will likely slow down their ability to close by several weeks to get that money released to you by their IRA custodian.
There might be certain covenants and clauses in the loan docs that the IRA custodian is going to require. So if it's an IRA, that's one direction.
Also, if it’s an IRA, there are some things that you can create there—win-win benefits for them and for you—that we’re going to talk about in the next section.
Now another source could be, let’s say, you locate somebody in your network who owns their home free and clear. You’re able to show them that they could unlock that equity they have in their home and turn that equity loose in your business. They can do this to build their net worth, build their income, build their wealth by unlocking that equity in their house.
So if the source is a home equity line of credit, you need to know that. The reason why you need to know that is that a home equity line of credit or even just a mortgage has a monthly payment. You, as the investor, need to make sure they’re making an income that’s enough to supplement and exceed the monthly payment they have to make to maintain that debt.
If they’re investing with cash, here’s the cash conversation that comes up. If they say, listen, I’ve got $100,000 of cash that’s just sitting there in a CD that’s earning half a percent interest, you can pay them 8 percent interest. OK, that’s a great conversation.
But you need to tell them, hey by the way, I'm going to be paying you 8 percent on your money, but you know that interest is taxable. You're going to have to pay tax on the interest you make and declare to the IRS that's interest you made on a loan.
That’s not true for an IRA. It is, however, true for a home equity line of credit. But they still get to claim the interest that they had to pay for borrowing that money, so they only pay net tax on the spread that they make from what they borrowed the money for and what they’re loaning it to you for.
But if they’re loaning you straight cash out of their own pocket, they will likely have to pay income tax to the IRS—however it calculates. They’re going to have to pay tax on that money.
You need to disclose that to them. You don’t want any surprises about income tax. They would be very unhappy with you.
The best real estate investors who work with private money folks are at the core educators, meaning you educate your private money investor who wants to work with you on why investing with you is amazing and also how investing with you works. Get that education yourself from BiggerPockets.
Question #2: The next thing you want to talk to them about is: What are their goals?
If you’ve got a private money person who’s looking to retire in two years versus a private money person who’s 30 years old but happens to have $100,000 in their IRA, those are two separate goals.
I have also encountered people who want to invest full-time eventually. That’s a different goal. They might want to get an education from you. They might want to learn how to do what you do as part of them loaning to you. You might need to expose them to a bit of the nuts and bolts, walk them on the job site, and show them what you’re up to—all those things on a weekly or monthly basis—in exchange for them loaning to you.
And maybe the interest rate doesn’t matter as much or what you’re going to pay them. The exposure that they get matters the most.
This is why their goals matter. Try to know everything you can about where they want to go, their wealth goals, and their future life goals. Where do you want to be in five years? That’s the best way—you should ask that of everybody.
If they don’t know, that’s a great conversation to have further, to help somebody discover that. Then through working with you, you can help them get where they want to go.
Those goals can have things to do with money or with their life (like I want to be a full-time investor). Or maybe they love what they’re doing but want to save up for their kids, for college or something like that.
I had an investor whose goal was to move back to Argentina. He was from there, moved to the U.S. for work, and because he did some investing with us, he was able to create a path to move back to Argentina eventually. This took like five years. It happened because he and I both knew what he wanted to do and because I asked that goals question.
We evaluated what is income was through the turnkey investments he had made with us and through some of the private loans we had done. Today he’s back home in Argentina, where he grew up, and he’s making passive income off of investments he’s made in the States.
Look to create a win-win situation.
So once you’ve got your questions answered, the next thing you want to do to pick the right private lender is to make sure that they are on board for a win-win with you. You’ve got to win, too. You don’t want to work with somebody who’s out to get you. There are predatory lenders out there that pose as private money. You don’t want to work with those folks.
Conversation #1: You want to discover just what the win-wins look like and enroll them in a win-win conversation. Win-wins might look like, if somebody’s got an IRA let’s say, maybe you can have the conversation about monthly payments. More specifically, if it's an IRA, you don't need to make monthly payments. How great would that be if you're doing a fix and flip, well you're not making any monthly payments during the life of the loan? You pay all the interest at the time the project's complete.
If they have an IRA, that money is not needed by them. They can’t do anything with it anyway, because it’s in the IRA. It’s just as fine for you to pay them all the money at the very end of the project versus during the life of the project.
If their money source is real estate equity, they have to have monthly payments, because it’s not fiscally responsible for you to put them in a position where they’ve got to maintain that debt the whole time and make those monthly payments just so you don’t have to. I would never ask somebody to do that.
Then obviously if they have cash, they might want monthly payments, too, because it just increases their personal cash flow. They can touch the money, they can put it in their pocket and use it versus an IRA where they can’t do that.
Conversation #2: The next thing that you want to bring up is terms and rate. If you've got somebody who wants to give you hard money loan rates, like they want to charge you 15 percent interest plus three or four points (you know one point equals one percent of your loan amount), it's not really a win-win. You have to pay that up front typically, so if you're borrowing $100,000 and they want four points, that's $4,000 you have to write to them at the day of closing as a profit line to them. There's your points; here you go, Mr. Lender.
And those points are due to them at closing regardless of how long the loan is. So if it's a shorter loan, they actually make a better return on their investment, because they got their money back and they can go and charge those points again.
Points in general are more of a hard money conversation. It’s less private money. So if you’ve got people who want to charge you a lot of points and a high interest rate, that’s not a win-win—unless you’re in a bind, unless you really need to do the deal fast. If it’s really, really a screaming hot deal and it still works at those rates and terms, fine. But I don’t like those types of terms as the standard moving forward, because it’s really not a win-win.
Look carefully at the written terms and make sure that it’s a win-win for you. And what’s a win for them?
A win for them brings them to their goals. So once you know their goals, you define the rest. If I didn’t know my investor wanted to go back to Argentina, I couldn’t define a win for him—that being carving a path for him getting back home.
A win for me was to elevate and grow my business with favorable loan terms that I could use over and over again, knowing that capital was there for me. It was almost like a line of credit. As soon as I needed the money for a deal, he was able to produce it lickety-split for us to go and close.
He was willing to buy projects we had that were ready for turnkey. It wasn't "no questions asked"; he did his due diligence on it. But he was a ready, willing, and able buyer, so I knew that was a win for me. I was able to produce product to sell it to him as a turnkey or to produce some deal that he was willing to loan to me on. This was a great arrangement.
The Bottom Line
The bottom line is the way you vet a private lender is to ask lots of questions and make sure you structure win-wins. High interest rates and lots of points are not wins for you. Lots of hurdles for you to jump through, weeks or months it takes to get the closings are not wins for you.
Have you used this type of financing before? What’s been your experience? If not, what’s your motivation for doing so? Do you have any additional questions for me about the process?
Let’s talk in the comment section below.