How do I structure terms with a private money lender?

Question

I'm planning on purchasing an investment property in the range of 30K-50K, instead of using my capital looking to borrow from a private money lender. This private money lender is an investor with many properties and is sitting on some cash, he is willing to fund me to grow my portfolio. I'm new to private money and I have no idea what the terms would be i.e. rate, how long? I was thinking of maybe 5 years but the positive cash flow would be around $400/month, so to pay off the loan in 5 years I would have negative cash flow. Negative cash flow is ok because my thinking is the property would be paid for in 5 years, the business has reserves that can take the hit, the private money lender would get his money back in a short period, and I would be able to write off the tax depreciation and expenses which will help the whole of the business. Is my thinking wrong? What am I missing? How do do I legally protect myself i.e. a note? How do I protect the lender i.e with his money i.e.a lien? Any suggestions would be greatly appreciated. Thanks

Jeff S. · Answer

Sorry, but title companies are insurance companies.  They have attorneys but these are not your attorney nor that of your lender.  They will review your loan documents to protect themselves but not for your interest or your lender's.  Might they prepare these? Yes, but no lender should rely on a title company to prepare a complete loan package and expect to be fully protected.  Real estate loans consist of many more documents than a note and deed of trust or mortgage.

Adding that “Escrow Instructions,” which are generally prepared by escrow from your purchase contract, have nothing to do with the loan terms.  Nor are these the same as “Lender Instructions” which describe the documents the lender is providing and how they should be handled by escrow and/or title.

Loan terms are generally defined in a “Term Sheet.”

The note, deed of trust or mortgage, and lender instructions are not the only documents required of a properly originated loan.  I provided a list in this thread a few years ago.  Even it’s a bit incomplete, but close.

You can agree on any terms you want @Samuel Bell, so long as they are legal.  Your lender should have his or her documents prepared by a knowledgeable lending attorney (which is not the same as a real estate attorney).  If they are in the business, they know that.  Alternately, hard money lenders understand private loans and have vetted paperwork.  Some, who are also brokers, will originate your loan for a fee.  This could be required in your state.  Others might simply be a good source of a referral to their lending attorney.

Best of luck to you, Samuel.

Mike Hartzog · Answer

@Jeff S.  Good catch, I used the wrong term there.  We use term sheets in our lending to get mutual agreement on terms before closing.  There may also be a draw schedule, depending on the situation.  With borrowers we have long standing relationships with (which is most of them for us) we do the doc prep ourselves and review with the borrower prior to closing.

That's a good list of items in the referenced thread, many of which a lender might be concerned about, especially when working with new borrowers.  IMO however, a borrower need not be concerned about protecting the lender, as it is the lender's responsibility to take whatever steps they feel appropriate to protect themselves.  The borrower needs a mutually agreed PSA, title insurance to protect against unexpected liens which were not caught in the title search, a note that defines the terms or the loan, and a security instrument which secures the loan with the property.  Ideally there is no personal guarantee, unless the lender insists on it.

Mike Hartzog · Answer

Good points by @Ronald Isgate and @Jamie Bateman.  I would add that private money is generally quite expensive.  Most hard money loans are in the 10-12 percent rate with points.  You mentioned wanting to grow your portfolio, which means to me that you want to keep the properties for rentals long term. In that case, you would use private money as a short term bridge to permanent institutional financing.  Use it for purchase and rehab.  Once the property is repaired and in a condition that a bank would lend on, go get a bank loan to pay off the private money loan.  Rinse and repeat. (Brrr strategy)  Once you have a few of these under your belt and have a track record to point to you can switch over to using lines of credit from smaller local banks to do the same thing and avoid private money altogether.

Another point.  Title companies know how to do the doc prep and recording for closing a transaction like this.  Your lender would typically provide "escrow instructions" which call out the terms of the loan.  (You should sign off on this before it is submitted.)  Title company uses that to prepare docs for closing, and records the security instrument afterwards.  I say this because as long as you and your lender are in agreement on terms and can write them down, an attorney is not necessary in this type of transaction.  Title companies have their own attorneys to review docs and such.

Samuel Bell · Answer

@Dave DeMarinis, good point. In this situation I'm considering is from a private lender. Thanks.

Dave DeMarinis · Answer

@Mike Hartzog @Samuel Bell Of course they are many definitions for Private Money vs. Hard Money, but to me - Private Money means the loan is primarily based on the relationship between borrower and lender. The lender is likely not a professional lender and the borrower should absolutely be thinking about protecting the lender.

For a Hard Money Lender, they will worry about protecting themselves which also provides a number of safeguards for the borrower because that is their job and profession.

EMarie Windham · Answer

@Todd Fithian. Indeed Todd!

Samuel Bell · Answer

I have used my own money in the past to purchase investment properties, which has been good but recently I put two props up for collateral and was able to build a relationship with a small bank to purchase my 5th prop. The Bank wants to see how this loan goes before they let me do it again(which I understand). I like the idea of using the private money lender to help me acquire the new investment properties and then have the finance with the bank for a longer loan period (rinse and repeat). The bank doesn't want to do paperwork on one prop at a time, 2 or more props, since they really don't have the people to spend time on small projects. Anyway I truly appreciate all of your advice concerning this. My goal this year is to acquire 4 more investment properties! Thanks!

Samuel Bell · Answer

Thank you @Ronald Isgate, @Jamie Bateman,@Mike Hartzog, @Jeff S. for your help! Much appreciated!

Jamie Bateman · Answer

@Samuel BellI would really try to avoid an intentional negative-cashflow situation. You could structure the loan terms so that the payments are interest-only for a period of time in order to keep the payments low. Or just amortize over a longer term (again lower payments) but save up money along the way or (pay more toward principal each month) if you want to pay the loan off early. No reason to lock yourself into a shorter term with higher payments if you don't have to. Also, most lenders will want you to have some of your own funds invested (if for no other reason than to have the collateral maintain a higher value than the loan amount).

What state are you looking to buy in? This will obviously affect what the specific documents will look like, but (as @Ronald Isgate mentioned), you'll have a note that spells out the terms of the loan and a mortgage or deed of trust that gets recorded to formalize your lender's lien against the property.

Ronald Isgate · Answer

You absolutely need to document the transaction.  The lender should really tell you what his/her terms are for lending you the money (i.e. interest rate, term to maturity, amortization rate, interest only payments, etc. etc.).  Since he is a lender (and not an equity partner of yours), you should have a note and mortgage, which would get recorded against the property.  I would recommend you speak with a real estate attorney in your area so that all the key terms are contained in the documents so that you and lender both know each other's obligations and expectations.

Best of luck!

How do I structure terms with a private money lender?

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