How Do Private Lenders Make Money?
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Originally Posted On: https://www.dohardmoney.com/how-do-private-lenders-make-money-private-lender-guide/
If you stay in real estate long enough, you’ll likely work with a private money lender eventually. But, for new investors, it’s not always clear what private lenders do. More precisely, how do private lenders make money?
Private lenders function similarly to hard money lenders. They provide alternative financing to real estate investors. Typically, they provide short-term loans for house flippers. As such, private lenders make money two ways: 1) origination fees on their loans; and 2) interest on the loan balances.
What is a Private Lender?
To explain how private lenders make money, I first need to outline what a private lender actually does. In basic terms, private lenders are individuals who A) have extra cash, and B) want to lend that cash to other investors and make money on the interest. More precisely, private lenders serve as an alternative financing source for real estate investors. In situations where conventional lenders (e.g. banks and credit unions) won’t issue a loan, private lenders often will.
While private lenders provide a variety of loans, they typically lend to real estate investors—frequently fix & flip investors. With a conventional mortgage, you generally cannot purchase a distressed property in need of repairs. This means that conventional mortgages don’t work for house flippers, as they inherently purchase properties in need of repair. Private lenders, on the other hand, base their loans on what a property will become. Rather than basing a loan on a property’s “as-is” value—like a conventional mortgage—private lenders loan against a property’s appraised after-rehab value, or ARV.
Private lenders provide real estate investors three primary advantages:
- Speed: Conventional mortgages typically take from 30 to 45 days (or more) to close. Investors can close a loan with a private lender in less than a week. This provides tremendous flexibility when trying to take advantage of new deals in competitive markets.
- Home condition: As stated, private lenders will issue loans for distressed properties. This means that house flippers can finance deals—as opposed to needing to pay all cash. While each private lender varies, many will lend up to 70% loan-to-value based on the property’s ARV.
- Lower credit requirements: Private lenders concern themselves more with the deal than the borrower’s credit profile. As a result, most will work with real estate investors who don’t have great credit. In general, the credit requirements for a private lender will be A) lower, and B) more flexible than a conventional lender’s requirements. However, having judgements or bankruptcies in your credit history will likely prevent you from securing a private loan.
Before issuing a loan, private lenders typically want to see equity in the property. This demonstrates that the investor has some “skin in the game” and will complete the renovation. Related to this, private lenders generally require borrowers to have actual real estate investing experience. They don’t want to lend to a first-time house flipper who may or may not successfully renovate and sell a property.
How Do Private Lenders Make Money?
Broadly speaking, private lenders make money in two ways:
- Origination fees: These are the fees a private lender charges to actually originate, or put together, a loan. Loan originations take time and administrative effort, and private lenders require compensation for this work. Depending on the lender, these fees can be charged as 1) a flat fee, 2) a percentage of the loan amount, or 3) a combination of these options.
- Loan interest: This is what private lenders charge for letting borrowers use their money. In conceptual terms, interest is how private lenders are compensated for the risk they’re taking by lending money. Private lenders assume greater risk than conventional mortgage lenders because private loans are secured by properties that still need to be renovated. If a borrower defaults prior to completing the rehab, private lenders need to foreclose on a partially-rehabbed property. Due to this increased risk, private lenders charge higher interest rates than conventional lenders.
Related to interest, private loans also tend to have shorter terms. They exist to finance fix & flip deals—not long-term investment property purchases. As such, most private loan terms range from one- to three-years, depending on the particular deal. This shorter time horizon also justifies the higher interest rate private lenders charged. They have less time to earn income, so to justify the risk, they need to charge higher interest rates.
Private Lender versus Hard Money Lender
If you know anything about hard money lenders, the above description of private lenders likely sounded familiar. In function, hard money lenders and private lenders are largely the same. They both provide alternative financing to real estate investors, frequently for house flip deals. And, both lenders make money through a combination of loan origination fees and loan interest.
Private lenders differ from hard money lenders in terms of organizational structure. Private lenders are individuals. On the other hand, hard money lenders are established companies. This organizational differences leads to some key advantages for hard money lenders over private lenders:
- Established systems and support: As a formal company, hard money lenders have established business processes and administrative support. These characteristics mean you’ll likely have a far more reliable partner in a hard money lender over a private lender. For instance, if you have a question about your repayment schedule, what happens if the private lender is on vacation? With a hard money lender, you’ll have the customer support of an actual business—not just a single person.
- Experience: As a business, hard money lenders deal with real estate loans every day. This gives them a tremendous amount of experience, and they can translate this experience into direct assistance for their borrowers. Conversely, private lenders may have little to no experience issuing these sorts of loans, meaning they won’t be able to provide you a guaranteed level of advice and assistance.
- Reliability: Unfortunately, private lenders—as individuals—are more likely to flake out of a deal than an established hard money lender. I personally dealt with this situation. At closing time, my private lender failed to show and stopped answering all phone calls. Fortunately, at the time I had a solid relationship with a hard money lender who was able to move in and close the deal.
How to Become a Private Lender
Advantages definitely exist to private lending. You profit from real estate deals—without the hassle of actually doing any fix & flip work yourself. You screen borrowers, lend money, sit back, and make money. However, it’s not for everyone. Before diving into private lending, you’ll need:
- Cash: It should be obvious, but if you don’t have a bunch of money sitting around to lend, you can’t be a private lender.
- Experience: While private lenders may not do the rehabs, they need to know everything about these deals. They need to intimately understand real estate risk, valuations, contractor bid processes, lending legal requirements, how to administer loans, and more.