Private Money Lending

29 Replies

Hi Everyone, I am a residential flipper in Atlanta, GA and I have a few questions regarding private money lenders. I have personally flipped 2 homes, but I am now in the process of developing a business plan to solicit outside private money lenders. I have covered most of my bases by gathering info from BiggerPockets and other online sources. 

I am in the process of developing the details of our promissory note and gathering intel to speak intelligently on how the lenders funds will be held and how it is used. Our lenders will fund a % of the asset purchase, and they will fund a % of the renovation costs. Obviously, the lender will wire funds at closing for the purchase, BUT how does my LLC hold the funds the lender is contributing to the renovation? The money will be used in draws, but the total invested money for the renovation will be contributed by the lender up front.

Does the lender simply cut our LLC a check and the promissory note state that we owe them X dollars with X percent interest? Are the funds held in a special bank account? How would you structure the holding of the funds to give the lender the most confidence and make is easy for the LLC to access when needed?

Thanks for your help and knowledge!

I think you would have an escrow account set up for the holding of funds.  A Title company should be able to do this for you.  I'd start there.  Not sure how it is done in Georgia.  Might ask a Title company or Title attorney.

True private investors are just someone you know and who trusts you.  So you can arrange this in any way that's agreeable to both parties.

I've done it from both sides, though through a broker in all cases.  The way it worked is that the lender wires the money to the title company the day before or day of the closing.  It was typically arranged so that the borrower received the purchase proceeds and a third of the rehab budget at closing.  Most of this, of course, went toward the purchase price and all the closing costs.  So, after the purchase price and closing costs the buyer would receive a check for some amount, but often much less than a third of the rehab budget.  The rest of the rehab budge would be disbursed by the title company in the form of two checks made out to the borrower.  These were given to the lender.  When the lender inspected the work, they handed over these additional checks.  Typically one when the work is "half" done and the other when it was fully completed.

Great post @Amir Vahab ! I was about to ask a similar question in the forums, but from the other side of the deal...

I am considering lending private money to a residential flipper in my area and was wondering how to go about it, and/or what to expect? So the discussion/contributions are right on time. Thank you all for sharing :-)

@Will Pritchett or @Jon Holdman  I am considering lending $18k to a local residential flipper at 20% interest. For my own clarity, being on the other side of the deal (as the lender and a complete novice), I'm assuming that lending through a title company officially ties my involvement to the actual property title? (Of course, I expect to execute a separate written agreement detailing the loan and terms between the flipper and myself outside of the title company's involvement... but that's just a piece of paper between associates)

I thank you both in advance for your time and consideration in response :-)

You're not "lending through the title company".  The title company just manages all the bookkeeping and the money.  Once the deal closes, they're done.  

Typically a loan like this involves two documents.  A deed of trust or mortgage and a promissory note.  Some states use deeds of trust, some use mortgages.  They're more or less equivalent.  This document is recorded.  The borrower is the grantor and the lender is the grantee.  This document gives the grantee a security interest in the property.  That is, the ability to foreclose if you aren't paid back.  The promissory note outlines the details of the loan - interest rate, repayment terms, what constitutes default, etc., etc., etc.  If you've ever done a mortgage when you bought a property, dig out these two documents and have a look.  A title company may have samples.  The DoT or mortgage is pretty standard, the promissory note less so.  These are not DIY documents.  Best to work with an attorney to review what you plan to use or to create them.

A 20% person to person loan would, as I understand it, be illegal here in CO.  IDK about NJ.  As a lender you are subject to regulations.  Another reason to spend time with an attorney.

That small amount makes me think this is a second and the borrower has a much larger first.  If that's the case, my advise is simple.  RUN AWAY! If the borrower defaults you have a very good chance of losing your entire investment.  If the borrower defaults on you but not the first, and you foreclose you best outcome is for someone to win the auction and you get whatever's left after costs.  Realize doing a foreclosure will cost you thousands of dollars, so someone would need to bid something like $25K or more for you to get your investment back.  If nobody bids (likely) you'll get the property, but subject to the first.  The first will certainly foreclose in a case like that.  You'll either have to pay off the first, or quickly sell the property for enough to pay off the first and get some of your money back.  There's no amount of interest that would get me to do a loan like this.  I have had a borrower default with me in first position and took a loss on that.  Had there been a second, they would have been wiped out.

@Amir Vahab ... unless these are family loans, you as borrower are not going to be preparing the Note for your deals.

The loan paperwork is prepared by the lender and signed at closing of the acquisition of the property. The security instrument (deed of trust/mortgage) for the full amount of the loan is recorded against the property but the funds themselves are disbursed over time as progress on the project is confirmed and title is updated.

Sometimes the title company (or title attorney, in your state) disburses the funds and sometimes the lender handles this function.

@Amir Vahab You might want to join the American Association of Private Lenders. They have excellent resources (membership is not free). 

Here are some Pro Tips:

-- If soliciting an institutional HML, the HML will steer the ship.

-- If soliciting an individual/local HML, the HML will still steer the ship, but will be much more flexible with structure than the institution.

-- If soliciting for a true private lender --friend/family member--who is inexperienced in the process, share the following information:

1. Security Instrument--there will be a Security Instrument in place (i.e. Deed of Trust / Mortgage), just like with a bank loan in a traditional mortgage situation.

2. Promissory Note--spells out terms and conditions. There are plenty sample forms on the internet, or a local R/E attorney can help. Or you can write one up with a crayon on a napkin. Your call.

3. Lien Position--the inexperienced lender needs to understand the impact of being in 1st, versus being in any other, lien position.

4. Title Insurance--we require the borrower purchase title insurance covering the lender. That's standard practice. The inexperienced lender needs to understand the reason for the importance of this insurance.

