Someone once said if someone offers me a guaranteed return then it guarantees they will make more. And if both parties are satisfied then it's not a bad arrangement. Individuals need to be savvy with their money.
When I first began to investigate this thing called private lending I was concerned that it was a scam. Yet the more I looked at it I realized that anyone who has ever opened a savings account at a bank, invested in a CD, or has an IRA is a private lender. In each of those instances there is someone or some institution that will pay us an interest rate so they can use our money to make more for themselves. As I said before, that's not a bad arrangement but it did beg the question, could an individual safely make more for themselves.
Banks have existed for centuries for a good reason - they are profitable. Individuals can do this and participate in some of the same benefits through something called "private lending."
What is a Private Lender? Private lenders are individuals with money to lend for investment purposes. They may or may not be wealthy, but they do have excess cash or assets available over and above what they need to live on. These individuals are willing to lend for a higher return than they can get with bank CD's or money markets. They usually lend against assets but will, at times, lend unsecured.
Private money lending became very popular as interest rates on traditional Money Markets and CD's dropped below 5%.
People with extra cash started looking for higher interest rates. So if they could get the high interest rate and enough security (collateral) they were willing to do loans without personal credit or the need to be worried about credit scores. That started the revolution that you see today where private money lenders are as big and popular as other types of lenders were 10 years ago. This trend toward private money will remain as long as the rate of return is greater than bank interest rates.
Though a private lender can be found in the art world, the auto industry, the antique's arena it is most often found in the real estate market. I will confine my investigation to the real estate industry.
One warning that I must immediately give is you should never give your money directly to the real estate investor. Instead send it to a 3rd party like the closing attorney or title company. If someone asks you to give him or her your check directly then do not even consider doing business with him or her. When the funds are distributed at the closing table to the investor it assures you that all the proper documents were signed and recorded for your protection.
There are 5 items that must be required by every private lender.
1) You must have a promissory note, which will state the amount borrowed and the terms for repayment.
2) You must have lenders title insurance, which will protect the lender in case something happened within the title somewhere along the line.
3) You must have a mortgage or deed of trust, depending on your state, recorded in your name in the county of the real estate.
4) You must get an After Repair Value Opinion; this can come through an appraiser or a real estate agent, they both access the same information. You need this because the total loans on the property should not exceed 80% and preferably 70-75%. This protects you regardless of the number of mortgages on the property
5) And lastly, you must be listed as a beneficiary on the Hazard/Fire/Property Insurance, which will protect you completely if the home is destroyed or damaged.
One of the benefits of Private Lending is that your funds will be earning the stated interest from day one, the day the investor closes on the purchase. The downside is that once the property is sold the real estate investor should return your money. When that happens you will no longer be earning the high rate of return. Yet, in most cases, the real estate investor will borrow your money again shortly.
Statically, the annual average rate of return for real estate private lending is higher than other investments. If you were to earn 10% on your money for 4 months or 3% on your money for 12 months, the 10% earns more.
Another area where private lenders can become their own bank is in the area of bridge loans. A bridge loan is a bit riskier but is a common entity. Bridge loans are borrowed funds to get the time required to sort out the issues of a specific transaction and meet rigorous timetables or when the sale of one property overlaps with the purchase of another. When bridge loans approach their maturity deadline, they are paid off either through refinancing or the sale of the other home. Some bridge loans are hours long but most are for months.
Private lending offers a good rate of return yet you should not put your last penny into it. Diversification is critical to any investment strategy. When adding to your wealth you need to have different items in your portfolio.
For many individuals private lending is more comfortable because it is much less affected by repeated marketplace fluctuations. In reality, throughout times of economic turbulence in the stock market, private lending transactions are looked upon in a favorable light. It is a stable investment that can return monthly income or lump sum income like a zero coupon bond.
Nonetheless, the possibility of foreclosure is real. A private lender is more protected than a bank in a foreclosure or deed-in-lieu of foreclosure situation. A private lender will have more of an equity cushion than most banks. A private lender should have at least 20-25% equity in the property, or they shouldn't become a lender. Maintaining that cushion allows a private lender to become involved at any level of mortgage, whether it is a 1st mortgage or a 5th mortgage.
There is a long a history of private money lenders investing their own money in real estate investments. Like many things, private money comes and goes depending largely on interest rates and the demand from real estate investors and other investors.
Many homeowners are able to become private lenders through the help of their own bank. They arrange an Equity Line (HELOC) with their bank on their home. Then borrow the cash at a rate of 3-4%. When you lend those funds you will be very much like your own bank (you are paying the bank interest to use their money to lend to someone else, sound familiar).
As a private lender you will be earning 8-10% or more from the real estate investor. Your net return, or "spread" as the banks call it, is 5 to 6 percent; that is your profit. At a 5% spread, on a $150,000 loan, you will earn $20.54 per day or $7500 for the year. The other benefit is that when the investor pays back the loan, the equity line stops charging interest as well.
One surprise I discovered was that the IRS approves of these transactions within your IRA. And if you have a self-directed IRA, you can use your retirement money to become a private lender and your earning will accumulate tax deferred or tax-free, depending on your IRA. Creating a self-directed IRA means you direct a 3rd party to do what you want with your money. The two largest 3rd parties that handle self directed IRA are Equity Trust (http://www.trustetc.com) and Entrust Group (http://www.theentrustgroup.com).
No investment is completely free of worry, yet there are methods to making your investment as safe as possible. If you insist on a promissory note, a mortgage, a hazard insurance policy and lenders title insurance the majority of your worries have been resolved. It is not uncommon to have the real estate investor pay for those costs.
Throughout this investigation it became more apparent that, as with all investments, a careful person can become a wealthy private lender. Though many banks seem to hide this from their depositors, anyone can become a private lender. Private lending is the quickest way for a person to make passive income. When secured with real estate, the risks are extremely low.
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