Did You Know About These 4 Biggest Risks Of Using Private Money?

For real estate investors looking to maximize their return on investments, the use of private money loans can be a great option but it’s important to make sure you understand the risks involved. 

In this blog post, we’ll take a look at four of the biggest potential risks associated with using private money for your next real estate investment project so that you can protect yourself from these potential dangers. 

1. Scam and fraud exists on private lenders

While there are many honest and reliable private lenders available, there are also scammers that prey on real estate investors who don’t carefully investigate their loan options. When faced with an opportunity from a private lender who offers seemingly great terms, real estate investors need to do the research and make sure they know who they’re transacting with. 

Also, because private lenders tend to do smaller operations (even compared to local credit unions), they are less prone to regulatory scrutiny. While nearly all reputable private lenders operate according to industry best practices, always conduct your own due diligence. A case of fraud can be happening anywhere where a large amount of money is involved.

What you can do:

• Research both the name under which the lender services the loan and the name under which the lender vests the loan. 
• Ask for references and speak with borrowers that the lender is now servicing or for whom the lender has packaged loans.
• Review your loan terms carefully and where possible have them reviewed by a real estate attorney who is familiar with private and private money lenders. 
• Know your federal and state rights when it comes to mortgage and loan practices to ensure you are treated correctly and know what recourse you have if something goes wrong.
• Research on the internet or county courthouse to see how many properties that lender has foreclosed upon, avoiding lenders with many foreclosures. High foreclosure rates may mean unscrupulous lending practices or a miniscule threshold of patience for delinquent payments.
• Search on the internet for more potential reputable lenders for an extra layer of reassurance.

2. You may agree to a loan you can’t afford.

Banks will take a close look at many factors that will impact your ability to repay a loan: income stability (the kind of work you do and how steady your paycheck is) reported income, credit score and even lifestyle via your bank statements. One of the largest factors among these is your debt to income:  how much money you owe on everything from vehicles to credit cards, mortgages and student loans in relation to your monthly income.

Private lenders are often less stringent, which means you can get more money even though you may not be able to repay it. Know your exact budget and limits, considering everything from your outstanding debt to the lifestyle you spend money to afford.

3. You didn’t review and/or understand the loan terms.

Private lenders will often move heaven and earth to help you close a deal if they can make it work. But it will be on their terms, and the higher the risk, the more terms you’ll need to meet. 

Beyond that, the nature of private money lending is that it is usually for business purposes and therefore does not have the consumer protection guidelines you’re accustomed to when obtaining a residential owner-occupied loan.

Always obtain counsel to review your loan documents and assist you in negotiating your transactions.

There’s not necessarily anything wrong or bad about this but it’s your responsibility to understand what you’re getting into. Unlike banks, private lenders don’t have industry-standard, cookie-cutter loan terms.

Check to make sure:

• You are prepared to make the balloon payment according to the terms. In order to keep your regular payments where you need them (especially if you’re using your available cash for a rehab or flip), the lender may add a large balloon payment at the end of the loan.
• You understand how quickly foreclosure can progress. While a bank may wait 60 to 90 days or longer to foreclose and have other payment plans available to keep you in ownership, private money lenders may foreclose after 30 days , especially if your loan is secured through a trust deed.
• You know what non-monetary covenants you must maintain. You may be able to afford the payment but will also likely be required to maintain several different ratios (e.g. debt service coverage) and follow additional practices as covenants to your loan.  If you are in default of these covenants, even if you are making your payment, you may go into foreclosure or convert your loan to an unlimited personal guarantee. If the covenants are mandatory, negotiate generous cure times or non-foreclosure provisions.
• Loan rates and fees haven’t changed to something you can’t pay. Until your transaction closes, don’t be surprised if there are a few changes.  This has less to do with the private money lender’s integrity and more to do with the fact that the lender is often funding your loan through individual private investors.  If the deal is quoted with one private investor and that investor backs out, the next investor may or may not agree to the same loan terms.
• You are prepared to make a personal guarantee. Personal guarantees are standard in the business, but you should be aware that you may be risking more than the collateral secured by the loan. Review all documents with competent counsel and know what you are signing.  Most private money loans do not come with the same protections as consumer owner-occupant loans do.

4. Your real estate financing can fall apart at the last minute.

Private money loan deals can fall apart more easily than can bank loans. While banks are lending their depositors’ funds which are readily available, real estate private money lenders are often at the mercy of one or more private investors.

Why could this happen?

• A private investor may commit to the fund and then back out at the last minute for reasons that have nothing to do with your transaction or the private lender (e.g. an illness, death in the family, change of heart, etc.).
• Many lenders – especially those using their own money to finance deals – will rely on cash flow from another deal to leverage into the next. If something goes wrong, it could pull the funds away from your transaction through the fault or issue of another borrower.
• Factors like a higher-than-expected payoff can throw off real estate private lenders calculations and make your loan no longer a good bet.

Conclusion

Now that you understand the four main risks of using private money, it’s time to take action. The best way to protect yourself from these risks is to work with a team of experts who can help you navigate the world of real estate investing. That’s where RE Investor News comes in. So give us a call today, and let us help you achieve success in your real estate endeavors.

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