How do I protect myself if I lend money to an investor?

13 Replies

Considering a personal loan to an individual for a real estate investment. The request is a loan with an interest of 12.5% paid annually x 2 years. After two years the initial loan amount is returned. Seems straight forward. 

The question I have is regarding if the individual defaults. What should happen if he does? What are the bare minimum requirements I should request in a written agreement/legal document with this individual to best protect my asset in case his investment fails or falls short. Thanks.

have you ever borrowed money from a bank to buy a property?

if so you are now the bank.

you want a mortgage or Deed of trust

and a promissory note.

you can get a 3rd party appraisal if you wish or you can establish your equity protection on your own.

then you need a lenders title policy when you close.

pretty simple stuff really.

Collateralizing the loan isn't a risk control.  If you think about it, it's a negative solution.  You get the problem that caused the default when the default happens.  How is that a good thing?

Here's what I do.  I run the money through an escrow account, with instructions to release the funds when I have an investment in place that will support the cost of the investment AND the payments on the original loan.

Then, I use that same account to filter the returns from that investment with instructions to first pay the debt service on the investment, then the original loan payment, and last I get paid with what's left.  This way, I don't touch the original funds at all, and I can't touch the payback funds until all debt payments associated with it have been paid.

This is a proactive, risk control.

Now this is just a 30,000 ft view of how I do it, details and other aspects of this system not mentioned here, but this overview of it should give you at least an idea of how you can handle it at your end.

...and what @Jay Hinrichs just wrote

@Joe Villeneuve   that post went right over my head.. I guess I am just one of those basic lender types.

put money out get a mortgage or deed of trust prom note.. lenders title policy and named additionally insured on the hazard insurance.

I think your talking about an investment scheme.. :) of some sorts.. 

Account Closed No matter what you put in writing, you really need to look at the person. Is this person honest and trustworthy? Are they reliable? Do they have a track record? There are all things banks look at when lending aside from the objective (i.e. credit score, collateral, etc). Do all those things but look at the person. Can you trust them? If yes, why? If no, why not? And go from there. Good luck! 

Originally posted by @Jay Hinrichs :

@Joe Villeneuve  that post went right over my head.. I guess I am just one of those basic lender types.

put money out get a mortgage or deed of trust prom note.. lenders title policy and named additionally insured on the hazard insurance.

I think your talking about an investment scheme.. :) of some sorts.. 

 LOL.  I doubt it went too far over Jay.  Basically, all you are doing is setting up an escrow account like a guardian of the funds.  All funds, coming and going, must pass the security checkpoint first, before moving through the door to the next location.

1 - The loan money sits in that account until the borrower/REI has the investment lined up that will make the payments back to the lender. Funds are released when this happens...and they are released to the closing table...not directly to the REI.

2 - Once the Investment has been closed on, and income from it established, that income comes in that same escrow account, and is released in this order - 
   a - Pay the debt service on the Investment (step #1)
   b - Pay the monthly payment to the original lender
c - Pay the rest of the cash flow to the REI

Originally posted by @Joe Villeneuve :
Originally posted by @Jay Hinrichs:

@Joe Villeneuve  that post went right over my head.. I guess I am just one of those basic lender types.

put money out get a mortgage or deed of trust prom note.. lenders title policy and named additionally insured on the hazard insurance.

I think your talking about an investment scheme.. :) of some sorts.. 

 LOL.  I doubt it went too far over Jay.  Basically, all you are doing is setting up an escrow account like a guardian of the funds.  All funds, coming and going, must pass the security checkpoint first, before moving through the door to the next location.

1 - The loan money sits in that account until the borrower/REI has the investment lined up that will make the payments back to the lender. Funds are released when this happens...and they are released to the closing table...not directly to the REI.

2 - Once the Investment has been closed on, and income from it established, that income comes in that same escrow account, and is released in this order - 
   a - Pay the debt service on the Investment (step #1)
   b - Pay the monthly payment to the original lender
c - Pay the rest of the cash flow to the REI

 I got it your talking about a long term loan for a rental.. I was thinking this was a 2 year loan for a flip project .. but yes controlled draws for work being done on the project are a good thing

@Joe Villeneuve Just curious looking at this post.  How do you ensure that you become the senior lender? In this case, you are basically stepping ahead of the original lender, but without their consent.  Obviously, the original lender always wants 1st claim on the collateral in case of the default .  Can you just write it on the contract and that will get honored that easily?

Originally posted by @Jay Hinrichs :
Originally posted by @Joe Villeneuve:
Originally posted by @Jay Hinrichs:

@Joe Villeneuve  that post went right over my head.. I guess I am just one of those basic lender types.

put money out get a mortgage or deed of trust prom note.. lenders title policy and named additionally insured on the hazard insurance.

I think your talking about an investment scheme.. :) of some sorts.. 

 LOL.  I doubt it went too far over Jay.  Basically, all you are doing is setting up an escrow account like a guardian of the funds.  All funds, coming and going, must pass the security checkpoint first, before moving through the door to the next location.

1 - The loan money sits in that account until the borrower/REI has the investment lined up that will make the payments back to the lender. Funds are released when this happens...and they are released to the closing table...not directly to the REI.

