Wholesaling vs Private Money Lending When Starting Out

[Beth Johnson]

A lot of aspiring investors who may not have enough capital to do a project by themselves (or simply don't want to dive into investing without the partnership of someone with more experience and knowledge) seem to take the path of getting started through wholesaling which can be daunting, to say the least. But have any of you chose to get started in real estate by acting as the private money lender on projects instead? 

I'm curious about the rationale between starting in wholesaling versus lending out your funds to more experienced flippers or investors so that you can learn the ropes and make some passive income along the way. I started out by lending money from my self-directed IRA, which was less work than wholesaling. It also helped me build up my capital to the point where I had enough funds for down payment to then purchase a rental property in my retirement plan and still be able to do private money lending out of it.

What are some pros and cons to either approach, in your opinion? 

[Jay Hinrichs]

Quote from @Beth Johnson:

@Jay Hinrichs In all cases where I've done 2nd lien positions, the CLTV was below 65-70% and 99% of them were behind conventional 30-year mortgages with banks/financial institutions that work A LOT slower than we can. There are a few advantages to doing it this way - 1) the bank doesn't actually figure out the default before we can so we can file a notice first before they have ever done, 2) the bank doesn't charge exorbitant default interest and penalties as a hard money lender might do, 3) the loan is 30-year so there is less risk of balloon payment penalties, 4) banks typically won't call the note due, or they haven't done so in the few instances we've had to foreclose, so we've never been required to pay off the existing 1st lien. Instead, the bank continues to accrue late fees and interest and we completed the foreclosure which can take anywhere from 5 months (best case scenario) to up to 18 months if a bankruptcy proceeding is involved. In the few that had a BK filing, none of the borrowers followed through with the required paperwork filings and the request for BK was dropped. So while it frustrated the process and made timelines longer, it didn't actually result in a trustee taking over the property and liquidating assets to pay off creditors. In WA state, not sure how it is in OR or if it's different, but secured creditors get paid before the debtor or unsecured creditors. So even if a BK were to come through to fruition, we would have been paid out AFTER the 1st lienholder.

I absolutely do not disagree with you that 1st liens are a more simplified way to start out in private lending. But I do want to point out the misconceptions people often have with 2nd liens, when done correctly. 

@Nicholas L. - I'm curious where you think a solid starting point is for newbies in real estate investing. Even if neither of these are good entry points to you, both are contemplated by new and aspiring investors all the time which is what prompted this post in the first place. I am always surprised how many WANT to start in wholesaling because I think they romanticize how easy it might be and would infuse quick hits of cash to get them started. But it's definitely not that easy. But private money lending - typically with small amounts of money - people call me all the time because they tried to gap fund a deal on their own and got screwed because their was no equity buffer or no personal guaranty or worse off, not secured by real estate at all. I get calls like this weekly, unfortunately. Some recover their capital, many have not. Those that do end up working through us for a little bit to learn the ropes and have our due diligence done on the deals. Not totally sure what the answer is on this - it definitely depends on the individual investor's goals and capital available to them. 

Beth , while I know you can spin these anyway you want.. fact remains junior position lending is far more risky than lending in first position that's why banks rarely do it. . Also I disagree with you on your point number 1. Generally, in a default situation the borrower pays the second since the payment is lower and stops paying on the first. There is no way for you to know if the first is not getting paid unless your borrower just tells you which would be EXTREMLY rare. The first time you realize the first is in default is when you get noticed of the foreclosure. And by then the first has grown substantially eroding your equity. Unless of course your borrower stops paying you first which can happen then I agree with you but it normally the exact opposite of what your describing in the real world. on your point 2 the bank will start a foreclosure if they are not paid so you if your allowed to as a junoir you will be advancing payments to avoid being wiped out. . some lenders will allow this some wont. This puts the second position lender into having to pay payments on the first and foreclosure costs , And if lender did this in their IRA and cost exceeded what they have in their IRA it can create a problem with your IRA big time . On your thoughts of BK that is not true second position does not always get paid ahead of unsecured. unfortunately, I have been through this personally which is why i say second position is VERY risky and is to be avoided unless the lender has LOTS of cash to bail themselves out which most beginner note investors either dont have or this is going to stress them out quite a bit..