Private Money (sometimes referred to as Hard Money) lending has been around for decades now. It gives the consumer access to real estate financing they can’t get from Banks or Credit Unions. Effectively, instead of a bank or credit union making the loan to a consumer, private investors (i.e. individuals, hedge funds, corporations, LLC’s, private mortgage funds, etc.) fund these Private Money loans.
Why do some borrowers select the private money lending route over the institutional lending route? The consumer will find their best loan terms from banks and credit unions, however, they might not qualify for these loans due to credit issues, income documentation issues, property issues, etc. Private money lenders can sometimes fill the lending void in these instances, as they can be more flexible in their underwriting guidelines. For example, banks/credit unions cannot lend on properties currently under construction or on the market to sell. However, private money lenders have the ability to do so from time to time. Furthermore, private money lenders can be much more flexible when it comes to a borrower’s credit issues, thereby becoming a borrowers best financial choice for their borrowing needs. Banks and credit unions have minimum credit score requirements, whereas, many private money lenders do not. In addition, banks/credit unions have much more stringent income documentation guidelines that they have to abide by. Private money lenders can be much more flexible documenting their loan files. We handle both institutional as well as private money loans here at Residential First Mortgage & Capital. Hence, we will do our best to place borrowers in more competitive institutional loans before we explore the private money options with them.
If a consumer cannot obtain institutional financing, their alternatives are to: not borrow, to sell their property, or to go to a family member or private money lender for their financing needs. Most borrowers who take private money in these instances, plan on only having it short term. Furthermore, most private money lenders don’t want to commit to lending long term. Hence, most private money loans are typically written for 1-3 year terms. Longer terms can be negotiated. In todays market, borrowers can obtain private financing in the 7.5% to 12.0% interest rate range. Most private money loans are being originated in the 8-10% range today. Investor yields have fallen the last 3-4 years due to the influx of investor capital into the private money lending space.
Why are investors interested in funding private money loans? If done properly, they provide a very nice investor return, with good collateral to back them up, making them very attractive to private investors. Banks/credit unions mainly focus on a borrower’s qualifications, whereas private money lender focus more on the collateral as the “safety net” for their loans. Banks/credit unions will lend up to 96.5% of the value of a home, whereas, private money lenders typically stop at 70%. They want to see a solid equity cushion behind their loan to help protect their position. Most of our loans are written at 65% LTV (Loan to Value) or less, or 60% CLTV (Combined Loan to Value) or less. Each loan is analyzed based on multiple factors (i.e., property location, property value, property desireability, LTV, CLTV, purpose of the loan, borrowers plan for repayment, and borrower financial strength). We always ask ourselves, “what is the worse case scenario” on this loan? Typically, that is a large earthquake that destroys the property. Knock on wood, but we have never had this issue in 4 decades of private money lending. That does not mean it can’t happen though. Note that we don’t require borrowers to maintain earthquake insurance as the cost of it is very high and the deductibles are also hgh, making the insurance not very attractive. We do require the borrowers to maintain adequate hazard insurance on their properties, so that if they burn to the ground, there will be able insurance proceeds to rebuild the structure.
We also ask ourselves, “what is the most likely outcome for our investors if the borrower defaults? We do our best to assess each situation individually and secure our lending position with enough protective equity that we feel will protect our investors if we have to take this borrower through the foreclosure process, which includes eviction, remodeling, marketing, and the resale of the property to get our investors paid back. We analyze each lending situation separately, doing out best to provide our investors with an adequate equity cushion to withstand a borrower default foreclosure “fight,” and/or a turn in the real estate market.
How are our loans secured? We record a Deed of Trust, whether that be a 1st TD, 2nd TD, or sometimes a 3rd TD, against the property and we get title insurance which insures the lien position on the property. We will lend at higher LTV’s on a 1st TD, than CLTV’s on 2nds, and 3rds. However, we make a lot of 2nds and some 3rds, when we feel there is ample protective equity for our investors. We service our own loans and have an excellent team of well-versed employees staying on top of the borrowers to make their payments, pay their property taxes and hazard insurance on time, and to maintain their properties. We have the power of foreclosure as our best tool to perfect these loans in the event of some form or default (i.e., they stop payments, they stop paying taxes, they stop paying their hazard insurance, or they don’t maintain their property, etc.).
Most of our loans are fractionalized, which means we have multiple investors owning each loan. On a $500,000 loan, we might put 5-8 investors with varying investments in the loan. Investors take a “tenants In Common” pro rata share of each TD. We service these loans in house and handle all issues with the loan file and borrowers. Most of our loans have monthly payments, which we collect from the borrower, and once they clear the account, we pay out the investors share of these payments after deducting our loan servicing fee. The investors sign loan servicing agreements with us on each loan. We also collect and disburse payoffs to our investors when a borrower sells or refinances their property.
Note that there are two types of private money loans, business purpose, and consumer purpose. We do both at Residential First Capital. The determining factor as to which type of loan you have is the “main purpose” of the loan. If the “main purpose” of the loan is for business purpose use, we can be much more flexible on our loan terms and underwriting. However, if the “main purpose” of a loan is for consumer purposes, the regulators put certain restrictions on consumer purpose loans, such as rate/fee caps, qualifying restrictions, loan impound account restrictions, and they do not allow prepayment penalties or balloon payments on these loans.
An example of a typical private money loan would be: A flipper comes to us and wants to buy a home to flip. We lend him up to 65% of the lower of his purchase price or our appraised value. We make him a 2- year loan, to give him plenty of time to complete the remodel, market, and sell the home. We put a 3- month prepayment penalty in the loan, meaning the borrower needs to make at least 3 payments to us before he pays us off without penalty. The borrower will typically make us interest only payments. We typically charge a 1.25% servicing fee, so if the rate is 10.0% on the note, our investors earn a net rate of 8.75% annually until their loan is paid back.
Private money loans, if properly underwritten and structured, can be excellent investments for private investors, as they provide a solid return with strong collateral backing it. We have been investing and servicing for decades now.
Ken Thayer, Presidential for Residential First Capital
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