2 - Once the Investment has been closed on, and income from it established, that income comes in that same escrow account, and is released in this order - 
   a - Pay the debt service on the Investment (step #1)
   b - Pay the monthly payment to the original lender
c - Pay the rest of the cash flow to the REI

 I got it your talking about a long term loan for a rental.. I was thinking this was a 2 year loan for a flip project .. but yes controlled draws for work being done on the project are a good thing

 Still works for short term...but works best for long.  What this does for me, is allow me to have unlimited use of the funds, and only have to pay for them one time...so I can offer higher interest rates, since every time I re-use the funds it reduces the cost per use to the point where as long as the returns from that investment covers these payments, that initial cost of the loan was insignificant. 

Originally posted by @Michinori Kaneko :

@Joe Villeneuve Just curious looking at this post.  How do you ensure that you become the senior lender? In this case, you are basically stepping ahead of the original lender, but without their consent.  Obviously, the original lender always wants 1st claim on the collateral in case of the default .  Can you just write it on the contract and that will get honored that easily?

 No, you're not stepping ahead of anyone.  This loan would not be collateralized.  The escrow account eliminates the need for it since it prevents the borrower from not making the payments.

Originally posted by @Joe Villeneuve :
Originally posted by @Jay Hinrichs:
Originally posted by @Joe Villeneuve:
Originally posted by @Jay Hinrichs:

@Joe Villeneuve  that post went right over my head.. I guess I am just one of those basic lender types.

put money out get a mortgage or deed of trust prom note.. lenders title policy and named additionally insured on the hazard insurance.

I think your talking about an investment scheme.. :) of some sorts.. 

 LOL.  I doubt it went too far over Jay.  Basically, all you are doing is setting up an escrow account like a guardian of the funds.  All funds, coming and going, must pass the security checkpoint first, before moving through the door to the next location.

1 - The loan money sits in that account until the borrower/REI has the investment lined up that will make the payments back to the lender. Funds are released when this happens...and they are released to the closing table...not directly to the REI.

2 - Once the Investment has been closed on, and income from it established, that income comes in that same escrow account, and is released in this order - 
   a - Pay the debt service on the Investment (step #1)
   b - Pay the monthly payment to the original lender
c - Pay the rest of the cash flow to the REI

 I got it your talking about a long term loan for a rental.. I was thinking this was a 2 year loan for a flip project .. but yes controlled draws for work being done on the project are a good thing

 Still works for short term...but works best for long.  What this does for me, is allow me to have unlimited use of the funds, and only have to pay for them one time...so I can offer higher interest rates, since every time I re-use the funds it reduces the cost per use to the point where as long as the returns from that investment covers these payments, that initial cost of the loan was insignificant. 

 OK then your borrowing the funds to then loan to another.. that's what I did with my big credit facilities in the day and we made the delta.  back in the day.. I had about 30 million in credit facilitees with banks at 6 to 7 % and lent it out at 20% apr and made the delta.. we did pretty good until the market cratered .. then it was OH boy.

oh i see. but if the borrower defaults, wouldn't the property go poof so there will be no money flowing into the escrow?  Maybe i'm not understanding it correctly. sorry.

Originally posted by @Jay Hinrichs :
Originally posted by @Joe Villeneuve:
Originally posted by @Jay Hinrichs:
Originally posted by @Joe Villeneuve:
Originally posted by @Jay Hinrichs:

@Joe Villeneuve  that post went right over my head.. I guess I am just one of those basic lender types.

put money out get a mortgage or deed of trust prom note.. lenders title policy and named additionally insured on the hazard insurance.

I think your talking about an investment scheme.. :) of some sorts.. 

 LOL.  I doubt it went too far over Jay.  Basically, all you are doing is setting up an escrow account like a guardian of the funds.  All funds, coming and going, must pass the security checkpoint first, before moving through the door to the next location.

1 - The loan money sits in that account until the borrower/REI has the investment lined up that will make the payments back to the lender. Funds are released when this happens...and they are released to the closing table...not directly to the REI.

2 - Once the Investment has been closed on, and income from it established, that income comes in that same escrow account, and is released in this order - 
   a - Pay the debt service on the Investment (step #1)
   b - Pay the monthly payment to the original lender
c - Pay the rest of the cash flow to the REI

 I got it your talking about a long term loan for a rental.. I was thinking this was a 2 year loan for a flip project .. but yes controlled draws for work being done on the project are a good thing

 Still works for short term...but works best for long.  What this does for me, is allow me to have unlimited use of the funds, and only have to pay for them one time...so I can offer higher interest rates, since every time I re-use the funds it reduces the cost per use to the point where as long as the returns from that investment covers these payments, that initial cost of the loan was insignificant. 

 OK then your borrowing the funds to then loan to another.. that's what I did with my big credit facilities in the day and we made the delta.  back in the day.. I had about 30 million in credit facilitees with banks at 6 to 7 % and lent it out at 20% apr and made the delta.. we did pretty good until the market cratered .. then it was OH boy.

 No.  You are borrowing the funds to use them.

Originally posted by @Michinori Kaneko :

oh i see. but if the borrower defaults, wouldn't the property go poof so there will be no money flowing into the escrow?  Maybe i'm not understanding it correctly. sorry.

 If the borrower defaults, the property goes poof anyway...one way or another.  The first requirement of the loan, and the first step above, is for the borrower to secure an investment that makes the loan payments.  The 2nd step is for those loan payments to be made under the control of the escrow account.

This is set up to prevent default.  Collateral is set up to penalize default.

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