Private Lender’s Checklist: 12 Tips to Ensure Your Deal is Done Right

The first experience I had with private lending was as a borrower. I purchased my first property after college with owner-financing because I didn’t have much in the way of credit history. Through the years, I have been on both sides. I purchased much of my buy-and-hold real estate portfolio with owner-financing, and I added private loans to my portfolio by lending to others for their real estate deals.

So, private lending has certainly benefited me both as a borrower and as a lender, and I see many investors lend from self-directed IRAs to further capitalize on the benefits.

Most importantly, I believe that when these deals are done ethically, they can be a great thing for both parties and for the community. Of course, not every deal is done ethically, and there are red flags to look out for.

If you didn’t do enough due diligence on the borrower and on the property (i.e. collateral for the loan), this increases the likelihood of default and a foreclosure that may even cause you to lose money (especially if there’s not enough equity in the property). Or perhaps you would like to remain passive and not take over the property in the event of default.

As an investor, of course you want to protect your investment and your preferred lifestyle, while completing the deal ethically. What can you do as the lender to minimize risk and ensure that the deal is beneficial to both you and the borrower?

12 Tips for Private Lending

1. Require Title Insurance.

Title insurance will protect against any unexpected liens, encumbrances, or defects in the title or actual ownership of a property.

A borrower might request that a note be put on the property instead of paying for title insurance. But if you were to go this route, how would you know that it’s in first position? Do they really own it?

2. Use Professional Paperwork.

It’s important to write everything down and have the paperwork prove what both parties agree to. As my dad used to say, “Expect it to go well, but plan for it to go badly.”

Plus, paperwork needs to be done professionally so it adheres to the requirements of a specific county or state. For example, a mortgage might not get recorded because it doesn’t have the proper margin sizes or font size for that county. I recommend utilizing a title company or escrow/closing attorney to keep all the requirements straight.

3. Check Property and Liability Insurance.

Does the property have the right type and amount of insurance? When the unexpected happens, not only can the collateral for the deal be in jeopardy, but both the lender’s and borrower’s money may be at risk as well.

For example, I’ve seen investors take losses due to fires or even demolitions by the city. One even had to pay personally, when a few teenagers threw rocks at a glass door, were cut, and then sued.

Property and liability insurance are the most common, but of course, additional insurance may be needed if the property is in a flood zone or an area prone to hurricanes or earthquakes.

4. Know the Value.

It is very easy to get appraisals these days, and so much information is available online.

Many folks make the mistake of only looking at comps nearby, but those properties might not be consistent with yours. For example, in cities like Philadelphia or New York, property values can be very different even one block from each other.

Also look at rental value (how much it could rent for) and replacement value (what it could cost to rebuild), which is good to consider when purchasing insurance as well. If I look back to 2008/2009, I remember that comps went way up but rental value and replacement value did not.

Although value will change with time and market conditions, having the most accurate information will help you determine what loan to value (LTV) you’re comfortable with. I typically look for 70-75% LTV, but I’ve seen others lend anywhere from 40-80% LTV, and the banks are usually closer to 80%. In 2006, some lenders/banks lent as much as 125% of the purchase price. Insane, right?

5. Understand the Borrower’s Exit Strategy.

If you don’t know the borrower’s exit strategy, you don’t know how to determine whether you’re on schedule, how long your money will be deployed, etc. You should always ask the borrower about their plan, and make sure they are prepared for it.

For example, if it’s a fix and flip deal that is supposed to be ready to sell in 6 months, you would be planning to get paid back at that time. If it’s a buy flip and hold, the borrower is going to be looking for refinancing, and you would want to make sure he/she has the credit to be able to get it. The borrower also needs to know how long he/she will be paying the interest rate that you’re asking for.

6. Have a Plan.

If the ideal exit strategy doesn’t work out, the borrower and lender both need to have back-up plans. If the market tanks and the borrower is unable to sell the property, will he/she refinance? If the borrower defaults on the property and you foreclose, will you be able to rent out or sell the property to make your money back? These scenarios show why it’s important to understand the true value of the property.

