When do you become a Private Lender

[Brandon Elliott]

My question to you... when does it make sense to become a private lender?

I have a client dying to get into RE but has no funds other than his HELOC with about $100K available rn. The interest on barrowed money is somewhere around 10% and I thought he may be able to use that to lend on deals and begin to build up a fund to invest himself.

When he asked if I'd do that I said, "No, I'm not at the stage in my career to lend money. I'm still building my portfolio." 

That got me thinking though... there's got to be people out there lending on deals even if they don't have a big portfolio(s).... So I am curious, when did you become a private lender and why? (Or how did it make sense for you?)

[Chris Seveney]

@Brandon Elliott

It does not make sense to get 12% and pay 10% as you will lose money after taxes….

To answer the question about private lending - most do it because they are tired landlords and not necessarily due to funds they have but wanting to be more passive

I would want $250k as many of the lower dollar loans are very risky

[Jeff S.]

Your friend is wise, @Brandon Elliott. He is not in a position to begin lending money for several reasons.

I assume the HELOC was made against his personal residence. Yes? If so, lending this money puts his home and, presumably, his family at risk. Unless he has the funds to repay the HELOC, how would he cover a borrower default? Could this be done before his HELOC lender completed a foreclosure?

Next, $100k might fund a second position rehab loan to a local flipper but it won’t go very far toward a first position purchase money loan. Second-position loans are about as risky as they get and not something your friend should get into. Even many of the largest hard money lenders don’t make second-position loans.

Last, run the numbers. How much is he now paying for his HELOC? 7%? If he could loan this money out at 12% plus 3 points, which is optimistic, that's a 15% annualized return. This leaves 8% (15% - 7%). What's his tax bracket? 40%? He'll end up netting 60% of 8% or 4.8%. Of course, since most HELOCs are adjustable, this will change for better or worse as rates change. How strong is his stomach?

Treasury bond money market funds pay over 5% now, tax-free from state taxes. Why take all the risk?

Lending tax-free or tax-deferred using a self-directed retirement plan is a great way to get into the business. Buying small dollar non-performing notes and working (hard) to get them to reperform is a good way into the business -- if your friend has the time. Laddering a few loans into many using hypothecation is another, but this takes enough money to make the first few loans. Once he has some experience, your friend could start a fund and take on investors. Of course, he could become a broker to make and arrange loans among others. The easiest is to become an affiliate and make a referral fee.

The mega giant hard money lenders can make money netting 2% by lending hundreds of millions of dollars. Your friend is not one of these. There are places for HELOC money in real estate. Lending like this is not one of them.

[Wyatt Wolff]

I definitely don't think he is in the position to be a private lender yet. I think most of the ones I have come across are either a) Very well off, and diversifying, or b) much later in their careers and they are using a vehicle they know (RE), just in a more passive way. 

[Mike Klarman]

Depends on the kind of private lending they want to do.  100k isn't really enough to back a deal.  For example, let's say someone is buying a house for 90k and it needs 60k in work.  You are going to privately lend an investor on this deal and you will offer them 85%/100% at 10.99%.  That means you'll fund 85% of the 90k plus supply the 60k in rehab.  That's a loan amount of 136,500.  More than the 100k your client has and that's a small deal.  To do real private lending you'd need at least 500k liquid unless you just lay out all you have in every loan 1 at a time.

Then there is Gap funding. In this same deal, the investor would need to come with 15% plus closing costs and let's call it 17k. They are looking for gap funding and you offer them the 17k at a 12% APR with interest only payments. That would be about 180/month coming back to the gap funder until the 17k is paid back at the exit - either sale or refi. That's more affordable for someone who has 100k for lending.

[Jay Hinrichs]

Quote from @Mike Klarman:

Depends on the kind of private lending they want to do.  100k isn't really enough to back a deal.  For example, let's say someone is buying a house for 90k and it needs 60k in work.  You are going to privately lend an investor on this deal and you will offer them 85%/100% at 10.99%.  That means you'll fund 85% of the 90k plus supply the 60k in rehab.  That's a loan amount of 136,500.  More than the 100k your client has and that's a small deal.  To do real private lending you'd need at least 500k liquid unless you just lay out all you have in every loan 1 at a time.

Then there is Gap funding. In this same deal, the investor would need to come with 15% plus closing costs and let's call it 17k. They are looking for gap funding and you offer them the 17k at a 12% APR with interest only payments. That would be about 180/month coming back to the gap funder until the 17k is paid back at the exit - either sale or refi. That's more affordable for someone who has 100k for lending.

Agree with this expect I dont at all recommend gap funding.. HIGHLY risky and rate of return on gap funds should be north of 20% given the risk.. just not something to start with.. chance of a wipe out is far to great especially starting out.  Totally agree with having at least 250 to 500k to start . and for those that want to make a living out of it.. you need 2 to 3 million.

[Brandon Elliott]

Quote from @Chris Seveney:

@Brandon Elliott

It does not make sense to get 12% and pay 10% as you will lose money after taxes….

To answer the question about private lending - most do it because they are tired landlords and not necessarily due to funds they have but wanting to be more passive

I would want $250k as many of the lower dollar loans are very risky

 Thanks for your thoughts Chris!

[Brandon Elliott]

Quote from @Jeff S.:

Your friend is wise, @Brandon Elliott. He is not in a position to begin lending money for several reasons.

