Many of us first think of getting a bank loan when we want to buy a house, a car, vacation home or a boat; invest in real estate; launch a business; and finance a college education. But a bank is just one source of funds for these items. No law says when you need a loan that you have go to a bank.
They key to a traditional bank loan is partly collateral but even more so income and credit scoring. On the other hand, the private lending world is built on collateral. Many private lenders might make more money if the loan recipient defaults.
What is the Key to a Successful Loan? Collateral
Let’s consider a hypothetical real estate investor. He has found a fixer-upper with great potential. It’s on the market for $75,000. With $30,000 in repairs, it can fetch $150,000, he believes.
Banks don’t like to loan on fixer-uppers even if you personally qualify for the loan. If the bank makes the loan and secures it with a mortgage (or deed of trust, depending on the state), the borrower might pay 6 percent on the note and pay 1 discount point. The bank informs him that it makes no promises, and it will take 45 to 60 days to close — if it will close. This uncertainty puts the transaction at risk, so he needs another option.
He approaches another investor, who loans her own money for such transactions, so she is very concerned about the collateral. She will make the loan based on terms where she would be happy if the borrower defaulted.
How a Deal Might Be Spelled Out
The investor is buying the fixer-upper for $75,000 and is planning $30,000 on repairs, for a total into the property for $105,000 plus closing costs. He has $30,000 to make repairs but does not have the $75,000 to acquire this great deal. The private lender agrees to make the loan of $75,000 if the borrower will put his $30,000 into escrow and take three draws of $10,000 to make the repairs. If the investor flakes out after closing or defaults, the private lender has only loaned $75,000 and has the $30,000 cash needed to repair the home in escrow that she can use.
All of these details are spelled out in a note and mortgage agreement drawn up by a good real estate attorney. What are the chances of the borrower not paying the private lender with $30,000 of cash in the deal plus the chance at another $30,000 net profit? The private lender will almost always be paid back per the terms of the agreement.
The terms of this private loan are negotiable but must not conflict with state usury laws. Maybe the private lender charges 3 discount points and a 10 percent note rate. That’s more expensive money than the bank, but the deal gets done in just a few weeks as opposed to maybe never with the bank. Sometimes the most important factor in making a good deal is not the cost of the money but the access to the money.
Making private loans as the lender or obtaining loans as the borrower might be a great fit for your personal financial goals. But either end of the deal will require more education and a team of professionals to make sure these are safe, profitable deals for all involved.