1. “Bad egg” private lenders do exist.
Because private lenders tend to be smaller operations (even compared to local credit unions), they are less prone to regulatory scrutiny. While nearly all private lenders operate according to industry best practices, always conduct your own due diligence. Research is the key to alleviating the biggest (although rare) risks of hard money. You’ll need to 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 currently servicing.
- Review your loan terms carefully. Where possible, have a real estate attorney who is familiar with private lenders review them also.
- Know your federal and state rights when it comes to your loan type to ensure you understand what recourse you have if something goes wrong.
- Research on the internet or at the county courthouse to see how many properties that lender has foreclosed on. Avoid lenders with many foreclosures. High foreclosure rates may mean unscrupulous lending practices or a miniscule threshold of patience for delinquent payments.
- Search our directory to source potential lenders for an extra layer of reassurance. (Although PMLG is never a replacement for your own due diligence.)
2. You may agree to a loan you can’t afford.
Another risk of private money is a lack of safeguards: lenders trust that you know how much you can afford. Banks will take a close look at many factors that will impact your ability to repay a loan. This includes income stability, reported income, credit score, and even lifestyle via your bank statements. One of the largest factors among these is your debt to income. Debt to income is 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 on these factors. This 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 (read: profitable) – you get much more flexibility and a personal touch. But it will be on their terms, and the higher the risk, the higher (and more) terms you’ll need to meet.
Beyond that, the nature of private money lending is that it is usually for business purposes. This means it’s not subject to many consumer protection guidelines, unlike 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 (see risks to lenders for a better understanding), 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.
To avoid loan term risks of hard money, check to make sure:
- You are able to make the balloon payment according to the terms. In order to keep your payments where you need them (especially if you’re using available cash for rehab), 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 to foreclose, private money lenders may foreclose after 30 days. This is especially true 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 also need to maintain several different ratios (e.g. debt service coverage) and follow additional practices. Your payments may be current, but if you are in default of these covenants you may go into foreclosure. Defaulting on covenants can also 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 is because private lenders often fund loans through individual private investors. If you receive a quote from one private investor and that investor backs out, the next investor may or may not agree to the same loan terms.
- You are ready to make a personal guarantee. Personal guarantees are standard in private lending. However, 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. Financing can fall apart at the last minute.
Hard money loan deals can fall apart more easily than can bank loans. While banks lend their depositors’ funds which are readily available, private money lenders are often at the mercy of one or more private investors. This risk of using hard money is often in neither yours nor the lender’s control. When working with a lender for the first time, you should know where the money comes from, and ask what happens if that source falls through. Here are a few main reasons financing may fall apart:
- A private investor may commit to the loan and then back out at the last minute. Often, it has nothing to do with your transaction or the private lender (e.g. an illness, death in the family, change of heart, etc.).
- Beyond that, 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 an issue with another borrower.
- Finally, private lenders are generally walking a thin line on profitability; factors like a higher-than-expected payoff can throw off their calculations and make your loan no longer a good bet.