I assume the HELOC was made against his personal residence. Yes? If so, lending this money puts his home and, presumably, his family at risk. Unless he has the funds to repay the HELOC, how would he cover a borrower default? Could this be done before his HELOC lender completed a foreclosure?

Next, $100k might fund a second position rehab loan to a local flipper but it won’t go very far toward a first position purchase money loan. Second-position loans are about as risky as they get and not something your friend should get into. Even many of the largest hard money lenders don’t make second-position loans.

Last, run the numbers. How much is he now paying for his HELOC? 7%? If he could loan this money out at 12% plus 3 points, which is optimistic, that's a 15% annualized return. This leaves 8% (15% - 7%). What's his tax bracket? 40%? He'll end up netting 60% of 8% or 4.8%. Of course, since most HELOCs are adjustable, this will change for better or worse as rates change. How strong is his stomach?

Treasury bond money market funds pay over 5% now, tax-free from state taxes. Why take all the risk?

Lending tax-free or tax-deferred using a self-directed retirement plan is a great way to get into the business. Buying small dollar non-performing notes and working (hard) to get them to reperform is a good way into the business -- if your friend has the time. Laddering a few loans into many using hypothecation is another, but this takes enough money to make the first few loans. Once he has some experience, your friend could start a fund and take on investors. Of course, he could become a broker to make and arrange loans among others. The easiest is to become an affiliate and make a referral fee.

The mega giant hard money lenders can make money netting 2% by lending hundreds of millions of dollars. Your friend is not one of these. There are places for HELOC money in real estate. Lending like this is not one of them.

 Wow, lot's to unpack here. THANKS for your thoughts and all this information. I appreciate your perspective and time writing this up!

[Brandon Elliott]

Quote from @Jay Hinrichs:

Quote from @Mike Klarman:

Depends on the kind of private lending they want to do.  100k isn't really enough to back a deal.  For example, let's say someone is buying a house for 90k and it needs 60k in work.  You are going to privately lend an investor on this deal and you will offer them 85%/100% at 10.99%.  That means you'll fund 85% of the 90k plus supply the 60k in rehab.  That's a loan amount of 136,500.  More than the 100k your client has and that's a small deal.  To do real private lending you'd need at least 500k liquid unless you just lay out all you have in every loan 1 at a time.

Then there is Gap funding. In this same deal, the investor would need to come with 15% plus closing costs and let's call it 17k. They are looking for gap funding and you offer them the 17k at a 12% APR with interest only payments. That would be about 180/month coming back to the gap funder until the 17k is paid back at the exit - either sale or refi. That's more affordable for someone who has 100k for lending.

Agree with this expect I dont at all recommend gap funding.. HIGHLY risky and rate of return on gap funds should be north of 20% given the risk.. just not something to start with.. chance of a wipe out is far to great especially starting out.  Totally agree with having at least 250 to 500k to start . and for those that want to make a living out of it.. you need 2 to 3 million.

 Makes a lot of sense, thank for sharing your thoughts Jay!

[Brandon Elliott]

Quote from @Mike Klarman:

Depends on the kind of private lending they want to do.  100k isn't really enough to back a deal.  For example, let's say someone is buying a house for 90k and it needs 60k in work.  You are going to privately lend an investor on this deal and you will offer them 85%/100% at 10.99%.  That means you'll fund 85% of the 90k plus supply the 60k in rehab.  That's a loan amount of 136,500.  More than the 100k your client has and that's a small deal.  To do real private lending you'd need at least 500k liquid unless you just lay out all you have in every loan 1 at a time.

Then there is Gap funding. In this same deal, the investor would need to come with 15% plus closing costs and let's call it 17k. They are looking for gap funding and you offer them the 17k at a 12% APR with interest only payments. That would be about 180/month coming back to the gap funder until the 17k is paid back at the exit - either sale or refi. That's more affordable for someone who has 100k for lending.

 Interesting thoughts here Mike! Thanks for sharing! 

[Beth Johnson]

I completely agree with what Chris and Jeff said. It's not the right time to arbitrage borrowed capital to lend out, IMHO. If you want to learn more about the practice (and art) of safely and securely finding and funding a PML to see if it's for you, check out my book on BiggerPockets called Lend to Live: Earn Hassle-Free Passive Income in Real Estate with Private Money Lending. 

As others have mentioned, 100K in some markets is doable but in most coastal, appreciation markets, it will not be sufficient to lend in a safe manner, i.e. with a large equity buffer to protect your principal investment. PML is for capital preservation and more predictable passive cashflow so you will want to ensure you do it properly so that your principal amount is returned to you, first and foremost. 

[Brandon Elliott]

Quote from @Beth Johnson:

I completely agree with what Chris and Jeff said. It's not the right time to arbitrage borrowed capital to lend out, IMHO. If you want to learn more about the practice (and art) of safely and securely finding and funding a PML to see if it's for you, check out my book on BiggerPockets called Lend to Live: Earn Hassle-Free Passive Income in Real Estate with Private Money Lending. 

As others have mentioned, 100K in some markets is doable but in most coastal, appreciation markets, it will not be sufficient to lend in a safe manner, i.e. with a large equity buffer to protect your principal investment. PML is for capital preservation and more predictable passive cashflow so you will want to ensure you do it properly so that your principal amount is returned to you, first and foremost. 

 Love this! Thanks Beth for your book recommendation as a resource as well!