Considerations Before Becoming A Private Money Lender Part 1

CONSIDERATIONS BEFORE BECOMING A PRIVATE MONEY LENDER PART 1

As an investor and private money lender I have seen and experienced many different situations over the years. For those of you that follow my blog I like to teach and learn through examples and case studies so let’s review the biggest mistakes I and other investors have made. Hopefully after reading this you can avoid some of the pitfalls and mistakes we have made.

Mistake #1: Lending money you might need

This is the biggest mistake an investor considering lending can make in my opinion. I often have investors that ask me about lending because they have a large amount of money in their account that is sitting there barely getting any interest. I can tell you as someone that has done this, when your nest egg or most of it is in someone else’s hands it can be incredibly nerve wracking. I had a friend of mine that wanted to sit out and watch the market for a period of time, so decided lending money was the best thing to do in the meantime. A few weeks later when market rates dropped significantly, he went to go refinance and was turned down because he did not have enough reserves to cover the debt he owed on his properties. He ended up having to wait a few months, only to see interest rates rise again. In another situation I had an investor that promised me funds in 2 months, and I had another deal that was supposed to close in 3 months. I figured a month cushion would be plenty and I had heavy penalties to make sure I got paid on time. With 30 days left to close the seller came back and asked if we could close in 7 days to which I said no. They offered me a steep discount to close early, so I followed up with my borrower and gave them incentive to payoff early. Rather than pay me according to our agreement, the borrower went over the timeframe, paying the penalty and I almost lost my other deal altogether. If I would have just held on to the funds and taken the big discount the seller was giving me it would have been more of a savings than the interest received. I have even lent money on deals before where I after lending, I came across another deal shortly thereafter. Because I could not get my money back in time before closing, I had to go borrow money at a HIGHER rate than I was lending at effectively losing money on lending to someone else. Which brings me to my next piece of advice.

Mistake #2 Do not lend your money too cheap

Most first-time investors lend money based on how much they are getting in their bank account, when you should be lending on what type of reasonable return you could get investing it. Keep in mind that lending has very few tax advantages, so a dollar earned lending is very different from a dollar earned investing in real estate, or even mutual funds. You don’t get to benefit from depreciation taken against the asset, appreciation of the value of the asset, and leveraging your money 5-20 times with financing.

12% sounds like a lot of money but let’s use an example. Pardon me for the crudeness of the numbers but let’s say that I lend to an investor for 1 point (1% in of the loan amount as an origination fee) and 12% and that investor borrows $100,000 for 1 month. I will effectively make $2,000 to tie up $100,000 of my cash. Meanwhile I also am spending my time underwriting the deal, and their creditworthiness. In many cases, the borrow requesting the funds may not decide to have you lend on their deal because somebody else gave them 1% less than you, so you sometimes waste your time looking at a deal to not close at all. All that for $2000?!?!?! Not to mention if you must foreclose and spend $2500-$5000 to foreclose do you really want to manage the investment? To avoid that…….

Mistakes #3 Only lend on deals you would foreclose on, and can foreclose on easily

I have a friend of mine that lends his money, and he is the nicest guy ever, but he makes a mistake of lending to people on deals that make it hard for him to make his money back. If the borrower does not pay, he is screwed and thus he does not want to foreclose. He will lend on deals on renovations funds only, second lien position, or he will lend purchase price plus rehab all up front. The problem with these deals is if somebody does not do what they are intending to do, you must spend $2500-$5000 to foreclose. If they bought the property for 100,000, with 20,000 rehab costs but decided to use the renovation funds for another project there is a good chance you could be underwater if you foreclose. If that happens, then would you? Now some would say you can do draws and then charge them. The problem with this is a lot of contractors do not like to get paid waiting for draws, so then the borrower is on top of you to release the funds and now you are going from thinking you have a passive investment to being a project or site manager so you may as well be doing the project with your own funds and money. Only lend in first lien position, and only lend renovation costs, where if you must foreclose you could take over the project and still make money. I always add in the cost of a foreclosure in your area to your bottom line as well when evaluating if you can make money if you had to foreclose on the deal. You are evaluating the deal anyways so if after all your costs to get the property back, you can still make money on and it is worth your time if you go from passive lender to active investor then it’s probably a green light. There is never a shortage of opportunities to lend and all you must do is raise your hand and people will come calling so be picky on your first few deals.

Mistake #4 Wheeling and dealing

A lot of investors like to negotiate, and in fact always attempt to. The second you adjust your terms at their suggestion, everything becomes a negotiation. If they make valid points and this may be something you agree with then simply say, “maybe on the next one I will offer those terms but not on this one.” Once you negotiate you begin to waste your time. You have the money; you have what everybody else wants. They can take it or leave it. I spent an hour on the phone with an investor that was a friend of a friend, and he made some valid points about lending on a deal so I agreed to a half point discount and before I knew it he was running by all these different scenarios where he could get better terms. If an investor tells you that, end the conversation immediately and tell them that you are glad they can get better terms, and let them know you have other deals you must evaluate. If an investor is asking you to lend, they either need the money or are looking for better terms than what they can get and if they are shopping around you could be wasting their time competing with another lender. You have what they want, not the other way around, you have all the negotiating power. Now with that said, not all borrowers are the same. A first-time flipper with no money versus a seasoned investor with lots of cash provide different risks so you do need to factor that in accordingly.

This concludes Part 1 of this blogpost. Next week I will post about advice on what to do when lending to others. Please feel free to email questions to address for our next blogpost to [email protected].