You should also prepare to jump in (or have others who can) should the situation call for it. For example, what if the borrower dies, becomes ill, or just walks away from the deal? Do you have a team ready to complete the rehab? Or, do you have other wholesalers lined up who would pick up the property, so you don’t take a loss on the resale?

7. Get Key Man Insurance.

Key man insurance can offer monetary assistance in the tragic event that something did happen to the borrower. It will pay off the loans that the borrower has out, and then the insurance company will take on the liability of his/her current deals.

If you’re an active investor who would work with the borrower’s family and take over the property in this situation, requiring key man insurance isn’t necessary. For other folks, who would rather remain passive and let the insurance company handle it, getting the insurance would be a good idea.

8. Evaluate Borrower’s Financial Health.

As mentioned, it’s important to understand the borrower’s credit, especially if a refinance is part of the deal. That said, you should also understand the overall financial health of the borrower, because this will help both of you mitigate risk.

For example, does the borrower have enough reserves to cover any unforeseen problems or expenses that may arise during the deal? What if mid-rehab, the borrower finds out there’s a structural problem that is going to cost another $10K to fix? Usually, I recommend that my borrowers set aside at least 10% of the loan amount just in case.

I also like to require interest payments throughout the deal instead of waiting until the end. It would be a red flag or early indication of financial distress if they are unable or unwilling to pay interest early on.

9. Become Familiar with the Foreclosure Process.

Some states can take a few years to foreclose, while others may only take a few months. The process and requirements vary.

Pennsylvania can take up to 3 years while Texas takes 3 months. How much does foreclosure litigation cost? Who will file the papers, i.e. what firm or attorney? Do you want to hold money in reserve from the loan in case foreclosure is required? What will the market conditions and carrying costs do to your profit? Know the answers or at least understand the risks going into the deal.

10. Use a Draw Schedule if Improvement Money is in the Deal.

For rehab deals, utilizing a draw schedule, where the money is made available to the borrower in stages, can minimize risk for the lender and help ensure that the money is being used ethically.

Some rehabbers use the motto “when I stand in the basement and I can see the sky, that’s the property I want to buy.” When the purchase price is low and the rehab is expensive, it makes perfect sense to use a draw schedule. Assume the purchase price is $80k and rehab is $220k. The draw schedule will have milestones identified, such as demolition, foundation, trades rough in, dry-in, floors, trades complete, appliances and cabinets in. The money can be released to the borrower based on each milestone. Making sure you are paying for “value added.” Always hold back 10% until the punch list is complete.

If you are buying a property for $250k and it needs $10k in painting and repairs, a draw schedule is probably not needed.

If you do decide to use a draw schedule, I recommend that both parties agree on the terms. For example, is the money released monthly or based on completion of project milestones? Is there an inspection required? How are the contracts with the subcontractors written? Make sure you get lien releases from the contractor and/or the sub-contractors.

11. Make Sure Taxes are Paid.

In the event of default, the government gets paid first, prior to the lender. Verify that taxes are paid annually, because if unpaid, these could potentially wipe out your loan.

I made the mistake of not doing this. I had a private loan to a borrower, who defaulted after losing his job. I liked the guy, so I tried to help him out by giving him some time. I gave him almost two years to start paying the loan back, but then I was notified by mail that he hadn’t been paying the taxes either and the property was going to auction. In this case, I was able to pay off those tax liens, and foreclose on the property, but it certainly cut into my return.

12. Verify that Any Association Fees or Senior Liens are Paid.

The same is true for any association fees or senior liens. Lien position determines the order of pay off in the event of foreclosure or resale. A loan in first position (i.e. no prior liens) will be paid before a lien in second position (i.e. a second mortgage).

Make sure that if you are lending money you have equity in the property that backs your investment even if you are in second or even third position. You can verify that senior liens are paid by adding clauses to the note/mortgage requiring status of senior liens and taxes being paid annually, as well as status of company and personal financials.

Now that you’ve read through the check list, do you feel prepared to lend money? Or, are you inspired to use other people’s money (OPM) to take on your next deal?

I’d love to hear from other private lenders out there – any questions or stories to share?