5. Insurance--we require the borrower to place us as mortgagee as first payee on the mortgage insurance. NOTE: New flippers should have a conversation with the insurance broker about what type of insurance they are purchasing (replacement v. cash value...does it cover vacant properties...etc).

6. LTV--since these are collateral based loans, using an LTV that provides equity cushion is a key component.

7. Liquidity runway--This is so important when working with the private lender. Liquidity runway is code for, how long is the lender comfortable not having the money back in his pocket? If the lender needs the money back in 6 months and a day, and the borrower says it's a 6 month loan....that has got trouble with a capital T written all over it. The private lender needs to have a runway between when the loan is due, and when the lender absolutely needs the money back. 

8. Flow of money. The lender will wire the money to whomever is doing the transaction (title company/closing attorney). In NC, it's the title attorney. The title attorney will disburse the loan funds as directed. In our situation, if we are dong draws, we hold the draw money and work directly with the borrower for payments throughout the loan. When the borrower is under contract to close on the sale, we provide the payoff amount to the closing attorney. The closing attorney wires proceeds to us. A lien sat needs to be filed.

@Henry Hill this is really good information here. We have partnered with 6 different people over the past year that have brought money in for a rehab. I would suggest having all of the money either go through the title company or go directly to the contractor so that there is never a question as to where the money went and there is no commingling of funds. That can get really bad if things don’t do as planned.  

@Adam Schneider great contribution to the thread. As we have partnered with people we always give them a deed of trust on the property and a promissory note detailing the repayment of the funds but I had overlooked adding them to the insurance policy. I usually use a hard money lender for the purchase and a private money lender for the rehab. I get title insurance when I purchase the property with the hard money lenders funds. Would I need to do this again for the private money funds? Would I also need to add the private money lender to the insurance policy behind the hard money lender? What are the possible ramifications if that doesn’t happen?

@Shiloh Lundahl It's an interesting model when one uses an HML for the purchase and a PL for the rehab or gap in rehab funds. The HML will require 1st position on the lien, so your PL needs to understand that he/she will be in 2nd position. Normally, the amount of money the PL is providing is small when it's gap / small rehab funding in 2nd position. Depending on how much money, how much equity, and how close your relationship is to the PL...how you handle some of the risk-mitigation recommendations will vary. If the PL is in second position and has a really small amount of money at play, I'm not sure I'd navigate the deal the same way as I would if there were just a PL in 1st. If there's a title issue or an insurance issue, the 1st position lien holder would get paid 1st (obviously). You might want to ask this question to a local title company and a local insurance broker...it feels like it may not make sense in many cases.

By the way, your suggestion of having the lender send payment directly to the contractor presents lots of risks. You might want to consider paying the contractor, receiving the waiver of lien, and then getting reimbursed by the private lender...

@Adam Schneider What is the potential risk you see having the private money lender pay the contractor directly? Our contractor has been doing our rehabs for the past 2 years and does several at a time so I know him pretty well and we are a good source of income for him and his subs.

@Shiloh Lundahl -- it sounds like you are comfortable in your relationship with your contractor. We all run our businesses differently. If you are a lender, and are paying the borrower's GC directly....everything is fine until it isn't fine. The lender is obligated to provide funds to the borrower, not to the GC...so, the borrower could (theoretically) want money that has already been paid to the GC....the likelihood of the scenario--pretty darn low!!! For us operationally, it's easier to pay the borrower and have the borrower pay the contractors.

@Shiloh Lundahl yeah it is a great discussion. I appreciate your insight and joining the conversation.

@Adam Schneider you, along with @Jon Holdman , mentioned the importance of understanding lien position as a PL.

Would it be better to partner on a deal as an equity investor, as opposed to being a passive private lender, to avoid an unfavorable lien position (assuming another lender would take first position)?

@Henry Hill  -- too many variables to your question. If you are the lender, just understand the risks of being in a second position. Charge accordingly. If there's too much risk being in second, either be in 1st or don't do the deal...you could do an equity partnership, but I'm assuming if you are in 2nd position that the amount you'd be putting in is a very small piece of the pie....

Originally posted by @Amir Vahab :

Hi Everyone, I am a residential flipper in Atlanta, GA and I have a few questions regarding private money lenders. I have personally flipped 2 homes, but I am now in the process of developing a business plan to solicit outside private money lenders. I have covered most of my bases by gathering info from BiggerPockets and other online sources. 

I am in the process of developing the details of our promissory note and gathering intel to speak intelligently on how the lenders funds will be held and how it is used. Our lenders will fund a % of the asset purchase, and they will fund a % of the renovation costs. Obviously, the lender will wire funds at closing for the purchase, BUT how does my LLC hold the funds the lender is contributing to the renovation? The money will be used in draws, but the total invested money for the renovation will be contributed by the lender up front.

Does the lender simply cut our LLC a check and the promissory note state that we owe them X dollars with X percent interest? Are the funds held in a special bank account? How would you structure the holding of the funds to give the lender the most confidence and make is easy for the LLC to access when needed?

Thanks for your help and knowledge!

 Amir, many private lenders will either deposit direct whole amount or do draws do you - just ask them what best practice they prefer.

@Henry Hill if you aren't sure the first thing you should find out now is what lien position he's offering. 20% is a red flag. As mentioned above it sounds like a 2nd position lien at best. There's a great recent post about a 2nd position lien given to an experienced flipper gone wrong here. It's not what I would call the space for a newer investor. 

Thank you all for your feedback and insight! I greatly appreciate hearing the differences in the way you all run your businesses. 

During our pitch to our private money lenders, I now plan to request that the total amount being invested be held in escrow, and drawn from bi-weekly. I think this will give the greatest amount of confidence to our private lenders. 

Many thanks to everyone that contributed!